AGENCY THEORY

INTRODUCTION:

In achieving the goals of an organization, we often hear of various obstacles. What causes these obstacles,
namely, due to a mismatch between the goals of the agent and the principal, both between shareholders and
management and between superiors and subordinates in an organization. Hence, throughout the challenges this can be
explained through agency theory.

The agency theory poses a potential conflict of interest between the stockholders and the managers.
Such conflict starts when the stockholders entrust to the managers the authority to make decision for the firm. The
managers, with the power bested upon them, may have personal goals that clash with the stockholder’s wealth
maximization.

This theory exists due to the creation of an agency relationship. This relationship is borne as soon as an individual
or group of people, called the principals, hire the service of an individual or organization called an agent, to perform a
service and exercise decision-making for the principal.

EXPLANATION:

EXAMPLE:

Imagine you are the owner of a successful chain of coffee shops and decide to expand your business by opening a new
location in a different city. To do this, you need a capable manager to oversee the day-to-day operations of the new
branch. In this scenario:
Principal: You, as the owner, are the principal. You have invested your money and trust in the manager to run the new
coffee shop effectively
Agent: The manager you hire to run the new coffee shop is the agent. They are responsible for making decisions on your
behalf and managing the store.
Now, let's examine how agency theory plays out in this real-life situation:
Conflict of Interest:
Alignment of Goals: Your primary goal as the owner is to maximize the profits of the new coffee shop and ensure its
long-term success. However, your manager may have personal goals that differ. For example, they might prioritize their
work-life balance, which could lead to them not putting in the necessary effort to grow the business.
Monitoring and Incentives:
Incentives: To align the manager's interests with yours, you might offer them performance-based incentives, such as
bonuses tied to the store's profitability. This incentive is designed to motivate the manager to work towards your goal of
maximizing profits.
Monitoring: You may also implement monitoring mechanisms, such as regular financial reports and surprise audits, to
ensure the manager is making decisions that benefit the business and not solely themselves.
Risk and Outcomes:
Risk Sharing: If the manager makes decisions that result in losses or a decline in the coffee shop's performance, you, as
the owner, bear the ultimate financial risk. The manager, on the other hand, may not face the same level of personal
financial risk.
In this real-life example, the application of agency theory becomes evident as you, the principal, seek to address potential
conflicts of interest, align goals, and ensure effective monitoring to maximize the success of your new coffee shop while
minimizing the agency problem between you and your hired manager.
The primary agency relationships are those between:

 STOCKHOLDERS AND MANAGERS

An agency problem will likely exist when the manager owns a very small percentage of the company’s
stock. When the firm is a sole proprietorship and the manager is also the owner, he or she will presumably
function to maximize his or her personal wealth. However, when the owner-manager decides to share the
company with an outside investor by making the firm a corporation, a potential problem may arise. If the
proprietor worked to his or her full potential before, this time, with shared ownership, he or she may tend to relax a bit,
knowing that some of the wealth will now accrue to the other stockholders. At the same time, the owner-manager
may be a little loose with the money or use more of its earnings knowing that some of the costs will be borne
by the other stockholders.
In many large corporations, potential agency conflicts are noted specially when the managers do not
own a small percentage of the company’s stocks. However, managers may be encouraged to act in
maximizing stockholders’ wealth by giving them incentives for good performance and punishment for poor
performance. Some of the incentives that maybe offered are as follows: increase in salary, bonus, stock options,
promotions, travel, and many more. For poor performance, the punishment maybe as follows: no bonus, threat
of termination, or no increase in salary. Other devices that may be used by the company so that the managers
will act in accordance with the interest of the stockholders are threat of takeover by another company and
shutdown.
LAST WORDS TO SAY:
 Effective agency seeks to strike a balance between the interests of stockholders and managers.
 Incentive structures and consequences play a crucial role in motivating managers to act in ways that maximize
stockholders' wealth.
 STOCKHOLDERS AND CREDITORS
Aside from the conflicts between the stockholders and managers, a conflict may also arise between
stockholders and creditors. Stockholders claims over the assets of the company are just a residue after
deducting the creditor’s claims. In the same manner. Creditors also have a claim over the firm’s earnings
through interests and principal payments. The firm’s creditors grant loans at rates based on the firms’ capital
structure, expected future cash flows, profitability, and stability.
The conflict between stockholders and creditors is more evident when the stockholders, through
management, undertake a huge project that is too risky for the firm and has been overlooked by the creditors
upon granting of the loan.

