Agency Problems and Costs in Business Finance: A Report

This report delves into the critical area of agency problems within financial contexts, specifically examining the relationships between owner-managers and lender-managers through the lens of agency theory. It meticulously outlines the intricacies of agency costs, including monitoring, bonding, and residual costs, and how these impact financial decision-making. The report dissects the manager-lender agency relationship, highlighting potential problems such as excessive dividend payments and underinvestment. Furthermore, it explores the owner-manager dynamic, addressing the responsibilities of managers and agents, control mechanisms, employee ownership models, social responsibility considerations, and the implications of termination. The analysis provides a comprehensive understanding of how agency theory shapes financial management and governance structures.

Running head: AGENCY PROBLEMS
Agency Problems
Name of the Student
Name of the University
Author note

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Executive summary
The main purpose of this report is to highlight that, how the agency costs and agency
problems are related to the relationships between the owner-manager and lender-manager
agency utilizing the agency theory. The report further highlights thoroughly the relation
between lender and a manager and on the other hand relation between manager and owner
under the light of agency theory.

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Table of Contents
Introduction................................................................................................................................3
Agency theory............................................................................................................................3
Monitoring costs.....................................................................................................................4
Bonding Costs........................................................................................................................4
Residual costs.........................................................................................................................5
Manager-lender agency relationship..........................................................................................5
Excessive dividend payments................................................................................................6
Underinvestment....................................................................................................................6
Owner Manager Relationship....................................................................................................7
Responsibility of the managers..............................................................................................7
Responsibility of the agents...................................................................................................7
Control mechanism................................................................................................................8
Employee ownership..............................................................................................................8
Social responsibility...............................................................................................................8
Termination............................................................................................................................9
Conclusion..................................................................................................................................9
References................................................................................................................................10

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Introduction
The purpose of this report is to explore the agency costs and agency problems related
to the relationships between the owner-manager and lender-manager agency using the agency
theories. It can be said that Agency Theory describes the way to best organize relationships in
which an individual party determines the job when another party completes the job. It is a
matter of fact that in this relationship the principal employs an agent for the completion of the
work or to do the work while the principal is unable to do the work (Berrone, Cruz and
Gomez-Mejia 2012). For an example, it can be said that, in some corporations principals are
the stakeholders of the organization entrusting the agents, which means the managerial body
of the organization does the work on behalf of them. In short, it can be said that Agency
theory is related to the relation between the principal and the agent who are employed or are
independent contractors (Block 2012). This is a utilitarian framework designed for the
governance and controls in the organizations. This idea provides a logical introduction of the
topic by evaluating the strengths and weaknesses and also uses various case studies to portray
how the theory has been applied in various organizations.
Agency theory
Agency theories are in most cases used to know the relationship where an individual
or a group of persons try to employ service of the agents for performing some activities on
their behalf. While doing so, principal delegates the decision taking authority to the agent and
this is widely known as agency relationship. The agent has s legal duty to act for the best
interests of the principal and the both parties assume that utility maximizers mean that agent
would not always act for the best interest of the principal and the risks that the managers may
undertake necessary actions those are detrimental towards the owners or towards the other
principals are in most cases termed as moral hazard (Ballwieser et al. 2012). Whenever the

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interests of the principal and the agent are not matched, there might be some incentives for
the management to act in such a way that may not be for the best interest of the principal.
This theory results in identifying of three types of agency costs such as, monitoring costs,
bonding costs and residual costs.
Monitoring costs
Monitoring costs are generally incurred by the principals to observe, control and
measure the behavior of the agents. These might include costs to audit the finance reports by
including the place operating rules or the costs to set up a compensation plan. When these
costs are primarily incurred by the principal, the principal would pass these costs on to the
agent (Bratman 2013). For an example, it can be said that, in the relation between the owners
and the managers, owners as principals are generally worried about the manager’s
performance would have more strict monitoring system and may pass these costs to the
manager by reducing the remuneration. In cases, where a debt contract is the issue, the
lenders are generally concerned with about the organization’s financial performance they
lend to and this may affect the risks included in lending (Nicholson and Snyder 2014). The
lenders, just like principals can also use auditing only to monitor the managers, the managers
who are considered as agents working for the stakeholders. Lenders are most likely to
enhance the rate of interests charged on loans or lend for short span of time if they are asked
to undertake more monitoring of the entity. These projects that the costs of monitoring
agent’s behavior get increased, the required remuneration paid to the agents would get
decreased, or the costs of the borrowings would get increased. It can also be termed as a
strategy of protecting the price.
Bonding Costs
This method of price protection means that the agents would bear the costs of
monitoring through the lower remuneration or higher rate of interests. Due to this, the

