Understanding Agency Cost in Organizations

This article explains the concept of agency cost in organizations, its types, and examples. It discusses the impact of agency cost on investors and how to mitigate it. The scenarios presented in the article provide a practical understanding of agency cost in different situations. The article also highlights the importance of monitoring, bonding, and opportunity costs in managing agency cost.

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Introduction
Agency cost can be defined as the costs incurred within the organization or a
compulsory payment to an agent who acts or represents the principal. Jensen & Meckling
(1976) the agency costs occurs due to issues such as conflict of interests, that is conflict
between the management and the shareholders where the shareholders want the management
to manage the company in a manner that raises their value and at the same time, the
management wishes to bring up the company in a manner that utilizes their power and
resources. this agency costs can be; monitoring costs which is incurred by the principal
during monitoring on the actions of the agent, bonding costs which is incurred by the agents
in the process of assuring the principal that they will act in the best interest of the principal
and finally the opportunity cost incurred in the process of evaluating and determining the best
alternative.
Scenario 1
In this scenario, the issue is having a dominant firm called Birim Equity with standing
shareholding of 48%. This firm is almost owning the firm by a half as compared to other
shareholders. The investor will be exposed to low agency costs, called the cost of
opportunistic behavior of Birim Equity which is seen to have its own hidden interest.
Bernanke & Gertler (1986 p. 79) the management is required to have a long-term contract
with their shareholders in order to maintain the reputation of the firm even if there is a threat
of another organization taking over the firm. In this case, the management of ABC Ltd is
facing a threat of Birim equity taking over the firm.
If Birim equity is separated from the firm, it means there will be a lot of cash outflow
since they own almost to 50% of the shares. This might lead to a liquidation problem where
the firm will luck cash to run the firm leading to the closure of the firm. If Birim equity

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remains, they will still be dominant and no cash will be lost. The only threat will be a
management problem which can be resolved by creating a strong bond with Birim equity and
other shareholders through long-term contracts so as to build its reputation with the investors.
Board of directors, in this case, can be used to close the gap that exists between the company
owners and the shareholders
Scenario 2
Talks of a graduate investing his 0.5 million in a listed company, having many
shareholders each having small shares. A listed firm is a firm that raises funds from the
general public. The actions of the shareholders are being monitored by the principle which is
the management. This graduate and other shareholders may want the management to report
the activities of their investment periodically through an accounting statement which have
been audited. All these activities require monitoring cost, therefore an investor will be
exposed to a medium agency cost called monitoring cost.
(Kim & Sorensen, 1986) Even though there are some benefits to a listed firm such as
tax allowance incurred by the government through listing in the stock exchange, acquire
material benefit from the firm and availability of information about competitors performance
from the stock exchange, the limitations are more risky for instance, confidential information
lost to the competitor and the public which might lead to a decrease in the share price, loss of
control due to many and new shareholders, low profit might lead to deregistration from the
stock exchange, and also they may be delays in decision making by the managers. This can
lead to some cast being lost. Proper auditing must always be conducted to ensure that the
shareholders can have access to their investment records on time.

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Scenario 3
This is about Tori a small time investor deciding to invest in Dada PLC having large
loans. It is very risky to this investor because this company might be declared bankrupt if
they fail to pay all their debts. Coffee, et al., (2018) the agency cost of debt incurred by the
investor will be high since the investor will want to favour the principle which in this case is
Dada PLC by contracting with its debtors. This cost can also be described as bonding cost
where the agent will want to induce the principal to depend on it. Delayed decision making
especially when the managers are the owners, and poor structure considering the fact that the
company is having large bank loans might be experienced. A proper balance of power is
required in this scenario in order to create clear defined roles and ensures that the
organization flexibility and also operational changes as well as new hires.

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Reference.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency
costs and ownership structure. Journal of financial economics, 3(4), 305-360.
Kim, W. S., & Sorensen, E. H. (1986). Evidence on the impact of the agency costs of debt on
corporate debt policy. Journal of Financial and quantitative analysis, 21(2), 131-144.
Coffee, J. C., Jackson, R. J., Mitts, J., & Bishop, R. (2018). Activist Directors and Agency
Costs: What Happens When an Activist Director Goes on the Board?
Bernanke, B.S. and Gertler, M., 1986. Agency costs, collateral, and business fluctuations.