Agency Theory in Financial Management

This research examines agency theory in corporate control and corporate financial management. Specific interest is directed toward the effects of agency theory on dividends, capital structure, capital budgeting, and mergers.

Agency, in law, refers to a practice where one party represents another in the transaction of activities (Nemmers, 1990). With respect to corporate control, agency refers to management's representation of the board of directors in the conduct of a firm's business, and to the representation of stockholders in the corporation by the board of directors in the conduct of the firm's business (Alchian, and Woodward, 1988).

Some theorists, researchers, and observers contend that evolution in the contemporary financial environment have created conflicts between shareholders and their agents, wherein shareholder interests are no longer always accorded preference (Morck, 1989). Others, however, contend that economic agency is an efficient form of organization, because a corporation has no "owners in a meaningful sense" (Fama, 1980, 288). The correctview likely lies at some point between these two views.

Communication between corporate management and shareholders is also an important part of agency. Among other things, agency theory holds that a conflict may exist between objectives of (1) maximizing shareholder wealth, and (2) maximizing management's compensation (Barnea, Haugen, and Senbet. 1981). It i

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relevant aspects of the decision can be described mathematically. . . . the word 'statistical' suggests an element of uncertainty in the process . . . " (Roberts, and Ling, 1982, 1). CAPITAL ASSET PRICING MODEL Two major goals of capital budgeting are to reduce investment risk, and maximize the return on investment (Rosenblatt, SinuayStern, 1989). The pursuit of these goals typically requires some modification of each. Two widely used approaches to the evaluation of risk and return in capital budgeting are "The Efficient Frontier," theory and "The Capital Asset Pricing Model" (Trivol, and McDaniel, 1987, 215228). The Efficient Frontier determines for a given portfolio the combination of investments within a portfolio offering the minimum risk for each alternative rate of return, or, for each alternative level of risk, the combination of investments within a portfolio offering the maximum rate of return. At the optimum, as an investor's goal is to increase expected return and reduce risk, the investors will be interested only in those portfolios which lie along the efficient frontier. The model makes assumptions, which permits the development of a result in which a single asset or portfolio of assets is considered a

Category: Economics - A