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managers more likely provide assurance that there would be making decisions for the best
interest of the principals. For an example, it can be said that, it might incur the time and lso
the effort involved in providing the quarterly accounting reports to the lenders or by agreeing
to sync a part of the remuneration payment to entity performance. If this process gets
implemented, the managers would have an incentive that would enhance the entity
performance, and that is also for the best interest of the owners. These are widely known as
bonding costs.
Residual costs
Though there are various methods of controlling the prices, it may appear costly to
guarantee that an agent would take decisions optimal to the principal at all the times and in all
situations. Sometimes, it may cost more to monitor the agents than the desired benefits from
monitoring (Berrone, Cruz and Gomez-Mejia 2012). For an example, it can be said that, it
might be way costlier to monitor the usage of a manager’s travel expenditures to make sure
that those are only for the purposes of doing business or for his personal use. This extra
divergence can be termed as residual loss.
Manager-lender agency relationship
Whenever a lender gets ready to provide funding to an entity, certainly there is a risk
factor that the party who is lending may not payback the sum. Agency theory might also be
used for understanding the relation between the management and the lenders. In this
circumstance, the manager is seen as an agent and the lender as the principal. In this situation,
the manager’s intentions are totally matched with the owner’s. in this scenario, the probable
agency problems that can arise are excessive dividend payments to owners, underinvestment,
claim dilution and substitution (Ballwieser et al. 2012). To avoid the price protection being
imposed by the lenders, the managers have incentives to showcase that they are acting in such

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a technique that is certainly not disadvantageous to the lenders. The debt contracts have
restrictions, which are identified as covenants and these are planned with an intention of
protecting the interests of the lenders. If the managers agree to the terms of these covenants
they will be able to borrow funding from the lower interest rate, and they can also borrow
more funding for longer period of time. The accounting data generally form the basis of these
covenants (Berrone, Cruz and Gomez-Mejia 2012).
Excessive dividend payments
While lending the funding, lenders price the debt to assume the level of bonus payout.
If the managers issue a elevated level of dividends or unnecessary dividend payments, hen
this can lead to a reduction of asset base securing the debt or leaving insufficient funds within
the entity to service the debt (Bratman 2013). Thus, to reduce this issue, the managers and
the lenders do agree to covenants that restraining policy and restricting dividend payouts as a
function of earnings. These, dividend payouts can be seen as a familiar covenant in cases of
Australian debt contracts and maintaining the working capital ratios can also enhance the
excessive dividend payments (Block 2012).
Underinvestment
Underinvestment can rise as an agency problem when the managers on behalf of the
owners have incentives not to undertake any positive net present value (NPV) projects if the
project will lead to increased funds available to the lenders. This may be the case where
entity becomes the financial difficulty (Chen, Lu and Sougiannis 2012). The creditors rank
way above the owners as the payments in the event, an entity liquidate and any funds from
those various projects will go towards debt rather than equity (Cote and Levine 2014).
Covenants which restrict the opportunities of investment of the organization are likely to
enhance the problems. The operational capital ratios also assists by requiring managers to

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sustain a specific level of funds in the entity in which managers are most likely to invest in
positive net present value assets (Cuevas‐Rodríguez, Gomez‐Mejia and Wiseman 2012).
Owner Manager Relationship
In an organization the owner initially can retain the complete authority in his or her
hands, but as the business grows the owner has to delegate decision making to the managers,
in short this can be termed as an owner manager relationship (Gilson and Gordon 2013). The
owners must hire people to act on his behalf, like, purchasing agents, salespersons and
finance managers and many more. When the owner gives authority to other persons to make
decisions the owner is taking risks that may contradict his or her desires (Heracleous and Lan
2012).
Responsibility of the managers
If the managers take decisions without the knowledge of the owners, the owner still is
responsible for those decisions. As an example, it can be said that, if the owner diversifies the
workforce and the manager specifically excludes some members belonging to a specified
ethnic group while hiring, the owner may face legal issues (Magat, Krupnick and Harrington
2013). In addition to that, if the management takes any harmful decisions that can come back
to the owner as he or she has the responsibility for the actions taken by the management of
the organization he or she owns.
Responsibility of the agents
If the owner of an organization hires people from as an outside agency or delegate the
decision making ability to another person who would act behalf of the owner, the owner
might not find that the agent is making all the right decisions for the organization and in those
cases organization might incur some losses (Nicholson and Snyder 2014). In those cases the

