Role of Agency Theory in Solving Agency Conflicts Between Managers And Shareholders
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Shareholder (principals) employ managers (agents) to work for them in turning their dreams into a reality. They transfer the rights of decision making and control of operations to the agents who act in their (principal) best interest. This paper discusses the role of agency theory in curbing agency conflicts between shareholders and managers. It also suggests ways of reducing the conflict by mainly limiting the capacity (either resources or powers) of agents.
Shareholders and managers are expected to work and relate in harmony in order to make a profitable business relation. However, in some cases, there exists a conflict between them due to several reasons. The main reason why this conflict arises is because principals (shareholders) expect returns or payouts from their investment which on the other side reduces the number of resources controlled by managers. For instance, managers may be willing to take on risk in their business operations while shareholders desire quantified returns in the form of dividends which eventually may result to agency conflict. Managers control the corporation and make strategic decisions while shareholders are owners. Nevertheless, all parties have an interest in the financial performance of the corporation as shareholders look on to their investment at large while managers look at growth and performance. However, each of them has different rights and rewards based on role.
There are several theories that try and define this scenario. The most applicable theory that explains this conflict is the agency theory which operates within the context of an agency relationship that result to agency conflicts. It deals with ways to reduce the conflict through motivation of individuals to perform better.
In this study, I will analyze the role of agency theory in agency conflict between managers (agents) and shareholders. Presence of unaligned goals or different aversion levels to risk forms the basis of agency relationship problem that agency theory tries to see off.
According to the Davis, J. H., Schorman, F.D., & Donaldson, L. (1997), agency theory has made some assumptions which cannot be associated to all managers. The theory assumes that managers are opportunistic and self-serving with a particular aim of maximizing their output. In addition, the authors also brought the issue of stewardship theory which defines managers as stewards who are not motivated by individual goals. In order to maximize shareholders’ interests, agency costs need to be reduced while aligning the agent-principal interests. This can be achieved through development of executive compensation structure and governance mechanisms. When financial rewards are used, they should provide both rewards and punishments in order to push those entitled to make decisions and control to maintain high standards of performance which meet shareholders’ interests. However, the agency theory doesn’t guarantee good performance as there are other issues other than lack of motivations that make managers fail to achieve their goals.
Kirchoff and Adams J.R. (1982) agrees that conflict in organizations arise due to several reasons and highlights four distinct conditions as causes; ambiguous roles, high stress environment, prevalence of advanced technology and multiple boss situations. All these conditions may force managers out of the expectations of the shareholders which eventually result to agency conflict.
In another study, Trevor et al. (2004), reviewed the influences of pay and job opportunities in respect to turnover rates, job performance and employee motivation as stipulated by the agency theory. The author used data obtained via organizational surveys of blue chip companies in Vancouver, Canada to pinpoint the primary causes of employee turnover and whether it is linked to salary growth. The research focused on analyzing a variety of pay structures such as organizational reward schemes and pay for performance. Further, the article notes that there are several causes of variances in employee motivation and turnover. The main limiting factor of the article was biasness as the survey sample comprised of only mid-level management, thus leaving room for more research to understand the employee turnover and job performance at different job levels.
Agency theory postulates that shareholders’ interests need to be protected either by separation of powers between the acting parties or by motivating agents (managers) through various ways so as to act in the best interest of principals. This calls for reduction of agency costs that arises in an agency relationship. However, the principal employs agents to work on their behalf to deliver some goals due to lack of information on how to deliver or due to some other commitments. For this reason, the employed agents (managers) must overcome the lack of information aspect and deliver as per the standards posed by shareholders.
The agency theory can be employed in governance to determine the incentives that encourage managers to perform better. This is done by analyzing what interests motivate the agent to act. Also, the theory can be employed to determine what discourages the agents from acting accordingly and remove them. Understanding the mechanisms that create problems helps businesses develop better corporate policy.
There are several mechanisms that can limit the conflicts of interest between managers and shareholders. These mechanisms aim at aligning the interests of both groups with those of shareholders being valued more whenever the interests of the two groups coincide. One way of reducing the conflicts is by linking managerial remuneration to firms’ performance. Definitely, the managers will work hard in accordance to shareholders interests in order for them to earn or maintain good remuneration. Also, Jensen (1986) noted that limiting managers’ freedom of action has a crucial role to play in reducing the agency costs of equity. He also recommended the reduction of free cash flow as a solution to curb managers’ selfish actions at the expense of shareholders money. This can be achieved through incurring extra debts, dividend payouts etc. which reduce the likelihood of unprofitable and expansion orientated investments being undertaken.
Fluor Corporation is a multinational engineering and construction firm that was founded in 1912 by John Simon Fluor as Fluor Construction Company. It provides services through its subsidiaries and is based in Irving, Texas. According to Fortune 500 rankings, the company features among the largest Engineering & Construction Company and is listed as 153rd overall (Fortune 500 Companies 2018).
The company offers a dividend payout at the ratio of 28.4% and a dividend yield of 2.42% (Fluor Corporation: 2017 Annual Report (Form 10-K)). A strong, sustainable dividend payout ratio is associated with good management as it shows to prospective investors and shareholders that the company is making sound financial decisions (Huston, Jeffrey L. 2015). As the statistics indicate, the company’s management is steering the company in the right direction.
Since agency conflict interferes with the normal smooth flow and performance of a firm, Fluor Corporation shows no chances of agency conflicts. This is evidenced by the fact that the company is able to pay a dividend payout of 28.4% of its earning.
Return on assets (ROA) is a financial ratio that measures the proportion of profit that a company earns in relation to its overall resources (Alan J. Marcus, 2004). Fluor Corp’s annual net Income for the quarter that ended in Sep. 2018 was $309 Million while the total assets was $9,134 Million. This sends the company’s annualized ROA for the quarter to 3.39%.
Return on equity (ROE) is another financial measure of performance calculated as Net Income divided by Total Stockholders Equity. Fluor Corp’s annualized net income in relation to stockholders for the quarter that ended in Sep. 2018 was $309 Mil while total stockholders’ Equity was $3,043 Mil. This makes the company’s annualized ROE for the quarter to stand at 10.17% (www.fluor.com).
Since both measures present a positive big figure, it can be denoted that the management performs in accordance to the shareholders’ interests in order for the company to generate profitable income. As a result, it can be deduced that the company has no agency conflict as it interferes with the normal operations of a firm thus altering the profit margins.
This ratio helps to determine the efficiency of a company to generate sales using its asset (Alan J. Marcus, 2004). It can be used to determine the efficiency and effectiveness of the management team of a company. Fluor corporation asset turnover ratio stands at 2.11(Thomson Reuters Corporation, 2019) which translates that the company is a bit efficient in its utilization of the assets. Since use and control of assets is passed on to managers, a good result from the use sends a picture of sound working environment that has few or no conflicts. This can be used to make a judgement that the company has few or no agency conflicts.
Agency theory is concerned with resolving problems that exist in agency relationships due to unaligned goals or different aversion levels to risk. In the work place, organizations can find it hard to recognize those who are good in achievement of goals and those who are not. This harts shareholders returns to investment, which in some cases may be caused by untrustworthy managers. Such condition would lead to agency conflicts between the two groups. However, this document has outlined several mechanisms that can be put in place to control the agency conflict.