What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.
In financial management, an agency relationship occurs when the manager seeks the services of an agent to run the firm`s daily operations or delegate critical decisions (Maï Django Wambé Thérèse, 2020). However, the delegation of roles does not give the agent full responsibility to some of the decisions made. More simply, an agency relationship denotes the agreement between a principal and an agent, where the agent agrees to work on behalf of the principal (Maï Django Wambé Thérèse, 2020). Agency relationships involve shareholders, investors, creditors, and managers. Since no external money was invested into the company, no agency conflicts would exist in this situation. At the same time, no agent was hired to act on behalf and delegate roles and decisions of the company.
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If you expanded and hired additional people to help you, might that give rise to agency problems?
Hiring more people would create agency problems. Employees are hired to perform different duties and partake in several responsibilities on behalf of the employer. Their actions and methods of operation are controlled by the employer (Marino, 2017). These actions include working conditions, contractual laws, and payment. This contractual partnership represents an agency relationship. Therefore, many agency problems surrounding employment and workplace conditions are bound to happen. Simultaneously, employees perceive that their employers generate much profit from the organization and only receive a small portion to repay their hard work. This scenario can lead to conflicts between them and the employer. Another conflict can arise when the owner sells part of the stock to outsiders (Maï Django Wambé Thérèse, 2020). As such, new top-level management is introduced into the company, creating room for more conflicts.
Suppose you need additional capital to expand, and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur?
When the owner sells a portion of the stock to outside investors to generate more capital, remaining as the biggest shareholder can create agency conflicts with other shareholders. The conflict between the owner and shareholders stems from biases and prejudice in the decision-making and running of the company (Maï Django Wambé Thérèse, 2020). The major shareholder, the owner, can make decisions or engage in projects that do not consider the interests of the shareholders (Marino, 2017). This type of conflict occurs when the goals and vision of the investors and the owner do not align.
Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs?
If the company opts to borrow money from outside lenders, then a conflict between the owner and lenders, who are the creditors, can occur. The company can decide to invest that money to finance a new project, a move that can prove rewarding or risky. As such, the project outcome can either be profitable or force the company into bankruptcy (Maï Django Wambé Thérèse, 2020). If profitable, all the profits are channeled to the shareholders. However, the creditors receive a fixed interest rate stipulated during the lending process.
On the other hand, if the project fails, the creditors are at a loss. Therefore, increased risk from the project will influence the increased debt rate of return. The company can be in a similar situation if it borrows money and then issues additional debt. The proceedings can be used to purchase outstanding stock. Such a move will significantly increase its financial leverage. The shareholders will also benefit from the increased leverage while the debt value will decrease due to the huge amount of assets to back up the debt.
References
Maï Django Wambé Thérèse. (2020). Ownership structure, agency relationship and dividend policy in unlisted Cameroonian companies. Journal of Modern Accounting and Auditing , 16 (5). https://doi.org/10.17265/1548-6583/2020.05.003
Marino, A. M. (2017). Firm specific human capital investment in an agency relationship. SSRN Electronic Journal . https://doi.org/10.2139/ssrn.2964983