 Sometimes, creditors didn't realize how risky these projects were when they lent money to the company.
 When projects are risky, creditors become cautious. They might raise the interest rates on loans and provide less
money because they want to protect their investment.
 If the risky project succeeds, stockholders enjoy all the rewards, but creditors earn less in interest. So, creditors lose
out.
 If the project fails, creditors share the losses because they might not get back the interest and principal they were
expecting.
 In the part of the creditors protection for themselves, they use some rules and think of these rules as their
safeguards
 For example, they might say, "You can't give out dividends (profits to stockholders) if you owe us a lot of money." This
ensures that stockholders can't take all the money while creditors are waiting to be paid.
 They might also say, "Don't borrow more money by issuing bonds," to prevent the company from getting into even
more debt.
 Another rule might be, "Don't buy too many assets," to stop the company from spending too much money on things
that don't directly make money.

So, in simple terms, stockholders and creditors sometimes clash because they both want a piece of the company's
earnings and assets. This conflict gets more intense when risky projects are involved. To protect themselves, creditors
set up rules to limit what the company can do with its money until they get paid back.

OVERALL: • Recognizing potential agency conflicts and implementing mechanisms to address them is
essential for maintaining the health and stability of a corporation.

 It can be concluded that the definition of agency theory is the relationship between the principal
(owner/shareholder) and agent (manager). And in the agency relationship there is a contract where
the principal authorizes the agent to manage his business and make the best decisions for the
principal.

MISCONCEPTIONS ABOUT FINANCIAL MANAGEMENT

Some of the most misconceptions about financial management are listed as follows:

1. FINANCIAL MANAGEMENT IS ACCOUNTING.

The most common mistake is thinking that financial management is accounting because it utilizes
financial statements to arrive at certain decisions. It is true that financial information’s necessary to arrive at a
sound decision is provided by accounting. However, the tools used in making decisions are different from the
ones used in accounting. Accounting has a standard to be followed while financial management does not
have any.
 In reality, financial management and accounting have distinct purposes and tools.
The tools and techniques used by finance people are more sophisticated and more scientific and vary
depending on what decision is needed.
Example: Let’s think of it this way: Accounting is like providing a basic recipe with ingredients and quantities,
while financial management is the chef using that information to create a gourmet dish. The chef (financial
manager) needs to go beyond the recipe (accounting) to make something special, adapting and enhancing the
ingredients as needed.
OVERALL: Accounting provides financial information useful for the common needs of multiple users.
In financial management, decision-making is directed to specific financial users.
2. FINANCIAL MANAGEMENT IS A REVIEW OF MATHEMATICS
In making financial decisions, a lot of formulas are used before arriving at a decision. With
computation of present values, future values, annuities, and other values, finance is thought to be too
 much mathematical. Mathematics is always present in every decision-making in financial management.
INTRODUCTION: There's a common misunderstanding that financial management primarily involves
complex mathematics and is all about numbers and formulas.

EXPLANATION: Financial decisions often require the use of formulas for calculations like present values,
future values, and annuities. These calculations help in assessing the financial implications of decisions. Additionally,
financial management may involve concepts from mathematics, investments, and algebra, but it's more about applying
these mathematical tools to real-world financial scenarios.

EXAMPLE: Think of it like baking a cake. We need to use measurements and calculations (mathematics) to get the right
ingredients and proportions. However, the real skill is in choosing the right recipe (financial strategy) and adjusting it to
create a delicious cake (financial success). So, math is a tool in the kitchen, but it's the chef's expertise that makes the
cake unique.

