Agency Costs and Financial Decision-Making

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Agency Costs and Financial Decision-Making

The Concept
An agency relationship is a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers and they may have divergent goals and objectives, and there is good reason to believe that the agent will not always act in the best interests of the principal (Jensen, Michael C., and William H. Meckling. "Theory of the Firm, Managerial Behavior, Agency Costs, and Ownership Structure." Journal of Financial Economics 3 (October 1976), 305-360)
The concept of agency cost recognizes there are …show more content…

By correctly identifying and addressing issues of agency cost, it is possible to minimize the influence of those factors, at least enough to allow the organization to continue moving forward, rather than running the risk of failure.
Determining the agency cost normally begins with looking closely at the potential costs or risks associated with including some type of agent or manager in the organizational structure. For example, one potential risk would be the possibility that the individual who is appointed as an officer in the company could seek to use company assets for his or her own personal gain, to the detriment of the company. At the same time, agency cost also looks at the expense involved in anticipating potential abuses of power and resources, and structuring the organization so that abuse is less likely to occur. This may include offering incentives to key employees that promote loyalty and lessen the chance of misappropriation of resources, or structuring the accounting process so that a series of checks and balances create a separation of control, effectively preventing any one individual from having too much power within the organization. (http://www.wisegeek.com/what-is-an-agency-cost.htm)
Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in

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