To reduce agency problems and contribute to the maximization of owners’ wealth, stockholders load agency costs. Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholders wealth rather than behaving in their own self-interests.
The notion of agency costs is perhaps most associated with a seminal 1976 Journal of Financial, Economics paper by Michael C. Jensen and William H. Meckling. Who suggested that corporate debt levels and management equity levels are both influenced by a wish to contain agency costs.
In absence of efforts by shareholders to alert managerial behavior. There will typically be some loss of shareholder wealth due to inappropriate managerial actions.
On the other hand, agency costs would be excessive if shareholders attempted to ensure that every managerial action conformed with shareholder interests.
Therefore, the optimal amount of costs to be borne by shareholders in determined in cost-benefit context-agency costs should be increased as a long as each incremental taka spent results in at least a take increase in shareholder wealth.
Types of Agency Costs:
Dealing with the agency problem is not free. Unfortunately, there is an agency cost associated with copping with the agency problem. There are four major types of agency costs: (i) monitoring, (ii) bonding, (iii) opportunity, and (iv) structuring.
(i) Monitoring expenditures:
Such expenditures relate to monitoring the activities of the management (agents) to prevent a satisfying in contrast to share price maximizing behavior by them.
Monitoring techniques include auditing financial statements, establishing budgets, establishing limits of expenditure, and explicitly limiting management decisions. Monitoring techniques are used to ensure that managerial behavior is tuned to actions that tend to be in the best interest of the shareholders.
(ii) Bonding expenditures:
They protect the owners against the potential consequences of dishonest acts by management/managers. The firm pays to achieve 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 corrupt acts of managers.
(iii) Opportunity costs:
Such costs result from the inability of large corporates from responding to new opportunities. Due to the organizational structure, decision hierarchy, and control mechanism, the management may face difficulties in seizing upon profitable investment opportunities quickly.
(iv) Structuring expenditure:
The most popular, powerful and expensive approach is to structure management compensation to correspond with share price maximization. The motive is to give managers incentives to act in the greatest interests of the owners.
In addition, the resulting compensation packages allow firms to compete for and hire the best manager available. The two key types of compensation plans are (a) incentive plans, and (b) performance plans.
- a) Incentive plans: These tend to tie management compensation to share price. The most exoteric incentive plan is the granting of stock options to management. These options approve managers to buying stock at the market price set at the time of the grant. If the market price increase, managers will be rewarded by being able to resell the shares at the upper market price.
- b) Performance plans: Many firms also offer performance plans. Which tie management compensation to measures such as earnings per share (EPS), growth in EPS, and other ratios of return. Performance share: Shares of stock given to management as a result of meeting the stated performance goals, are often used in these plans. Another form of performance-based compensation is cash bonuses, cash payments tied to the winning of particular performance goals.