The agency problem is pervasive in our society. It is not just evident in business. It also exists in clubs, government agencies, churches, and many other types of organizations.

Types of Agency Problem:

The objective of management may differ from those of the firm’s stockholders. Stockholders want to maximize the wealth of the firm, but management wants to increase their personal benefits.

From this conflict of the proprietor and personal goals, wake what has been called the agency problem. Famous writer James C. Van Horne remarks on three types of agency problems in his book. “Financial Management and Policy.” Those problems are discussed below:

Stockholders versus manager:

In large businesses, separation of ownership and management is a practical necessity. Major corporations may have hundreds of thousands of shareholders. There is no path for all of them to be actively engaged in management. The breakage of ownership and management has clear advantages. It allows share ownership to shift without interfering with the operation of the business.

It allows the firm to rent professional managers. But it also brings problems if the managers may seek a more leisurely or luxurious working lifestyle. They may shun unpopular decisions, or they may attempt to build an empire with their shareholders’ money. Such conflicts between shareholders’ and managers’ objectives create agency problems.

Stockholders versus creditors:

In addition to the agency conflict between stockholders and managers, there is a second class of agency conflicts-those between creditors and stockholders. Creditors have the primary claim on part of the firm’s earnings in the form of interest and principal payments on the debt as well as a claim on the firm’s assets in the event of bankruptcy.

The stockholders, however, hold down control of the operating decisions (through the firm’s managers) that affect the firm’s cash flows and their corresponding risks. Creditors lend capital to the firm at rates that are arisen on the riskiness of the firm’s existing assets and on the firm’s existing capital structure of debt and equity financing, as well as on expectations regarding changes in the riskiness of these two variables.

The shareholders, acting through management, have an incentive to induce the firm to take on new projects that have a greater risk than was expected by the firm’s creditors. The increased risk will raise the required rate of return on the firm’s debt, which in turn will cause the value of the outstanding bonds to fall.

If the risky capital investment project is effective, all of the benefits will go to the firm’s stockholders. Because the bondholders, returns are fixed at the main low-risk rate. If the project fails, however, the bondholders are forced to share in losses. Such conflicts between shareholders and creditors create agency problems.

Stockholders versus other stakeholders:

Other stakeholders-employees, suppliers, customers, and communities-may have different agendas and may want to monitor the behavior of equity holders and management.

AS for example, owners want to pay inadequate salaries and allowances, but employees want to increase their salary and allowances to a sufficient level. Similarly, customers want to buy goods at low prices. But owners want to sell goods at a high price. Such conflicts between shareholders and other stakeholders create agency problems.