agency costs meaning

As such, he brought a successful action in minority oppression in order to force the payment of dividends by the Ford Motor Co. Mr Dodge’s inability to receive a dividend without litigation is another example of agency cost. In cases where the shareholders become particularly distressed with the actions of a company’s top brass, an attempt to elect different members to the board of directors may occur.

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The management may face difficulties in seizing profitable investment opportunities quickly. Additionally, a significant purge of shares could potentially spook potential new investors from taking positions, thus causing a chain reaction, which could depress stock prices even further. The firm pays to obtain a fidelity bond from a third-party bonding company to the effect that the latter will compensate the former up to a specified amount for financial losses caused by dishonest acts of managers. To exercise the major shareholders’ legal voting rights, the large institutional shareholders communicate with and exert pressure on corporate management to perform or face replacement. An agency problem is a potential conflict of interest that can arise between a principal and an agent. This article contains general legal information but does not constitute professional legal advice for your particular situation.

What is the difference between direct and indirect agency costs? Give an example of each.

Furthermore, an agent may commit to contractual obligations that limit or restrict the agent’s activity. For example, a manager may agree to stay with a company even if the company is acquired. In Enron’s collapse it also took down its accounting counterpart firm, Arthur Andersen, who were certifying Enron’s books to be clean, when they very obviously weren’t.

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Shareholders and managers often find themselves in disagreement about the best moves a company can make, and this is known as the “agency problem.” Costs stemming from agency problems are agency costs. Principal-agent problems occur when the interests of the principal and agent are not aligned. Agency costs are further subdivided into direct and indirect agency costs.

What Are Agency Costs?

Whilst in theory the concept was sound, it meant that Enron’s management could now deceive the markets for their own monetary gain, and they did just that. Higher management decided to take on high debt and risky activities, leaving these transactions ‘off the books’ and essentially meaning Enron was falsifying information. Enron had reached the point where it was overstating profits by $1.2 billion and eventually lead to its collapse. Such costs result from the inability of large companies to respond to new opportunities.

  • The first type of agency cost is when managers use resources to further their own goals—at the expense of shareholders’ goals (like when a manager books a luxurious hotel room during a business trip).
  • When the top management books the most expensive place or requests extra hotel upgrades while travelling, agency costs are incurred.
  • While they may feel justified, a manager who acts in opposition to shareholders’ wishes creates agency costs.
  • Thus, managers have a strong incentive to take actions that maximize stock prices and possibly to avoid taking over.
  • Stockholders on the other hand have an interest in taking on more risk.

For example, agency costs are incurred when the senior management team, when traveling, unnecessarily books the most expensive hotel or orders unnecessary hotel upgrades. The cost of such actions increases the operating cost of the company while providing no added benefit or value to shareholders. However, the principal-agent relationship may also refer to other pairs of connected parties with similar power characteristics. For example, the relationship between politicians (the agents), and the voters (the principals) can result in agency costs.

Financial Management: Overview and Role and Responsibilities

When these conflicts occur between an agent and principal, it is known as the agency problem. When the top management books the most expensive place or requests extra hotel upgrades while travelling, agency costs are incurred. Such activities cost the company more to operate while offering shareholders no additional advantages or benefits.

However, it only applies when those decisions go against the shareholders’ interests. Usually, it occurs when agents don’t fully represent the best interest of principals. Sometimes, this misrepresentation may exist because agents don’t understand what those interests are. In other circumstances, they may have their personal interests in mind, which go against the principal’s best interests. When a principal appoints an agent to act on their behalf, they expect their best interests to be critical.

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Enron, a U.S. energy giant operated for decades trading large and highly demanded commodities. However, 2001 saw the fall of the giant as a result of poor management, and a deeply rooted principal-agent problem. To save content items to your account,
please confirm that you agree to abide by our usage policies. If this is the first time agency costs meaning you use this feature, you will be asked to authorise Cambridge Core to connect with your account. The CEOs or other top executives can be forced out of office due to the company’s poor performance. The agency problem can arise from business corporations, partnerships, finance, marketing, planning, and other business operations.

agency costs meaning

Who pays agency costs?

Agency costs are costs incurred by shareholders as a result of disputes between owners and managers. Managers who spend resources on ventures that are profitable for them but not shareholders are one type of agency cost.