Agency costs increasingly become a significant part in a business’s expenditure. For years, many scholars and practitioners have contributed their time, knowledge, experiences in researching, and published many papers about agency problems. They recommend and also prove these recommendations through empirical tests on how to mitigate the costs from agency problems and enhance the firm’s performance.

There are internal approaches (compensation structure, governance, capital structure) and external approaches (take-over market, government regulations) to deal with agency problems (Cheng & Indjejikian, 2009).

However, so far these mechanisms are addressed separately in dealing with certain agency problems. In this paper, I aim to synthesize the internal approaches that companies can choose by themselves.

This paper is compiled with the purpose of reviewing the contemporary literature (from 2005 to 2010) about agency problems and mechanisms for moderating the agency costs.

I will also give suggestions about factors that managers should consider when choosing mechanisms in dealing with agency costs in specific conditions including country of origin, size of the company, age of the company, and type of agency problems.

I also suggest ideas for further research. The remainder of this paper is organized as follows: part 2 is a literature review about agency problems and mechanisms to mitigate agency problems; part 3 is a list of recommendations for managers and suggestions for further research; part 4 is the conclusion.

Literature review

Originating with the seminal works of Jensen and Meckling in the 1970s, literature about agency problems has made tremendous steps. To make my research more convenient, I will review literature about agency problems, agency costs, agency types, and the necessity of defining a specific type of agency problem.

Agency problems are defined as problems happening due to conflicts of interests between a principal and an agent. An agent is hired by a principal and is supposed to perform on behalf of the principal with the aim of maximizing the principal’s benefits. However, the agent also has his own interests, and, during the time working for the principal, he may diverge from the ultimate purpose of working for the principal and may perform for his own benefit. In the financial field, there are two primary types of agency problems: between shareholders and managers, and between equityholders and debtholders (Brigham & Ehrhardt, 2003).

First, I address the agency problem between shareholders and managers. When a company is set up, the founder is the owner and manager. He will act on behalf of himself to create more wealth. If the owner sells a part of his ownership to outsiders, the owner-manager will not possess 100% of the company and a conflict of interests occurs. The insider manager/owner will not behave in a way that maximizes the company’s wealth and will have a tendency to take advantage, consuming for his personal desire at company’s expense. The less company stocks the managers own, the more likely conflicts of interests will occur (Brigham & Ehrhardt, 2003).

The solution to the shareholders-managers agency problem is aligning the interests of managers with those of the shareholders, forcing them to work in a way that maximizes shareholders’ wealth. The incentive compensation is used to encourage managers, for governance structure to monitor them, or for leverage to constrain them. To execute the solutions, costs occur, and they are called agency costs. There are three main types of agency costs: costs occurring due to applying methods to monitor managers’ actions such as fees for using independent auditors; costs arising due to setting up the company’s organization in order to limit the managers from diverging shareholders’ interests; and opportunity costs that happen when shareholders take time to get a consensus before letting managers take action (Brigham & Ehrhardt, 2003).

Next is the agency problem between equity holders and debt holders. The debtholders give loans to the firm and get returns from firm’s cash flow in the form of interest payments. The interest rate applied for each loan is calculated based on the existing risk level of the firm at the time the loan is issued. After receiving the loan, the stockholders take action through their management in the company and change the risk level, such as selling some assets and investing in risky projects. The debt value decreases because more debt risk is borne. In case the risky project is successful, debtholders will not receive more returns because their income is fixed. However, if that project fails, debtholders have to share the risks. In this case, the interests of the two parties are not aligned. In order to protect their benefits, the debt-holders will apply some mechanisms such as stricter covenants or rising interest rates. This causes the company difficulty in accessing the financial market and the debt costs increase. This creates agency costs (Brigham & Ehrhardt, 2003). To alleviate agency cost from debts, equityholders’ and debtholders’ benefits should be balanced; scholars suggest the use of incentive compensation and convertibles in a company’s leverage (Ortiz-Molina, 2007; Siddiqi, 2009).

