Agency Theory and the Agency Problem

A shareholder in a large company cannot run it. She appoints directors, and the directors appoint managers, and those people make the daily decisions about what to buy, whom to hire and which projects to accept. They are using her money, but they are not her.

If their interests were identical to hers there would be no problem. But they are not: a manager wants a good salary, a safe job, a bigger empire and a comfortable life, while the shareholder wants the value of her shares to grow. Agency theory is the study of this problem.

This topic explains the agency relationship, the five ways in which agency conflicts arise, the costs that shareholders incur because of them, with numerical illustrations. The next topic covers the ways in which the problem is reduced: governance codes, listing rules and reward schemes.

Agency theory underlies governance, remuneration policy and the case for independent directors, so it appears in scenario questions on how to align managers and owners. Read stakeholders and conflicts of objectives first.

The agency relationship

Agency theory was developed by Jensen and Meckling (1976). They defined the agency relationship as a contract between a company’s owners and its managers, in which the owners appoint an agent (the managers) to manage the company on their behalf and delegate decision-making authority to them. The owners expect the agents to act in the owners’ best interests as the contract states.

But a perfect contract cannot be written: the managers’ decisions affect their own interests as well as the owners’, and where they conflict the managers will tend to give priority to their own. When that happens, there is a weakness in the governance of the company.

How agency conflicts arise

• Moral hazard. A manager has an interest in the benefits of the position: status, a company car, lunches, sponsored events. The incentive is stronger when the manager owns few or no shares, and the problem is biggest in large companies.
• Effort level. Managers may work less hard than they would if they owned the company, with the effect of lower profits and a lower share price. It exists at middle and senior levels, and interests differ between them where senior managers have profit incentives and middle managers do not.
• Earnings retention. Directors’ pay is often related to the size of the company and not its profits, which gives managers an incentive to grow turnover and assets, and to reinvest profits to make the company bigger and not to pay dividends.
• Risk aversion. Executives earn most of their income from the company and want it stable, to protect their job and income. They may be reluctant to invest in higher-risk projects, while shareholders, who can diversify, may want bigger risks if the expected returns are high enough.
• Time horizon. Shareholders care about long-term prospects, because the share value depends on long-term expectations. Managers may be interested only in the short term, partly because bonuses depend on short-term results and partly because they may not stay long. They may try to raise the accounting return on capital employed (ROCE) while shareholders care about long-term share value.

An illustration: risk aversion and time horizon

A division earns ₦60m on capital employed of ₦300m, a ROCE of 20%. A new project would cost ₦100m and earn ₦15m a year for ever. The company’s cost of capital is 12%. The project is worth ₦15m ÷ 0.12 = ₦125m for a cost of ₦100m, so it adds ₦25m of net present value. But the division’s ROCE after the project would be (₦60m + ₦15m) ÷ (₦300m + ₦100m) = 18.75%, below 20%.

A manager paid on ROCE would reject a project that makes the shareholders richer.

Agency costs

Agency costs are the costs that shareholders incur when professional managers run their company. They do not exist when the owners and the managers are the same people; they start to arise when some shareholders are not directors. They are potentially very high in large companies with many shareholders and a large professional management. They have three aspects:

• Monitoring costs. The costs of systems to watch the actions and performance of management, such as the requirement that directors present an annual report and audited accounts. Preparing and auditing accounts has a cost, as does the board’s own oversight.
• Costs of decisions not in the shareholders’ interests (opportunity costs). For example, directors pay ₦900m for a subsidiary worth ₦700m because running a bigger group enhances their status. The overpayment of ₦200m is a cost to the shareholders, about ₦2.00 a share if there are 100 million shares and the share price falls to reflect it.
• Bonding costs. The costs of giving managers incentives to act in the shareholders’ interest, mainly the cost of executive remuneration packages: free shares, share options and cash bonuses linked to financial targets.
  For example, 400,000 share options at an exercise price of ₦8.50, exercised when the share price is ₦12.10, give the manager a gain of 400,000 × ₦3.60 = ₦1.44m, which is a cost to the shareholders.

The ideas in more depth

Why the problem grows with the size of the company

When one person owns and runs a business, her gain from an extra naira of profit is the whole naira and her loss from a perk is her own. When ownership is spread over thousands of shareholders, each of whom owns a tiny part and has little power, the manager captures the benefit of a perk but bears only a tiny share of its cost. The incentive to look after the owners’ interest weakens.

Why a perfect contract is impossible

Future events cannot all be foreseen, managers’ effort and the quality of their judgement cannot be observed fully, and it costs money to monitor. So the owners must accept some divergence and spend money to keep it down, up to the point where an extra naira of control saves more than a naira of agency cost. This is the logic of the governance measures in the next topic.

Sources and references

• No accounting standard governs this topic. The theory was set out by Jensen and Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” (1976).

These points are stated as at 5 November 2026.

Worked examples

1. NPV.
   ₦15m ÷ 0.12 = ₦125m
   ₦125m − ₦100m = ₦25m.
2. ROCE.
   (₦60m + ₦15m) ÷ (₦300m + ₦100m) = 18.75%, a fall.

1. Overpayment.
   ₦900m − ₦700m = ₦200m.
2. Per share.
   ₦200m ÷ 100m = ₦2.00.

1. Gain.
   400,000 × (₦12.10 − ₦8.50) = ₦1.44m.

How to answer in the exam

• Define the agency relationship (principal, agent, delegation) and say why a perfect contract is impossible.
• List the five conflicts and give a short example of each, tied to the scenario.
• Separate the three agency costs and say which applies to each fact in the question.
• Quantify an agency cost where the figures permit.

Common mistakes in the exam

• Describing agency costs as only the cost of paying managers.
• Saying that agency costs exist in an owner-managed business.
• Confusing monitoring costs with bonding costs.
• Missing risk aversion and time horizon among the conflicts.
• Not linking the conflict to the shareholders’ wealth.
• Treating the ROCE of a division as a measure of value created.

Quick revision

• Agent (managers) acts for principal (owners); no perfect contract.
• Conflicts: moral hazard, effort, earnings retention, risk aversion, time horizon.
• Costs: monitoring, opportunity cost of poor decisions, bonding.
• Nil when owners are managers; highest in large companies.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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