What is Agency Theory in Financial Management?

What is Agency Theory in Financial Management?

Agency Theory is a risk-sharing between Principle and Agent. For a company “Principle” means owners or shareholders and “Agent” means managers. Managers are the decision making authority in an organization and shareholders are the owners of the organization. In large companies, there is a divorce between management and ownership. This is called “Agency Theory” in Financial Management.

How does Agency Theory work in an Organization?

In theory, managers should act in the best interest of shareholders; that is, their actions and decisions should lead to shareholders wealth maximization. In practice, managers may not necessarily act in the best interest of shareholders, and they may pursue their own goals.

Managers may maximize their own wealth(in the form of high salary and perks) at the cost of shareholders or may play safe and create satisfactory wealth for shareholders than the maximum. They may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholder’s wealth. It is Agency Theory.

Managers may sometime think they need to enter into a growing business segment. For that reason, they focus most of their attention on that. In the beginning years, they may not earn a huge profit. But they calculated, in the long run, it will be very profitable.

But, giving their most attention building that new company may decrease a little of their profitability in the existing business and it lowers EPS(Earning Per Share) for their shareholders. And that may create a glitch between their understanding. Because shareholders always want to maximize their earning. And, managers need to think about future sustainability and long term. It creates an agency problem in the organization.

For more details read here https://www.fin2learn.com/2020/01/agency-theory.html