Question

What is an agency relationship? Explain how monitoring costs, bonding costs and residual loss arise in agency relationships. Why would managers' interests differ from those of shareholders?

Answer 1

An agency relationship is a relationship of trust between two or more persons where one person allows another person to act on his/her behalf. The person who gives this authority is known as the 'principal' whereas the person who is supposed to act on behalf of the principal is called the 'agent'. The agent has to act under the control and supervision of the principal and therefore must adhere to his/her instructions. Monitoring costs refers to the costs which are incurred to monitor the performance of the agent. It is the principal who initially bears such costs, however, the agent ultimately bear such costs. To facilitate this, agents have to establish structures to help themselves act in the best interests of the principal or compensate him in case of failure. The costs incurred to set up and adhere to these systems are called bonding costs. Despite of monitoring and bonding, there may be instances where the interest of the principal is unlikely to be completely aligned. As a result, there are some agency losses still arising due to conflicts of interest. Such loss is called residual loss. Managers' interests differ from those of shareholders because managers like to retain the profits whereas the shareholders want higher level of profits to be distributed in the form of dividend. Shareholders are concerned with the company's future cash flows for an indefinite period whereas the managers are concerned with company cash flows for their employment term. Managers tend to be more risk averse as compared to the shareholders, therefore, it is very unlikely that they will take any investment decision that will increase the risk of the company.