Agency problems is Kenyan firms

JULY 2007

Agency problem

Definitions
Agency problem arises whenever one party (principal) contracts another party (agent) to act on his behalf. The principal will cede authority to the agent in order for the agent to execute his tasks. The agent is normally compensated for providing the service. Agency problem occurs since agents tend to act in their own interest rather than wholly in the interest of the principal.

Agency problem in the modern firm arises because firms are held by a diffused group of people called shareholders. Due to this diversity and their numbers it is not possible for them, to participate in the day-to-day running of the enterprise. They instead delegate authority to oversee the operations to a small group of people called the management. Agency problem exists between the owners and the management. In order to deal with the management’s tendency top maximize their own interest’s shareholders incur additional costs called monitoring costs.

Stock compensation is one of the many ways to deal with the agency problem. Stock ownership is where top management is given a proportion of shares that are locked. They are not available for sale for a period specified in the contract. The essence being that managers have an interest to ensure maximization of share prices as they stand to gain more when prices are higher. They are motivated to carefully select and make decisions that contribute to market share appreciation. This ensures convergence of expectations between shareholders and the managers.

Advantages

· Leads to increased manager to firm loyalty hence reduced turn over.
· Stability that is useful especially in succession planning
· Leads to favourable evaluation by lender i.e. they know that they are dealing with locked in management
· Leads to competitive advantage due to cost containment, in efficient markets share price appreciation is supported only by fundamentals
· Managers are motivated to act in the shareholders best interests.
· Managers are more likely to focus on maximizing stock prices if they are themselves large shareholders.
· The company is able to attract and retain able managers
· Managers actions will be in line with interests of stockholders whose primarily interest are stock price maximization.
· It is in line with the modern method of measure of managerial performance i.e. economic value added (E.V.A) where executive compensation is pegged on shareholders wealth maximization. E.V.A is considered as a better method; to measure a firm’s true profitability. E.V.A is found by taking the after tax – operating profit and subtracting the annual cost of all the capital a firm uses.
· Increased pressure from financial institutions with interest in companies has awakened the directors on the need to improve corporate governance and wealth maximization of shareholder failure to which can lead to firing.
· Hostile takeovers (when management does not want the firm to be taken over) are more likely to occur when the firms stock is under valued. Relative to its potential, because of poor management and hence the needs to motivate the CEO to take action designed to maximize stock prices.

Disadvantages
· Based on the notion of efficient markets i.e. that share prices reflect all the available information
· It is futuristic hence based on estimates there could be problems of estimation for example what if prices dipped such that the share option is no longer attractive to managers or what if the prices rose due to market correction is there any need for managers to be committed?

· Most managers on average are highly paid. Therefore for the share plan to be attractive it must consist of substantial number of shares. Putting such many shares in the hands of management gives them a controlling stake besides their preferential position as managers. Such powers could easily be abused.

· The plan assumes managers rationality i.e. that their marginal utility for an extra shilling increases indefinitely. This is not always the case. Many managers have been known to be empire builders.

· The plan is only useful for market dominant firms i.e. blue chip companies. Their stocks are a premium and can not be matched by other firms hence the attraction to management to maximize their capital gains as and when they are able to sell.

· Possibilities of over emphasizing on wealth maximization in the short run without considering the long run financial implications.
· Managers tend to prefer project with short-term profit with higher returns to the long-term project with relatively lower but stable returns.
· Other secondary objectives like the welfare of the employees cannot be considered if its short-term cost implication will be in conflict with wealth maximization.
· Possible conflict between the medium level mangers and the CEO where the former feels that they are not being considered for the senior most positions in the company and that can lead to conflict of interests which can jeopardize the ultimate goal.
· Possibility of window dressing of company performance to portray better performance, which will be in line with increased share valuation e.g. underestimating of certain provision to show a better performance. E.g. Enron and world COM.
· The complication that arises on how to treat the stock compensation should it be expensed as a form of a cost to the company since it is compensation.
· The complication as to which methods is to be used in measuring the value of the shares more attention is paid to accounting measure especially E.P.S. however stock prices depends not on today’s earning and cash flow but future cash flow and the risk ness of the future earning stream also affect stock prices. Some actions may therefore increase earning and yet reduce stock price and the vice versa.
· Companies that undertake actions today to enhance its earning may see a drop in its stock price.



References
Financial management theory and practice by Eugene F. Brighen and Michael
C Heraldry 10th edition
Fundamental of financial management 10th edition by Brigham al Houston.


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