Agency costs definition
/What are Agency Costs?
Agency costs are the costs associated with the differences between the intentions of an agent and a principal, where the principal does not have complete control over the situation. These differences in viewpoint can lead to substantial additional costs or the loss of value. For example, when the managers of a company take the business in a direction that is disagreeable to shareholders, the shareholders are more likely to sell off their shares in the business, which reduces the market value of the shares. This decline in value is an agency cost.
Indirect Agency Costs
There are indirect impacts resulting from agency costs, which are lost opportunities. Here are several examples:
Missed investment opportunities. Managers may avoid high-risk, high-reward projects to protect their positions, even if those projects could increase shareholder value. This risk aversion means the firm might lose out on profitable ventures, resulting in an opportunity cost for shareholders
Excessive caution. Managers may avoid investing in R&D or new technologies to keep short-term earnings stable. While this makes the company look profitable in the short run, it often stunts long-term growth and leads to lost market share and competitiveness.
Reduced managerial effort. Managers who don’t have significant ownership in the company may lack the motivation to put in the extra effort to maximize performance. This can mean lower productivity, slow decision-making, and a lack of attention to strategic planning, ultimately impacting company profitability.
Perks and lifestyle choices. Executives might spend on luxury offices, private jets, or expensive perks that aren’t directly related to company performance. While these expenditures don’t show up as fraud or direct theft, they consume resources that could have been invested in ways that directly benefit shareholders.
Empire building. Managers may be incentivized to grow the company in terms of size (through mergers, acquisitions, or unnecessary expansions) rather than value. This "empire-building" behavior may increase their personal prestige and compensation but doesn’t always benefit shareholders, especially if these expansions lead to poor performance or require substantial debt.
Over-retention of earnings. Managers sometimes prefer to retain earnings within the company rather than paying them out as dividends to shareholders. By keeping cash reserves, managers have more control over resources, but this can lead to lower returns for shareholders who might have benefited from those funds if they were distributed.
Indirect agency costs can have a significant, long-term impact on shareholder value by limiting profitability and growth potential. Addressing them typically requires strengthening governance structures, aligning incentives, and improving transparency.
Examples of Agency Costs
As an example of agency costs, shareholders may want to increase earnings per share by focusing on cost cutting, while managers are more intent on spending money to increase their perks. Or, the senior managers of a business engage in reporting fraud in order to increase the share price and cash in their stock options, after which the stock price drops, harming shareholders. Another relationship that can result in agency costs is between elected politicians and voters, where politicians may take actions that are detrimental to the interests of voters.