What are Agency Costs? Definition, Explanation, and Example

An agent is a person or entity with the legal empowerment to act on another person or entity’s behalf. Usually, agents are employees of the principal and must perform duties in their best interest. A client may employ the agent to represent them in negotiations and other dealings with third parties.  In most cases, the agent has the authority to make decisions on their client’s behalf.

In contrast, a principal is a person or entity that is the chief participant in a transaction. In finance, this person or entity is usually a shareholder who owns a company’s shares. The principal cannot contribute to its decisions directly. Therefore, they appoint an agent to act on their behalf. In this case, the agent is a director or the company’s board of directors.

When a principal appoints an agent to represent them, they expect the agent to act on their best behalf. However, conflicts may arise in any transaction or relationship. When these conflicts occur between an agent and principal, it is known as the agency problem. This problem may also give rise to agency costs. However, it is crucial to understand what the agency problem is first.

What is the Agency Problem?

The agency problem is a conflict of interest between a relationship between an agent and principal. This problem can exist in any relationship where one party must act in another’s best interest. In finance, the agency problem is the conflict of interest between the management and shareholders. As mentioned, the management is the agent in this transaction while the shareholders are principals.

When a principal appoints an agent to act on their behalf, they expect their best interests to be critical. However, some agents may also consider their personal benefits in mind. In this regard, they may ignore or actively go against the principal’s best interest. Therefore, a conflict of interest may arise between both parties. This conflict of interest is known as the agency problem.

The agency problem may arise from various factors. Usually, it occurs when agents don’t fully represent the best interest of principals. Sometimes, this misrepresentation may exist because agents don’t understand what those interests are. In other circumstances, they may have their personal interests in mind, which go against the principal’s best interests.

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Overall, the agency problem exists as a conflict of interest between an agent and a principal. In finance, this problem exists between shareholders and a company’s management. Sometimes, agents may also include brokers who conduct transactions on an investor’s behalf. Even in those transactions, agency problems may exist due to the conflict of interests. These costs can also cause agency costs.

What are Agency Costs?

An agency cost isn’t an expense that appears on the income statement like other expenditures. Instead, it is an internal company expense that arises from agents acting on a principal’s behalf. However, these costs primarily relate to the conflicts of interest that arise from the relationship. In essence, agency costs relate to the agency problem.

Agency costs arise from the core dissatisfactions, disruptions, and inefficiencies in an agent-principal relationship. The payment of these costs occurs to the acting agent. In essence, agency costs are internal company costs that arise from the competing interests of principals and agents. Usually, these costs involve any expenses incurred toward resolving any disagreements between both parties.

Agency costs may also relate to managing the agency relationship between agents and principals. These costs primarily come from the separation of ownership and control. For example, these may include expenditures that benefit the agent at the principal’s expense. Similarly, it may involve costs related to monitoring agents’ actions to keep the relationship intact.

Agency costs can be significantly crucial for companies and their shareholders. Usually, these costs may include two types. The first involves any expenses incurred when the agent uses resources for their personal benefits. In contrast, the other is when principals prevent agents from prioritizing those personal interests. Both scenarios can increase the agency costs that companies incur.

Overall, agency costs will always exist within an agency relationship. Usually, these costs relate to the difference between the principal and agent’s interests. Therefore, agency costs arise from agency problems that may exist between both parties. Companies may also suffer two types of these costs. They may include agency costs of equity and debt.

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What is the Agency Cost of Equity and Debt?

As mentioned above, agency costs refer to expenses incurred by a company for agency problems. These problems arise with a difference between a conflict of interest between management and shareholders. However, companies may also have other stakeholders that are relevant to this issue. Therefore, agency costs may fall into two categories, agency cost of equity and debt.

Agency Cost of equity

The agency cost of equity is straightforward as it arises from the core agency problem. This cost arises due to a conflict of interest between shareholders and a company’s management. However, agency costs only occur when both party’s goals diverge from each other’s. As long as this issue persists, the shareholders have to bear the agency costs.

Agency costs are prevalent when the management takes decisions that do not favor the shareholders’ best interests. Therefore, any measures or safeguards to tackle these issues fall under those costs. On top of that, it will also include the expenses related to the decisions that the management takes. However, it only applies when those decisions go against the shareholders’ interests.

The agency costs of equity are usually higher compared to the agency cost of debt. It happens because shareholders do not have the same measures to implement against their agents. Therefore, they may incur higher costs to monitor the management and prevent any conflicts. These costs also include managing the relationship between both parties, which lasts longer than debts.

Agency cost of debt

Apart from shareholders, a company will also have debtholders who have an interest in its business. In this situation, an agency relationship may exist between those holders and the management. In some cases, the management may prioritize their personal gains over that of debtholders. Similarly, it may act in the shareholders’ best interest while not considering debt providers.

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In these cases, the agency problem may also exist between debtholders and the management. Therefore, agency costs will arise due to the actions taken by those holders. These may include various preventative measures to disallow the management from ignoring their interests. Some debtholders may charge a higher interest rate to protect themselves from those costs. Therefore, the additional interest will form agency costs.

The agency cost of debt, although critical, isn’t as prevalent in companies. Usually, debtholders use several measures to protect themselves against such conflicts. Similarly, the relationship between these holders and a company also lasts for a limited period. Therefore, it may not be as prevalent as the agency cost of equity. Despite that, it is crucial to understand what it is.

Example

During a business trip, a company sends three directors to close a deal. Those directors use company resources to stay in five-star hotels and dine in the best restaurants in the down. On top of that, they hire personal chauffeurs to drive them around town. These expenses significantly increase the value that closing the deal will provide. This way, it also reduces the wealth it creates for shareholders.

Knowing of these actions, the company’s shareholders may use preventative measures to stop them. For example, it may include monitoring costs related to those actions. Furthermore, it may also involve other general safeguards. For instance, they may link the management’s performance to their bonuses. All of these costs can help prevent agency problems and are, therefore, agency costs.

Conclusion

Agency problems may exist between an agent and principal. These problems can also lead to agency costs being higher. Usually, these costs may include any expenses associated with the conflict of interest between both parties. These costs may fall into two categories, the agency cost of equity and debt. Both of these have the same agent, but the principals may differ.