## Agency Problem and Agency Cost
### Agency Problem
An agency problem is a conflict of interest that arises when managers (agents) prioritise their personal goals — salary, perks, job security — over the interests of the shareholders (owners/principals), whose goal is wealth maximisation.
### Agency Cost
Agency cost is the additional cost shareholders bear to monitor and control managers' behaviour so that managers act in the shareholders' best interest.
Four types of agency cost:
| Type | What it covers |
|---|---|
| Monitoring cost | Cost of overseeing managers' actions. |
| Bonding cost | Cost of arrangements that ensure managers act in shareholders' interest. |
| Opportunity cost | Cost of sub-optimal decisions taken by managers. |
| Structuring cost | Cost of creating systems/controls to limit agency problems. |
### Agency Problem with Debt Lenders
Lenders face an agency problem when managers take on excessive risk (which benefits shareholders but endangers lenders). This is controlled by imposing negative covenants — restrictions on further borrowing and other risky actions.
### Agency Problem between Managers and Shareholders
The core issue is the misalignment of managers' personal interests with the goal of shareholder wealth maximisation.
### Ways to Address the Agency Problem
1. Managerial compensation — link manager pay to company profits and long-term objectives.
2. Employee Stock Ownership Plans (ESOPs) — make managers part-owners, aligning their interests with shareholders'.
3. Monitoring — strengthen oversight mechanisms to ensure managers act in shareholders' best interest.
### Key takeaway
The agency problem is fundamentally an alignment problem. The cheapest long-run solution is to make the manager think like an owner (ESOPs, profit-linked pay); monitoring and covenants are the control-based backstops.