Question

Please provide the references for the examples.

Question: (a) What is meant by the term agency cost? Discuss a real incident where the executives or managers of a business grganisation may have undertaken some actions that you feel have led to agency costs. Then, discuss any two measures that can be adopted to avoid similar agency costs. [2 + 3 + 5 = 10 marks] (b) Does agency cost occur in all 3 legal forms of businesses (.e., sole-trader, partnership, and company)? Why or why not? Discuss. [4 marks) (c) We have covered the three main roles of financial managers (capital budgeting, financing decision and working capital management). Please have a thought on these roles. How can agency costs occur during a manager undertaking each of these roles? Can you give any examples? (6 marks)

Answer 1

a. Agency cost can also be termed as costs suffered by the principal ,due to the creation of an agency relationship--more so when the agent either acts recklessly or wantonly , which have financial consequence to the principal.The agent's acts with bias or under conflict of interest , often give rise to agency costs--that may take the form of appointment of inefficient contactors ,taking bribes from the latter, or employing unskilled labor to do a specialised job,all for money--the loss of orders due to sub-standard output units due to the above --are real-life examples of agency costs, created by those in charge for the company's operations --that are clearly against the interests of the owners or the shareholders.

Real world incident: Those in power in the Enron, misrepresented earnings of subsequent periods , to current periods, believing which, the existing & new investors poured their hard-earned income , in these stocks , which money was siphoned to the executives' personal accounts(not even to company's accounts), which lead to the ultimate bankruptcy & de-regulation of the company--one of the worst agency cost example.(Reference:https://finance.laws.com/enron-scandal-summary)

Though, the agency costs cannot be fully avoided.It can be minimised by

i. providing profit-sharing plans to employees & executives , by which they may try to maximise profits , as if the company was their own & work towards improving efficiency and thereby profitabililty.

ii. They can be involved in policy decisions regarding appointment of contractors , vendors or suppliers --so that they will honor the decision , for which they were part of & thus reduce nepotism.

b.NO.Not in all , but to some extent in the partnership & maximum in companies.

Agency costs do not at all occur in sole -trader business, where both the principal & the agent are one & the same person.

In partnerships, there is some possibility of agency costs, if only any of the partners collude with some other outside person and volunteer to get some part of work, under his control, to be done at a higher price than that known to the other partners , & pocket the balance money , in collusion with that third party.

In companies, the possibility of agency costs occuring is the maximum, as there the ownership is separated from management, ie. The shareholders do not manage the day-to-day operations & those who do that can resort to these activities.

c.In capital budgeting, the financial manager can opt for a lesser quality equipment , in the place of a more efficient one, acting in favor of a particular supplier, thus giving rise to agency costs-- in the form of lower production quality outputs.

In Financing decision, ie. In obtaining funds for the company, he can opt for a particular loan which is more costly interest expense -wise(agency costs)-- there may be conflict of interest when he/his family runs a financier-business.

In taking a working capital decision, he may select a supplier for the inventory , who offers less discounts or adjust with delayed collections from a particular customer-- discount money lost and interest lost on uncollected a/cs receivbales are agency costs , here.