The Role of Corporate Governance in Reducing Agency Cost
You are asked to discuss the concept of corporate governance and its importance in minimising agency costs.
Corporate governance is referred as the scheme of rules, practices and procedure through which an organization is directed and organized. Corporate governance particularly comprises of the balancing the benefits of the organizations several stakeholders, such as shareholders, administration, trades, dealers, investors, community and government. The mechanism for corporate governance is considered as those mechanisms that protect the interest of the shareholders. A nation’s financial expansion increases with the assistance of the worthy corporate governance.
As stated by Panditharathna (2016), organizations would face greater difficulties of agency cost at the time when they possess weaker organisation of corporate governance and despite increasing the organizations value, managers of these organizations stuff themselves in personal pursuits. Additionally, studies have directly measured the agency level of cost and have later determined the factors that have impacted the organizations agency costs that are limited in number. The objective of the study is to assess the effectiveness of the mechanism associated with the corporate governance and assembly of title in reducing or monitoring the cost originating from the agency problems.
Agency cost could occur in the form of self-serving conduct for the executives focussed on the prestige or unwarranted extra consumption, non-optimal venture judgement making or the deeds of bookkeeping misadministration or the business fraud. Opposing impact of these activities is experienced as demolition of the shareholder wealth and extensive influences on the corporate stakeholders. The current work is based on the role of the corporate governance in alleviating the agency cost and suggests that the agency cost can be reduced with the help of internal governance mechanism with empirical evidence to support this argument. For the study done by the Francis et al. (2016), small boards are noticed to be less powerful and operative in comparison to boards that have been larger in size. Dang et al. (2017) have supported such evidences, by stating that the association relating to the board size and asset utilization ratio is constructive and are vital statistically. Moreover, it can be stated that the agency cost would be lesser with better utilization of the asset utilization. According to Dalwai et al. (2015), studies have represented that the size of the board creates a bad effect on the agency cost that forms the substitute to asset income, which means that with the greater the board size the superior will be the cost of agency due to the lower efficiency.
Greater board freedom is viewed as the monitory instrument that could hekp in restricting or regulating the problems of agency. Studies from Al-Najjar, (2014), have highlighted the role of independent directors and have proposed that they are most probably to work in the favour of shareholder’s interest. Tricker & Tricker (2015), who have stated that agency cost would be lower with higher amount of independent directors on the board and also noticed identical results. Findings from the studies have suggested that the independence of board does not play assist in reducing the cost of agency. The literature strongly lay down its suggestion by stating that the separating the post of the CEO and chairperson would not only assist in improving the performance of an organization but also assist in minimizing the agency costs.
Board Size and Agency Cost
Another considerations regarding the lowering of the agency cost is the structure of remuneration. It is projected in the study that the greater the salary of the managers the lesser would be the cost of agency. This is because such kind of incentives would enable the executives to work for the betterment of the organization in order to constantly receive the benefits and to safeguard their occupation security. Nevertheless, on the contrary to the forecasts that is made in the earlier studies regarding the relations between the structure of remuneration and agency cost Honoré et al. (2015), has noticed that the effect of wage structure on the agency cost measure the asset utilization ratio to be undesirable. This indicates that the with greater remuneration of director it does not lower the agency cost. Simultaneously, it is noticed that wage structure has undesirable relation with the liquidity asset ratio, which suggest that the wage structure reduces the agency cost. The agency cost would be reduced with the higher ownership since the owners of the managers in the organization increases, which would ultimately causes the conjunction of interest among the directors and the shareholders.
Institutional shareholders play a vital role in lowering the agency cost since they could screen the performance of the organization and the act of the mangers, which could influence the decision making of the management. According to García?Castro et al. (2013) institutional investors in respect to the private shareholders that have less information will be able to monitor the management performance at lower agency cost because of the availability of the greater expertise and resources. The variable of external proprietorship is viewed as the sum of all the separate shareholders excluding the administrative and institutional shareholders. Concerning the institutional shareholders the other substantial external shareholders can increase their worth by assessing the organizations performance that would result in lowering of agency costs.
Similarly, the institutional ownership will have noteworthy affirmative effect on the asset utilization ratio. The institutional investors assess the organizations performance through efficient monitoring that aligns with the interest of the shareholders and owners resulting in lowering of the agency cost (Colombo et al., 2014). Evidences from the findings have suggested that smaller size of the board plays an important role in the reduction of agency cost in respect to the wider size board.
Observing and understanding the actions of the management is behind the reduction of the agency cost by judging the performance of the managers through wealth maximization of shareholders. Monitoring of cost is based on the expenditure which is paid for controlling and measuring the behaviours of the managers. Initially these costs are paid by the shareholders however in the end it is covered by the managers since their remuneration is based on covering these costs.
