Principles of Financial Investment Introduction In corporate sector a relationship of agency exists. Shareholders contributing to the capital of the company are mostly large in numbers, particularly when the structure is that of public company. They are the owners and it is difficult for them mange the day to day affairs of the company…
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The effects of these agency problems create agency costs that work against the benefit of all stakeholders as well as for the company. This write up identifies those agency problems, its agency costs, and enumerate the ways to mitigate the agency costs in order to provide maximization of wealth of stakeholders as well as for the benefit of management and the company itself. Definition of agency problem The nature of conduct of business in respect of proprietorships, partnerships, and cooperative societies is that those are owner- managed organizations. But in case of companies the share holders, who are the owners of the companies, are not involved in the management of the affairs of the company. The management of the company is conducted by board of directors. Directors may or may not be professionally trained but they have little or no stake in the ownership of the firm. It is true that there are certain compelling reasons for separation of ownership and management, but a separate structure leading to conduct of management through the agency of board of directors leads to conflict of interest between managers (agents) and the shareholders, who are owners of the company. Therefore the agency problems emerge from this separation of ownership and control. ...
“This pattern of widely held corporate ownership resulted in what came to be known as separation of ownership from control. More recently, the economists have called this as an agency problem or principal- agent problem. The managers of the company are entrusted with the responsibility to make company as profitable and valuable as possible for the benefit of owners. However, the owners (principles) may have difficulty in ensuring that the managers (agents) actually carry out this responsibility.” (Robert Edward Anderson, page 49)i Ownership is concerned with maximization of wealth of shareholders. Therefore owners are always ready to critically assess the actions of the management (agents) so that their slackness anywhere is pointed out so deficiencies are rectified in effort to enhance the wealth. Accordingly enhancement of wealth is possible by making an assessment or sort of observance of the actions of the management. The key factors that are judged in management’s performance are the composition and independence of board members, transparency of their actions, their outside reporting, observance of accounting standards, and adherence of strategic objective of enhancement of shareholders wealth. This monitoring or observance lead to difference of opinion with reference to strategic objectives of the corporation and give rise to agency problems in the corporate sector of management. Basically agency problems have two aspects. First aspect is the situation where it is not possible for the principal to verify the appropriateness of the actions of the agent. This generally is the case when goals or objective differ and create difficulties to verify what agent is doing. The second aspect of the agency problem is
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