Jenson and Meckling (1976) define agency theory as a relationship between the contractor and another party (the agent) in which the contractor will delegate some decisions to the agent. In this relationship, the contractor will hire an agent to perform a specific task given to them. For instance, in partnerships, the principals are the investors of an organization, assigning to the specialist i.e. the administration of the organization, to perform errands for their sake.
Assumptions on Agency theory
There are three assumptions on agency theory that are related to human behaviour they are humans have bounded rationality which means that there are breaking points to what individuals know. The second one is humans are selfish which implies that individuals put their own needs before other individuals. The final assumption is humans will always seek to maximise their own utility such as wealth and health over other individuals.
Agency costs are costs that are internal that must be paid to, an agent following up for the benefit of a principle. After given the assumptions by the agency theory the interests between the contractor and the agent are divergent, this leads to agency cost being incurred. These are Monitoring costs by the principal which indicates whether individuals are performing very well. The second one is Bonding costs by the agent which indicates whether the individual is reporting back to the principals to demonstrate performing. The final one is Residual Loss is the decline in the value of the firm that emerges when the manager reduces his rights. William (1988) suggest that this is the key cost; however, the other two are brought are only occurred when they yield financially decreases in the residual loss.
For example, when an agent demonstrations reliably with the principals’ interests, agency loss is nothing. The more an agency pay attention to the principles interests, the more agency loss increases. Therefore, the agency should focus more on ideas created by them instead of taking note from the principle, then agency loss becomes high.
Agency issues arise because of the disagreement or dissociate of attention between the contractor and the agent. Agency problem in finance has occurred when there is conflict between the manager and the shareholders in the business. There are different types of an agency relationship in finance for instance managers and shareholders. Managers employ experts (supervisors) who have specialized aptitudes. Managers may take actions, which are not to the greatest advantage of shareholders. This is generally when the managers are not the owner of the property i.e. they don’t have any shareholding. The involvement of the managers will be in conflict with the interest of the owners. Murphey (1985) argues that managers tend to build the extent of organizations regardless of whether it hurts the interests of investors, as regularly their compensation and distinction have decidedly corresponded with organization measure. Therefore, this causes conflict between the manager, who tend to esteem development, and investors, who are orientated towards the boost of the estimation of their offers.
The agency problem in the corporation
According to Smith (1776) the executives of such like joint stock in organizations, in any case, being the managers of other individuals’ cash than their own, can’t be very much expected that they should watch over it with a similar watchfulness with which the accomplices in a private co-partner as often as possible watch over their own.
The organisation in agency theory
Jenson and Meckling (1976) suggested that organisations just legitimate fictions which fill in as a nexus for an arrangement of contracting connections among people.
The role of the board of directors:
Garrat (1997) defines the function of the board directors as Monitor and control managers and CEO.
Board of directors regularly has power more than one board. Executives are additionally known to have a few duties and regularly clashing necessities. They have time requirements, what’s more, subsequently need to precisely deal with their endeavours for most extreme outcomes. The main purpose that tests the capability of a board is that of observing and control of the presidents and their execution. The more noteworthy the level of observing, the more prominent the likelihood of achievement or upgraded budgetary execution
In agency theory, there are two contracts they are outcome-based contracts and behaviourally based contracts. These are some of the propositions for Outcome-based contracts vs Behavioural based contract:
· When there is a contract between the principal and the agent then this is known as outcome-based, the agent will behave most likely in the interest of the principle.
· When the principle has information regarding the behaviour of the agent, then the agent is most likely to behave in the interests of the principle.
· Information systems are identified positively to behaviourally based contracts and outcome-based- contracts are identified as negatively.
· Agency relationship is identified as positively connected to behaviour-based contracts. Whereas, outcome-based contracts are identified as negatively connected.
Agency theory and executive compensation
Principal-agent model is the standard economic theory for executive compensation. The theory supports that organizations look to plan the most effective compensation packages in order to attract, retrain, and motivate CEOs, executives, and managers. Shareholders in the agency model are set to pay. Nevertheless, in practice, the compensation agency of the board decides to pay for the benefit of shareholders. A principal who is known as shareholder plans agreement and makes a deal with the agent (CEO/manager). Executive compensation improves an ethical peril issue such as manager opportunism emerging from low firm rights. By utilizing investment opportunities, confined stock, and long-haul contracts, shareholders encourage the CEO to boost firm esteem. In other words, shareholders will try to plan optimal compensation bundles to deliver CEO with motivating forces to adjust their common advantages. This is the agreement way to deal with executive pay.