Holding monitoring cost by the managers drives them to create their actions on the shareholder’s interest or else the managers would have to suffer the consequences. The cost involved in setting and working in agreement with the monitoring system is known as the bonding cost (Chen et al., 2014). These cost is generated by the managers with the financial and non-financial aspects of business. These cost are borne in an attempt to provide information to external shareholders accurately and in time. The managers can restrict carrying the bonding cost for managerial balance, lowering the monitoring cost equivalent to the increasing the bonding cost.
Independence of Directors and Agency Cost
Contempt to the monitoring cost and cost of bonding the difficulty involved in assembling the interest of the shareholders and managers would continue to be adding to other differences among the manager decisions and decision of increasing the benefits of the shareholders. This results in agency loss arising from the conflict of the interest that is known as residual loss. such loss is not assessed in accordance with the expectations of the shareholders or high level managerial performance (Zeitun & Tian, 2014). Therefore, increasing the role of managers will help in reducing the agency cost. This would help in promoting the idea of providing bonus by signing contracts imposing costs for making differential cost equivalent to the differential benefits to lower down the residual loss.
Solving the problems of agency and lowering the agency cost can be done with the help of managerial labour market. However, solving the problems of ownership separation should be created as this forms an effecting factor which enables the managers of acting towards the shareholder’s interest by providing stimulus of encouraging the managers. Such factors are presented in the managerial labour market for corporate governance and leading the inappropriate administrative performance to administrative replacement (O’Brien et al., 2014). The managerial labour market makes the use of the previous performance reports of the managers to determine the opportunities for the company which turns out to be the bonus for the managers. The managerial labour market can help in maximising the role of the managers in determining the shareholder value and simultaneously helps in reducing the agency cost.
Conclusion:
The study has attempted to assess the concept of corporate governance in minimising the agency cost. The essay has made use of the asset utilization ratio to assess the agency cost. The findings from the essay has revealed that better director and institutional ownership helps in reducing the agency cost. The smaller size of boards leads to the lowering of the agency cost whereas the variable size of the board creates a noteworthy negative relationship with the asset utilization ratio. Greater individuality creates an encouraging relationship with the asset utilisation ratio. The parting of CEO from the post and chairperson with greater wage would help in reducing the agency cost at the time when the asset utilisation ratio was regarded as the dependent variable
Reference List:
Al-Najjar, B. (2014). Corporate governance, tourism growth and firm performance: Evidence from publicly listed tourism firms in five Middle Eastern countries. Tourism Management, 42, 342-351.
Chen, V. Z., Li, J., Shapiro, D. M., & Zhang, X. (2014). Ownership structure and innovation: An emerging market perspective. Asia Pacific Journal of Management, 31(1), 1-24.
Colombo, M. G., Croce, A., & Murtinu, S. (2014). Ownership structure, horizontal agency costs and the performance of high-tech entrepreneurial firms. Small Business Economics, 42(2), 265-282.
Dalwai, T. A. R., Basiruddin, R., & Abdul Rasid, S. Z. (2015). A critical review of relationship between corporate governance and firm performance: GCC banking sector perspective. Corporate Governance, 15(1), 18-30.
Dang A, R., Houanti, L., Le, N. T., & Vu, M. C. (2017). Does corporate governance influence firm performance? Quantile regression evidence from a transactional economy. Applied Economics Letters, 1-5.
Francis, B., Hasan, I., & Wu, Q. (2015). Professors in the boardroom and their impact on corporate governance and firm performance. Financial Management, 44(3), 547-581.
García?Castro, R., Aguilera, R. V., & Ariño, M. A. (2013). Bundles of firm corporate governance practices: A fuzzy set analysis. Corporate Governance: An International Review, 21(4), 390-407.
Honoré, F., Munari, F., & de La Potterie, B. V. P. (2015). Corporate governance practices and companies’ R&D intensity: Evidence from European countries. Research policy, 44(2), 533-543.
O’Brien, J. P., David, P., Yoshikawa, T., & Delios, A. (2014). How capital structure influences diversification performance: A transaction cost perspective. Strategic Management Journal, 35(7), 1013-1031.
Panditharathna, K. M. (2016). Corporate Governance and Firm Performance.
Tricker, R. B., & Tricker, R. I. (2015). Corporate governance: Principles, policies, and practices. Oxford University Press, USA.
Zeitun, R., & Tian, G. G. (2014). Capital structure and corporate performance: evidence from Jordan.
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