Agency Conflicts: An agency relationship arises whenever someone, called a principal, hires someone else called an agent, to perform some service, and the principal delegated decisions making authority to the agent.
In companies, the primary agency relationships are between:
1. Conflicts between stockholders and creditors
2. Conflicts between Inside Owner/Managers and outside owners
3. Conflicts between managers and shareholders
Conflicts between stockholders and creditors Conflict between shareholders and creditors is common for the company which use debt capital to form an optimum capital structure. As mentioned earlier, agency relation exist when one party works as an ...view middle of the document...
On expectations concerning future capital structure decision.
These are the primary determinants of the riskiness of a firm’s cash flows and hence its debt, so creditors base their required rates of return on these factors.
Now suppose the stockholders, acting through management, have the firm take on a large new project that has a greater risk than was anticipated by creditors. This increased risk will cause the required rate of return on the firm’s debt to increase, which in turn will cause the value of the outstanding debt to fall. If the risky capital investment is successful, all of the benefits will go to the firm’s stockholders, because creditors’ returns are fixed at the old, low-risk rate. However, if the project is unsuccessful, the bondholders will have to share in the losses.
Conflicts between Inside Owner/Managers and outside owners
If a company’s owner also runs the company, the owner/manager will presumably operate it so as to maximize his or her own welfare. This welfare obviously includes the increased wealth due to increasing the value of the company, but it also includes perquisites (or perks) such as more leisure time, luxurious offices, executive assistants, expense accounts, limousines, corporate jets, and generous retirement plans. However, if the owner/manager incorporates the business and then sells some of the stock to outsiders, a potential conflict of interest immediately arises. Notice that the value of the perquisites still accrues to the owner/manager, but the cost of the perquisites is now partially born by the outsiders. This might even induce the owner/manager to increase consumption of the perquisites because they are relatively less expensive now that the outsider is sharing their costs.
This agency problem caused outsiders to pay less for a share of the company and require a higher rate of return. This is exactly why dual class stock that doesn’t’ have voting rights has a lower price per share then voting stock.
Conflicts between managers and shareholders
While stockholders and business managers are primarily concerned with the profit performance of the business in which they are shareholders, they have inherent conflict of interests.
The dividends that stockholders receive and the value of their stock shares depend on the business’s profit performance. Managers’ jobs depend on living up to the business’s profit goals.
The conflicts between...