Finance Business Resource: How to define Agency Problem and Cost

How to define Agency Problem and Cost

Agency problem
An agency problem implies potential conflict of interests that can arise between a principal and an agent.

Within the financial management context, the agency problems are those-

1.Conflict between owners and managers
2.Conflict between owners and creditors
3.Conflict between owners and other parties

Agency costs
Agency costs borne by shareholders to prevent or maintain a corporate agency problems and contributes to the maximization of owner’s wealth.

Goal of the firm
The goal of a firm is to maximize the economic welfare of owners of the firm. There are two widely discussed approaches:

1.Profit maximization approach
Profit maximization means maximizing the profit of the firms. According to this approach, action that increases profit should be undertaken and those that decrease profits are to be avoided.

The criticism of Profit maximization concept
i.Unclear definition of profit
ii.Ignores time value of money
iii.Ignores risk and uncertainty
iv.Ignores justification and social welfare

2.Wealth maximization approach
Wealth maximization means maximizing the net present of a course of action to shareholders. The net present value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore is desirable. A financial action resulting in negative NPV should be rejected sense it would destroy shareholders wealth.

We know, Wealth = Price per share × No. of shares

Rationale to wealth maximization
i.It is clear concept
ii.Risk consideration
iii.Time value of money consideration
iv.Cash flow consideration
v.Social welfare