Managing finance 

1.0 Introduction of Agency Relationship

            Agency relationship is an arrangement where one entity hires another entity to work on behalf of it. Agency relationship involves between two parties, one is principal and another is agent. This relationship arises when one or more individuals (known as principal) appoints another individual (known as agent) to complete some service and delegate the decision making authority to that agent. In addition, agency relationship is a fiduciary relationship that means it based on the trust and confidence where the principal delegates the authority and funds to the agent. It is also known as principal –agent relationship. However, in a large corporation, there is separation of management and ownership. It means those who are the owners don’t participate to manage the firms and those who manage the firms are not the owners. As we know, shareholders are the owners of the large corporations. Therefore, shareholders employ the managers to work on behalf of them where shareholders are the principal and mangers are the agent. Usually shareholders employ professionals who have technical skills, knowledge and experience so that the can work to protect the best interest of the shareholders. But mangers might take actions which are not in the best interest of shareholders For example, Nasser works on behalf of Rami. Nasser contracts with Raza to purchases 500 football. Unfortunately, Raza are not able to pay 200 football bill after delivering the product. Rami can legally responsible for Raza’s bill although the business was made by Nasser. So, here Nasser legally not responsible for this since Nasser works as agent of Rami.

2.0 Agency problem

            In the relationship of management and shareholder, there is a possibility of conflicts to interest between the principle and the agent called agency problem which actually occurs in finance. An agency problems occurs when the shareholder gives to manager (agent) to look after the company, the manager may look to their own needs first. However, if in a company employs want to earn more profit by using false accounting report, the owners will loss. Enron is a well-known organization, in 2001 this organization was lost a large amount of dollars due to personal needs of employs. On Dec. 2, 2001, Enron declared bankruptcy. Thousands of people were thrown out of work, and thousands of investors - including most of the company's employees - lost billions of dollars as Enron's shares shrank to penny-stock levels (Edmonds, P. 2015).   As from example of Enron, in 2001, the collapse of energy giant Enron indicated how catastrophic the agency problem can be when the company’s officers and governing body, including Chairman Kenneth Lay, CEO Jeffrey Skilling and CFO Andy Fastow, were offering their Enron stock at higher price because of accounting reports that made the stock appear to be more significant than it really was. After the embarrassment was revealed, a considerable number shareholders lost a large amount of dollars as Enron share value plummeted.

Another agency problem occur when financial analysts invest to best interest of their customer. A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. A collateralized debt obligation (CDO) is so-called because the pooled assets – such as mortgages, bonds and loans – are essentially debt obligations that serve as collateral for the CDO (Staff, I. 2003). Thereof, Goldman Sachs is better example of regarding this problem. Goldman Sachs and other stock brokerage firms established mortgage-backed securities, the mortgages would suffer foreclosures. As from example of Goldman Sachs and the real estate bubble made short-term sellers. At the point when the housing bubble hit in 2008, the estimations of the CDO's dropped and the short-sellers made a huge number of dollars. In the meantime, a huge number of investors and property holders lost nearly everything in the collapse.

3.0 Agency costs

            Agency costs are internal costs incurred from asymmetric information or conflicts of interest between principals and agents in an organization (Wilkinson, J.2013). It refers the owner of the company want manager to run the company in order to increase share value of shareholder, the manager may look at own benefit even though market value of the company is low which stated agency cost. However, in a large corporation, two types of agency costs forms are direct agency cost and indirect agency cost. The direct agency cost refers the suboptimal decision are made by managers in order to grow own benefit of managers either market value high or low of the company. In a corporation, have three direct agency costs are monitoring costs and bonding costs and corporate expenditure. For example, the manager try to avoid those project have high risk and there is possibility of outcome is negative.

3.1 Direct costs

3.1.1 Monitoring costs

            It is another agency costs which costs are allowed by shareholder to monitor or restriction action of manager. As Jensen and Meckling (1976) states that “Monitoring costs are expenditures paid by the principal to measure, observe and control an agent’s behavior. They may include the cost of audits, writing executive compensation contracts and ultimately the cost of firing managers” the cost of the monitoring will be paid by the owner although the compensation occur by agent.  For example, if a board of director at a company acts behave of shareholder to monitor the management activities in order to increase the shareholder value. The costs of having consider as monitoring costs. However, monitoring will able to prevent more obvious agency cost like Parks. It can confirm that managers are putting adequate time for the occupation. Be that as it may, monitoring for controlling to diminish the monitoring costs by managers needs time and money. In spite of the fact that a percentage of the monitoring are beneficial, yet some of them is soon come as far as possible when an additional dollar spent of monitoring would not give back an additional dollar worth from reduced agency cost .