3. FINANCIAL MANAGEMENT IS A BRANCH OF STATISTICS.

Statistics is used at times to ascertain the risks involved in decision-making . Standard deviations,
correlation coefficient, coefficient of determinations, and forecasting tools and techniques are used to
measure the risk before making financial decisions.
Explanation: Financial managers do use statistical tools like standard deviations, correlation coefficients,
coefficient of determination, and various forecasting techniques to gauge the risks associated with financial
decisions. However, financial management encompasses a broader set of principles and strategies for making
sound financial choices.
Example: Think of it as driving a car. We may use a GPS (statistics) to assess the traffic and find the best route,
but driving involves much more than just following GPS directions. You must consider factors like road conditions,
fuel efficiency, and driving skills (financial management) to reach your destination safely and efficiently. Statistics
is a valuable tool, but it's only part of the journey.

Overall: With statistics as part of the decision-making process, it is thought that financial management is a
branch of statistics.

SOCIAL RESPONSIBILITY

In the world of financial management, the primary goal has traditionally been to maximize stockholders'
wealth. However, a critical question arises: Should companies operate solely in the interest of their stockholders,
or do they also bear responsibility for their employees, customers, and the communities they belong? It is
understandable that firms have to be responsible to their employees by providing them with the good working conditions;
to the environment by not polluting the air and water; and to their customers by producing quality goods or services in the
most efficient way. However, to be socially responsible, the firm has to incur costs.

 Social responsibility implies additional costs to the company. Not all firms are willing to take the extra cost in
order to follow the rules and regulations set forth by good standards.
 Does it mean that companies should not be socially responsible? The answer is, not necessarily. It only
means that social responsibility has to be mandated rather than voluntary to ensure that a burden will not be shouldered
by a single firm, but rather, distributed uniformly among businesses.

 To ensure a fair distribution of social responsibility, governments can establish clear guidelines and
regulations, covering aspects like employment, environmental protection, safety standards, and antitrust
measures. These regulations aim to prevent one firm from shouldering an undue burden.

EXAMPLES:

1. Employee Welfare: Companies demonstrate social responsibility by providing good working conditions, fair
wages, and opportunities for employee growth.
2. Environmental Stewardship: Socially responsible firms prioritize eco-friendly practices to protect the
environment. Many companies have adopted eco-friendly practices, such as using biodegradable materials,
reducing plastic waste, and implementing sustainable supply chains. This shift benefits both the environment and
the company's public image.
 An example is Tesla's commitment to electric vehicles, reducing carbon emissions and promoting
sustainable transportation.
 Fast- food restaurants used to serve soft drinks in plastic cups which can easily be recycled and are
biodegradable.
3. Customer Satisfaction: Companies practicing social responsibility focus on producing quality goods and
services efficiently, enhancing customer satisfaction.
 Apple's dedication to product innovation and user experience showcases this approach.
4. Social Outreach: Organizations like PLDT and San Miguel Corporation actively engage in social projects, such
as supporting housing initiatives for disadvantaged communities. These endeavors demonstrate a commitment to
the greater good.

They believe that the role of business is to promote the public good, not just the good of the firms’ shareholders.

As stated by the president of the Body Shop, it is impossible to separate business from social responsibility. For
other firms, socially responsible endeavors may not be expensive at all. They would incur more cost if they do
not follow the accepted standards of production and good business management procedures. Many industries in
the past suffered losses, or even worse, became bankrupt due to lawsuits as a result of being socially
irresponsible.

In the end, the debate over social responsibility in financial management continues to evolve. While it presents
challenges in terms of costs and competition, many firms recognize the importance of balancing profit motives
with ethical obligations. Government regulations and corporate initiatives are driving positive change, fostering a
business environment where social responsibility is not just a choice but a shared commitment to promoting the
public good alongside shareholder interests.