Lecture 2. The Principal –Agency Problem The modern organization is comprised of a number of stakeholders who have different interests. The Agency theory provides the framework for discussing the relationships that exist between the various interest groups within the organization. The organization is viewed as a composite unit with various interest groups pursuing their interests. Each interest group pursues its own interest and ensures that it is an advantageous position in relation with the organization. Each group however recognizes that its success is a function of the company vis-a vis other companies within the industry.

Agency Relationship It arises where one person or a group of persons called Principal appoints another called Agent to do some work on his/its behalf and gives him/it the appropriate decision-making authority. In strategic financial management such relationships occur among others, between: Shareholders and management and Creditors and shareholders It is natural that where such relationships exist there is bound to be conflict of interest which creates a problem known as Agency problem

Managers Vs Shareholders The reason behind the conflict is the separation of ownership and control. Some of the areas in which the conflict may arise are: (a). Choice of project appraisal techniques. In pursuit of self-interest managers may prefer projects that are short term as opposed to long-term. Therefore they prefer the use of payback method instead of Net Present Value. (b) Appraisal of risky projects Financial managers may not prefer projects which are risky but bringing in great benefit to shareholders because these may have negative impact of this risk on their own financial position. However, this risk presumably been diversified away by the shareholders.

(c) Gearing Managers may not prefer a high level of debt in the capital structure and therefore may not take advantage of tax deductions which may be beneficial to shareholders. Diversifying through acquisitions Managers are only prepared to diversify operations if only it will benefit them more than shareholders. To management it may lead to leadership changes which affect them. Takeover bids Managers may resist a compulsory takeover because of fear of losing their jobs yet it would bring in substantial benefit to shareholders.

(f) Leveraged buy-out Whereby management acquires ownership of the organization through buying all the ownership shares of existing shareholders. Managers may drive down the share price/ value of the company so that they buy the company at bargain prices. (g) Dividend Policy Management may pursue of a conservative dividend policy paying out very little to shareholders and ploughing back the earnings to the displeasure of shareholders. (h) Disclosure of information in the financial statements Managers may do “window dressing” or creative accounting painting a rosier situation in the financial statements than it is in reality. Disclosure may also influence the approvals/disaprovals of certain expenditures as required ny management.

(i) Ethics Management may practice certain unethical practices when dealing with the organization, customers, the public or the environment e.g pollution, c.f bank practices in Zimbabwe- buying bricks using depositors’ funds, conditional selling in some retail shops, corruption in the public sector, heft salaries and allowances

Possible Solutions Goal congruence Convergence of the interests of the various stakeholders such that the overall objective of the organization can be attained. Shareholders have to ensure goal congruence or management acts in the best interest of the organization. The following action may be taken to ensure that: Monitoring Shareholders may need to monitor the actions of management continuously. This however results in agency costs such as the costs of monitoring structures. (ii) Giving management ownership shares so that they become part –owners of the organisations.

Contd (iii) Giving management attractive salaries, allowances and pay packages such they see these as being a function of the success of the organization. (iv) Executive share schemes Performance based share scheme which allows management to buy shares of the company in the future at a price agreed now. This will push management to work hard so that the value and the share price of the organization goes up. They only benefit if the future share price is greater than the price they agreed to now. (v) Performance share schemes

(v) Performance share schemes Shares are given to top management and are linked to company performance as measures by the fundamentals- Return on capital employed (ROCE), Return on equity ( ROE), Earning per share (EPS). These are important for as long as they are not adversely affected by stock market fluctuations.

2. Creditors Vs Shareholders The agency problem of creditors and shareholders (with management as agents) arises in the following two situations: Capital Investments Creditors would not want to see the approval of risky projects since these may put their funds at risk if the project fails and alternatively, if the succeed shareholders would get greater benefit while they only get fixed interest. Also if they raise their interest rate the value of their outstanding debt would gone down. (b) Gearing Where the company increases its debt to level which more increases the financial risk to a level unexpected, the value of debt would fall because the asset backing and earning of existing debt would fall to accommodate new debt.

Solutions Built in solutions Shareholders try as much as possible not to exploit creditors since such action may attractive punitive interest rates, restrictive covenants and restrictive access to capital markets. Shareholders would therefore want to maintain cordial relationship with creditors as that would maximize their wealth.