A Referential Guide To Agency Cost Example : An Overview

An agency cost is a type of internal company expense, which comes from the actions of an agent acting on behalf of a principal.

This blog post will go over agency cost example in detail and various aspects surrounding it:

Agency Cost :

Agency cost is the difference between the return an agent could earn on behalf of a principal and what the agent actually earns.

In other words, agency cost is the amount of money that is wasted due to the agency relationship.

Shareholders may desire management to run the firm in a particular manner, which is known as shareholder value.

The management, on the other hand, could look for other ways to grow the company that might potentially go against shareholders' best interests. As a result, agency costs would be incurred by shareholders.

The Principal-Agent Relationship:

The agency relationship is one that exists between two separate entities, which are known as the principal and agent.

One of these parties may be a business owner who hires someone to run their operations for them or an outside company hired by another firm .

Hiring sales people, for instance, may be one of the costs of doing business. In making decisions about how to maximize value for shareholders, management of the agency would act on their behalf.

Shareholders are considered principals because they own the business assets while management is acting as agents on behalf of shareholders.

Agency Cost Example:

1) Executive Compensation:

One agency cost example is executive compensation. Executives are hired by the company to make decisions that will benefit shareholders.

However, their pay packages may be set up in a way that incentivizes them to make choices that might not necessarily align with what shareholders want.

This could lead to agency costs as executives would receive higher payouts despite making bad decisions .

The use of options and restricted stock grants is one approach corporations try to reconcile the interests of executives with those of shareholders.

However, if they aren't structured correctly, these strategies might still result in agency costs.

2) Agency Costs and Diversification:

Another agency cost example is agency costs related to the diversification of a business.

If management takes on too many projects, it might become difficult for them to be effective in all these areas .

For example, if they are attempting to manage several divisions at the same time, there may be a staffing issue because of scheduling difficulties.

3) Risky Projects:

Agency costs could also come from risky projects. If management initiates a new project that has the potential for high returns, but is very risky, it might not be worth pursuing .

If shareholders are on the hook for any losses incurred through this agency cost example , then they would have made poor value-maximizing decisions with their money.

On the other hand, if executives take risks and fail while still getting paid handsomely, agency costs result again.

This becomes an issue because of moral hazard where agents tend to act differently when there is no chance of them bearing risk themselves .

4) Agency Costs and Incentives:

Agency costs could also occur due to agency problems related to incentives.

In some cases, managers may not have enough information or access to the right data that they need in order to make good decisions .

This agency cost example is a result of principal-agent problem as well because shareholders are unable to receive accurate reports from management on what's going on at their company.

As a result, they might be paying more than necessary for agency costs.

5) Corporate Culture:

Agency cost example is the company's culture. Agency costs can be present when a firm has a strong corporate culture that employees feel they need to adhere to .

This could lead to them making decisions that might not be in their best interests, but are instead what the company wants.

There are many other agency cost examples, such as those related to debt financing and organizational design.

6) Debt Financing:

Agency costs may be present when companies use debt financing.

This agency cost example happens because shareholders are on the hook for lenders if management makes poor decisions that lead to default .

From this perspective, agency problems arise again since they don't have any incentive to act in their best interests, but instead choose what is easiest or most profitable for them.

The more cash a firm borrows by issuing bonds, the more likely it is to experience moral hazard concerns, in which agents take risks without accepting responsibility for them.

Another agency cost example related to debt financing occurs when firms do not pay off loans plus interest .

How to reduce Agency Costs:

• Executive Pay:

One way to reduce agency costs is through the use of executive pay.

In order to align the interests of shareholders and executives, firms often try to structure their pay packages in a way that will minimize agency costs .

However, there are many ways this can go wrong and agency costs still might be present.

• Monitoring:

Another way to reduce agency costs is through monitoring.

Firms often try to monitor their employees so they are able to investigate any agency cost example that might have happened at the firm .

If this isn't done properly, then it could result in agency costs once again because management has no control over what's going on inside of their company.

The more cash a firm borrows by issuing bonds, the more likely it is to experience moral hazard concerns, in which agents take risks without accepting responsibility for them.

• Incentives:

Incentives can also be used to reduce agency costs. It's common for firms to use incentives when they want their employees to make decisions that will help the company in some way .

However, there are many ways this agency cost example could go wrong if it isn't done correctly and agency problems still exist

Conclusion:

Agency costs are a major issue in business, and agency cost example is something that companies need to be aware of.

It's critical for businesses to track their workers' behaviors, provide incentives when required, and structure executive pay packages correctly in order to minimize agency costs or difficulties in general.

If they do this successfully, agency costs will be minimized and agency problems won't occur at their firms.