Nowadays, with the evolution of the business world, many new agency problems occur. Margaritis and Psillaki (2010) mention other types of agency problems such as conflicts of interests between shareholders who are executing company control and shareholders who are not, or minority shareholders. This happens when controlling shareholders who usually own a substantial portion of a firm’s ownership make decisions that are not beneficial for minority shareholders who do not have enough power to affect the decisions with voting rights. Overinvestment problems happen when there are surplus free cash flows and managers investing in projects that are not value-added without facing financial constraints (D’Mello & Miranda, 2010). Underinvestment problems arise when a company acquires too many debts, and the risk of default makes managers reluctant to invest and analyze thoroughly before deciding. Sometimes these managers ignore risky but high return projects and choose investments in safe projects without good returns (Margaritis & Psillaki, 2010). Cohen and Yagil (2006) mention another type of agency cost, which arises from using money to pay dividends and not investing in positive Net Present Value (NPV) projects.

In general, agency problems are related to the structure of ownership. The problems occur when the owners do not totally operate their businesses by themselves and when the owners acquire debts to finance the business. In other words, the benefit sharing among parties make people think and act more for themselves and lead to conflicts of interests. The shareholders and the managers, the majority shareholders and minority shareholders, the equityholders and the debtholders all invest in businesses, perhaps in different forms, and want their returns. However, with the participation of many parties, no one will be able to get all of the returns.

Each agency problem has its own core causes. Each mitigation mechanism also has its strengths and weaknesses. Thus, in order to deal effectively with a specific agency problem, we have to analyze the causes of the problem and choose the most suitable approaches to deal with it. In order words, we have to know what agency problems we are facing and why they occur. In the next section, I will review the mechanisms for dealing with agency problems.

Scholars and practitioners posit many approaches (internal and external) for curbing agency problems (Cheng & Indjejikian, 2009). I will concentrate on internal mechanisms that companies can choose actively by themselves. They are compensation structure, corporate governance, and capital structure. However, the different aspects in operating the economy in each country should be considered at first, because the agency theory was developed and mostly tested in full-market economies such as the U.S., Canada, or Europe. In other countries, if the economies are not operated in the same ways as the U.S., Canada, or Europe’s, the agency theory may not be totally supported (Barakat, 2008; Jo & Kim, 2008). In order words, the country of origin should be considered when deciding how to deal with agency problems.

Compensation structure

The conflicts of interest between managers and shareholders cause agency costs. Shareholders put money into a company, and they want their wealth maximized. Managers are hired to manage the company’s day-to-day activities. They invest their human capital in the company, and they want to maximize their investments as well. If the interests of the managers are attached to those of the shareholders’, this divergence is solved (Kanagaretnam, Lobo & Mohammad, 2009; Zhang, Bartol, Smith, Pfarrer & Khanin, 2008). Stemming from this approach, companies offer incentive compensation to executives as a way of encouraging them to act in value-added ways to shareholders. Thus, in the executives’ incomes, besides basic salaries and quarterly bonuses, there are some incentive payments tied to their company’s performance in order to encourage executives to pay more attention to long-term performances. There are two popular types of incentive compensation: stock ownership and stock-option grant.

When the managers join the company, they are given a certain amount of stocks with preferred pricing or other ways to connect their interests with their company’s interests. While stock ownership gives managers the feeling of keeping real wealth, the stock-option grant gives executives opportunities to purchase a certain amount of their company’s stock at a predetermined price for a specific range of time in the future. Managers will own the stocks if they execute their rights, or their options will expire. The logic of these incentives is that managers will try their best to increase the company’s stock price because they can get more returns. This behavior benefits shareholders as well.

When this mechanism is put into practice, its effect is inconsistent. Some studies argue that incentive compensation such as the stock-option grant help alleviate equity agency problems (Zhang, 2009; Zhang et al., 2008; Edmans, Gabaix & Landier, 2008). However, other studies provide adverse results (Harris, 2009; Kanagaretnam et al., 2009). The differences in results come from the differences in the samples taken and indicators used for testing. On average, the effects of compensation to alleviate agency problems are favorable. Although the empirical studies support incentive compensation, there also are some divergences. Some scholars prove that stock ownership works better in solving agency problems and also mention that out-of-the-money options do not reduce the agency problems, but stimulate them (Zhang et al., 2008).

It is easy to understand that even though managers’ benefits are tied to those of the company, if the current stock price is higher than their predetermined price, it is a more attractive situation for managers. However, in the case of out-of-the-money options, the current s