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Agency theory

Jenson and Meckling (1976) define
agency theory as a relationship between the contractor and another party (the
agent) in which the contractor will delegate some decisions to the agent. In
this relationship, the contractor will hire an agent to perform a specific task
given to them. For instance, in partnerships, the principals are the investors
of an organization, assigning to the specialist i.e. the administration of the
organization, to perform errands for their sake.

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Assumptions on Agency theory

There are three assumptions on
agency theory that are related to human behaviour they are humans have bounded
rationality which means that there are breaking points to what individuals
know. Second one is humans are selfish which implies that individuals put their
own needs before other individuals. Final assumption is humans will always seek
to maximise their own utility such as wealth and health over other individuals.

Agency costs

Agency costs are costs that are
internal that must be paid to, an agent following up for the benefit of a principle.
After given the assumptions by the agency theory the interests between the
contractor and the agent is divergent, this leads to agency cost being
incurred. These are Monitoring costs by the principal which indicates whether
individuals are performing very well. Second one is Bonding costs by the agent
which indicates whether the individual is reporting back to the principals to demonstrate
performing. The final one is Residual Loss is the decline in the value of the
firm that emerges when the manager reduces his rights. William (1988) suggest
that this is the key cost; however, the other two are brought are only occurred
when they yield financially decreases in the residual loss.

For
example, when an agent demonstrations reliably with the principals interests,
agency loss is nothing.  The more an
agency pay attention to the principles interests, the more agency loss
increases. Therefore, the agency should focus more on ideas created by them
instead of taking note from the principle, then agency loss becomes high.

Agency problem

Agency issues emerges because of
the disagreement or dissociate of attention between the contractor and the
agent. Agency problem in finance is occurred when there are conflict between
the manager and the shareholders in the business. There are different types of
agency relationship in finance for instance managers and shareholders. Managers
employ experts (supervisors) who have specialized aptitudes. Managers may take
actions, which are not to the greatest advantage of shareholders. This is
generally when the managers are not owner of the property i.e. they don’t have
any shareholding. The involvement between the managers will be in conflict with
the interest of the owners. Murphey (1985) argues that managers tend to build
the extent of organizations regardless of whether it hurts the interests of
investors, as regularly their compensation and distinction are decidedly
corresponded with organization measure. Therefore, this causes conflict between
the manager, who tend to esteem development, and investors, who are orientated
towards the boost of the estimation of their offers.

The agency problem in the corporation

According to Smith (1776) the
executives of such like joint stock in organizations, in any case, being the
managers of other individuals’ cash than their own, can’t be very much expected
that they should watch over it with a similar watchfulness with which the
accomplices in a private co-partner as often as
possible watch over their own.

The organisation in agency theory

Jenson and Meckling (1976)
suggested that organisations just legitimate fictions which fill in as a nexus
for an arrangement of contracting connections among people.

The role of board of directors:

Garrat (1997) defines the
function of the board directors as follows:

·        
Determine the company’s purpose and “ethics”;

·        
Decide the direction, that is, the strategy;

·        
Plan;

·        
Monitor and control managers and CEO; and

·        
Report and make recommendations to shareholders

Board of directors regularly have
power more than one board. Executives are additionally known to have a few
duties and regularly clashing necessities. They have time requirements what’s
more, subsequently need to precisely deal with their endeavours for most
extreme outcomes. The main purpose that tests the capability of a board is that
of observing and control of the presidents and their execution. The more
noteworthy the level of observing, the more prominent the likelihood of
achievement or upgraded budgetary execution

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