Saturday, May 23, 2009

Agency Theory

Posted on 3:08 AM by Mirza Muhammad Qayyum Baig

Agency Theory:
Probes the relationship between principals and agents. Principals appoint agents to get the work done. The goals of principals usually differ from those of agents. This gives rise to the agency problem.

For example, advertisers (principals) tend to emphasize sales goals and the cost­-effectiveness of marketing communications, whereas advertising agencies may be more inclined to think of creative goals and attention­-getting commercials. Professors of top Business Schools would like to spend most of their time doing research and consultancy. But the owners expect these professors to spend more time with students both in the classroom and outside. Agency theory is a key concept in corporate governance. Professional managers often pursue strategies that increase their personal payoffs at the expense of shareholders. For example, they may grant themselves lavish perquisites including elegant corner offices, corporate jets, large staffs, and extravagant retirement programs. Managers also often tend to pursue growth at the cost of profitability. Shareholders generally want to maximize earnings, as it results in stock appreciation. Since managers are typically compensated more for sales than earnings growth, they tend to be enthusiastic about strategies like mergers and acquisitions even when this enthusiasm is not really justified. Managers may also pursue diversification opportunities that are not necessarily in line with the company’s best interests. In other cases, managers may become complacent and allow things to drift. They may avoid risk since they feel they are more likely to be fired for failure, than for mediocre performance. Executives may be far less entrepreneurial than they should be. They may not make the bold moves that the situation demands. One way to tackle the agency problem is to align the interests of managers with those of owners by using appropriate incentives such as stock option and executive bonus plans. But ironically enough, these schemes may also tempt managers to act against the best interests of the firm. For example, they may manipulate the financial statements to increase earnings artificially.
Application of Agency Theory:
  • Risk Management
  • Supply Chain Management
  • Incentive Management
  • Logistics Management

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