Agency cost

An agency cost is the cost incurred by an organization that is associated with problems such as divergent management-shareholder objectives and information asymmetry.

The information asymmetry that exists between shareholders and the Chief Executive Officer is generally considered to be a classic example of a principal-agent problem. The agent (the manager) is working on behalf of the principal (the shareholders), who does not observe the actions of the agent. This information asymmetry causes the agency problems of moral hazard and adverse selection.

These costs were first identified by Michael Jensen and William Meckling in 1976. Berle and Means first identified these costs in the late 19th century, while observing the structure of US organisations.

According to Ross and Westerfield (Corporate Finance, 7th edition): when a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies, imposing agency costs on the firm. These strategies are costly, because they lower the market value of the whole firm. These strategies may be: 1. Incentive to take large risks; 2. Incentive toward underinvestment; 3. Milking the property.