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owner needs to show some passion and faith on the agent as he has given an authority to him
or her and the owner should respect it.
Control mechanism
The owner might show some controlling attitude towards people who has the
authority to act behalf of the organization and may reward them in occasions where they have
achieved their goals and likewise can penalize agents for whom the organization incurred loss
(Rankin et al. 2012). This mechanism actually serves many purposes and builds a positive
ambience within the organization. This mechanism reduces the risk of hiring agents by huge
margin.
Employee ownership
The owner can offer some sharing of the profit by rewarding them with some shares
or stocks of the organization (Van Essen, Otten and Carberry 2015). This method can highly
boost the motivation level of the agen and that would allow him or her to work more for the
benefit of the organization as well as his own.
Social responsibility
The efforts of the owner of the organization should be positive towards the
community and the agents should work likewise for the betterment of the reputation of the
organization (Van Puyvelde et al. 2012). The owner must ensure that the organization has a
published list of policies involving racism, treatment of the handicapped, sexism and equal
respect for various religious beliefs .These proposed policies would benefit the organization
to a larger extent, and the agents of the organization should respect these and act accordingly
aiming firther prosperity of the organization.

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Termination
In some cases the owners of organizations should take decisions wisely without
wasting much time whether it is time to hire an agent and employ a new one or not. In cases
where the relation between the agent and the owner is degrading rapidly and for that the
organization is suffering, the owner should not hesitate to take rapid decision. In such cases,
the agent might try to ruin the reputation of the organization due to having bad terms with the
owner (Zu and Kaynak 2012). In today’s world, if history of business has taught mankind
anything, then that is brand value or reputation is the ultimate factor for an organization to
reach the height of success. Thus the owner should not take such risks in those particular
cases.
Conclusion
Thus to conclude, it can be said, that the relation between owner and the manager, and
relation between lender and the owner is a very important aspect for doing business. It is a
matter of fact that if the relation between this owner manager and lender owner is balanced
within an organization, it can taste the success that all the organizations can imagine of.

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References
Ballwieser, W., Bamberg, G., Beckmann, M.J., Bester, H., Blickle, M., Ewert, R.,
Feichtinger, G., Firchau, V., Fricke, F., Funke, H. and Gaynor, M., 2012. Agency theory,
information, and incentives. Springer Science & Business Media.
Berrone, P., Cruz, C. and Gomez-Mejia, L.R., 2012. Socioemotional wealth in family firms:
Theoretical dimensions, assessment approaches, and agenda for future research. Family
Business Review, 25(3), pp.258-279.
Block, J.H., 2012. R&D investments in family and founder firms: An agency
perspective. Journal of Business Venturing, 27(2), pp.248-265.
Bratman, M.E., 2013. Shared agency: A planning theory of acting together. Oxford
University Press.
Chen, C.X., Lu, H. and Sougiannis, T., 2012. The agency problem, corporate governance,
and the asymmetrical behavior of selling, general, and administrative costs. Contemporary
Accounting Research, 29(1), pp.252-282.
Cote, J.E. and Levine, C.G., 2014. Identity, formation, agency, and culture: A social
psychological synthesis. Psychology Press.
Cuevas‐Rodríguez, G., Gomez‐Mejia, L.R. and Wiseman, R.M., 2012. Has agency theory run
its course?: Making the theory more flexible to inform the management of reward
systems. Corporate Governance: An International Review, 20(6), pp.526-546.
Gilson, R.J. and Gordon, J.N., 2013. The agency costs of agency capitalism: activist investors
and the revaluation of governance rights. Columbia Law Review, pp.863-927.

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Heracleous, L. and Lan, L.L., 2012. Agency theory, institutional sensitivity, and inductive
reasoning: Towards a legal perspective. Journal of Management Studies, 49(1), pp.223-239.
Magat, W., Krupnick, A.J. and Harrington, W., 2013. Rules in the making: A statistical
analysis of regulatory agency behavior. Routledge.
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2012. Contemporary issues in accounting. Milton, Australia: Wiley.
Renders, A. and Gaeremynck, A., 2012. Corporate governance, principal‐principal agency
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international review, 20(2), pp.125-143.
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Management, 41(1), pp.164-202.
Van Puyvelde, S., Caers, R., Du Bois, C. and Jegers, M., 2012. The governance of nonprofit
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management. International Journal of Operations & Production Management, 32(4), pp.423-
446.