3.1.2 Bounding costs

            This will be issued to ensure that manager’s activity will not hurt shareholders wealth and to guarantee that the principal will be compensated in case of manager harmful by such activities. Bonding cost is borne by the agent which is included misdemeanor, contractual obligation on the power, limitation on profitable opportunities to take full advantage. In most of the agency relationship the agent will bring about positive monitoring and bonding costs, i.e., financial and in addition non-monetary, and edition. However, there will be some difference decision between the principle and the agent that the decision would expand the welfare of principle. For example, if a manager agree to stay with a company in order to run the company behave of shareholder. The managers have to forgo other potential opportunities are considered as bonding costs. Denis (2001) argues that optimal bonding contact must look at best interest of shareholder in order to take all decision by managers. Moreover, since managers cannot made to do everything that shareholder would wish to do. But bonding gives a method for making managers do a portion of the things that shareholders would like by composing a not as much as perfect contract.

3.1.3 Corporate expenditure

            It refers the costs is shareholder but management takes benefit. This cost bone by shareholder. In a corporation, management works behave of shareholder to manage the company in terms of increase the share value of company. Corporate expenditure raises those costs which is more expensive and is not important to buy for the company. Assume, the company purchases new luxuries jet which is not needed for the company but the management will take this advantages.   

3.2 Indirect costs

3.2.1 Loss of opportunity

            It refers despite the investment is favorable for company, the managers not agree to take this investment for their self-interest. As we know business means risk. If the company doesn’t take a risk to invest, the company will not able to run their business and the share value of the company will not increase. However, if a company wish to invest new share. The new investment is expecting to favorable impact for the share value, besides that also have some risky for the firm. The owners of the company wish to take this investment in order to rise the share value. The manager may not wish to take this decision because there is a possibility of negative outcome. The managers will not make this investment due to loss their job if the outcome is negative. In this case, the company may lose a valuable opportunity.

4.0 Remedies to reduce the agency problem

            Conflict of interest is one of the major problem in public listed companies due to separation of their management and ownership. Generally it arises when there is a difference between shareholders and management goals. The difference of the goals may affect the performance of the company. Therefore, it is obligatory for the companies to resolve this conflict. However, the remedies of conflict of interest are discussed below-

4.1 Managerial Compensation

            Managerial compensation is one of the way of reducing the conflict of interest between the management and shareholders. If the company provide enough remuneration and facilities to the managers it can reduce the conflict of interest. However, compensation can be in the form of shares instead of remuneration which may be the effective way of resolving conflict of interest.

1)      Executive Share Option Scheme: This is a performance based scheme by which managers can buy the shares of the company in the future date where the prices are determined now. This scheme inspire the mangers to work in such way that will push up the price of shares at future time. When the mangers works to rise the share price, it increase the company performance that may result a high profit for the company which is main goal of the shareholders. But this scheme may not be beneficial for the company.

2)      Performance shares: A kind of shares given to the managers that are connected with the company performance and the performance of the company depends on the earning per shares, return on capital, return on equity. When the EPS, ROE increase the price of the performance shares increase. These kind of shares motivate the managers to work on behalf of the company in order increase their share price.

Furthermore the conflict of interest can be reduced by taking two extreme position regarding the top managers of the company.

1)      Threat of dismissal: Companies can threat to the top managers that if the company make a bad performance they will be cut off. But this process is not very effective for large companies where the ownership and the management are highly dispersed.

2)      Exposure to take-over Bid: When the performance of the company is bad, and the share is consequently undervalued it may be exposed to hostile takeover bid.  Which may affect the top manager’s jobs. The tendency of hostile takeover bid motivates by other companies motivates the managers to take their actions in such way which can maximizes the share price.

4.2 Corporate governance

            Companies can reduce the conflict of interest by establishing good corporate governance within the organization. According to Dayton (1948) corporate governance as the process, structures and relationships through which board of directors oversee what the executive do to achieve the objective of the company. The main objective to have a good corporate governance to ensure that all the activities of the organization are in line with the interest of shareholders. A corporate governance do the following in order to resolve the conflict of interest.

1)      It establish a culture in which Directors will give priority to protect the shareholders best interest.

2)      It analyzes corporate audit regulations, corporate disclosure framework to improve the accountability and transparency of companies, compliance to statutory regulation, best ethical practice, and consumer protection and so on.

3)      It ensures that the audit committee assists the board of directors to make the financial statements accurate and transparent ensuring compliance with the legal and regulatory requirements, and the efficiency of the company’s internal audit functions.

4)      It ensures the creditability of companies, and the existence of managerial system which promotes creative entrepreneurship.

5)      It increase corporate value by ensuring transparency and efficiency.

6)      It allows the board of directors to observe management activities by implementing policies.

7)      It ensure the reward of those who provide finance to the Companies.