Agency Costs and Dividend Policy in a Recession - Research Proposal Example

Agency Costs and Dividend Policy in a Recession Introduction During a period of recession, the frequent occurrence of corporate bankruptcies and business failures draw attention to the function of the manager as agent of the firms’ shareholders. The 2008 subprime mortgage debacle in the United States that spawned a full-blown financial crisis in the United Kingdom and elsewhere, has plunged the world into an international recession that is expected to have long-term repercussions. With the spate of corporate closures, erosion of shareholder wealth, and massive layoffs, there is a public clamor for the corporate executives and officers of these apparently mismanaged firms to be held accountable for their utter failure to perform their tasks as stewards of these businesses. Primarily, the recent financial crisis has brought attention to the disproportionately large executive payoffs particularly in companies that have declared bankruptcy. The answer appears to lie in the relationship of management and shareholders, the agency costs associated with this relationship, and the repercussions on the capital wealth and dividends that should have accrued to these shareholders. This study is intent on determining how agency costs are affected during a period of recession, and how, in turn, this affects dividend policy. Literature Review Agency theory is based on the suggestion that the firm is a (loosely defined) nexus of contracts between individuals who have, through debt or equity, invested in the firm. When one or more of said debt or equity holders (principals) hire one or more individuals (agents) to perform services (management of the company) and delegate decision-making authority to these individuals in their (the principals’) name, then an agency relationship is established. Primary agency relationships that are of significance in business are those that exist: (a) between stockholders and managers, and (b) between debtholders and stockholders. It is a given that these relationships are seldom harmonious. Agency theory is in fact primarily interested in understanding the conflicts that exist between parties to the agency contract, and their implications in corporate governance and business ethics. Furthermore, when agency arises there are also necessarily the emergence of agency costs. These are expenses incurred to sustain and maintain an effective agency relationship. Agency costs may include, for instance, management perquisites and performance bonuses to motivate managers to make decisions in favor of shareholders’ interests. Agency costs was first formalized by Jensen and Meckling (1976) as a conflict of interest between managers and shareholders (Depken, Nguyen and Sarkar, 2006). This conflict highlights the often divergent views of management and shareholders, a clash which is brought into stark contrast particularly during financial crises and economic recession. Theory states that agency costs should be inversely related to the ownership share of the primary owner. The reason for this is that the incentive to consumer perquisites declines as his ownership share rises, since his share of the firm’s profits increases with increasing ownership share, whereas his benefits from perquisite consumption remains relatively constant. Conversely, agency costs tend to increase as the number of non-manager shareholder rises. When the number of shareholders increase, the free-rider problem lessens the incentive for limited-liability shareholders to oversee the management function; and when there is less monitoring, there is usually higher agency cost. (Ang, Cole and Lim, 2000) The study by Boivie, Lange, McDonald and Westphal, published in 2009, examined the effects of CEO organizational identification on the agency costs incurred. It proceeds from the assumption that the interests of corporate management in the person of the chief executive officer normally diverge on important issues. It is presumed that CEOs make decisions and pursue actions that serve their personal interests and advance their individual goals. This “agency theoretic perspective of the firm” is also known as the “agency problem”. It states that managers are by nature primarily motivated by personal goals and are predisposed to use their corporate control over policy to serve their own interest over those of the corporation. Agency costs result from this “problem”. Related to this would be the effect of bonding and monitoring on executive compensation and, subsequently, agency costs. An investigation into this relationship was discussed in the study by Depken, Nguyen and Sarkar (2006). The study distinguished between internal and external mechanisms that are at work in reducing and regulating agency costs. External mechanisms consist of the monitoring procedures conducted but the capital market, legislators, investment professionals and investors themselves. The internal mechanisms are comprised of compensation contracts, bonding, and monitoring activities within the firm. Both mechanisms aim to align the utility of the manager with the utility of the shareholder. Depken, et al. concluded that agency conflict is mitigated by these internal and external mechanisms. Boivie, et al. (2009) have also arrived at two other principal mechanisms adopted for the purpose of reducing the chances that corporate action would advance the interests of top management while imposing additional and unnecessary costs to the shareholders. The first is to enact a compensation scheme that intends to align the goals of the CEO with those of the shareholders. Second is the enhancement of director independence from management. (Boivie et al., 2009) Apparently contradicting the Depken and Boivie findings is an article by Hoskisson, Castleton and Withers (2009). The researchers here treat on the nature of monitoring and bonding as concurrent substitutes in a system of corporate governance. However, while this may be so, they do not offset one another so much as concur with each other. The study suggested that increased monitoring intensity shifts risk to managers, who therefore require higher compensation in view of their increased employment and career risk. Because of this, monitoring and bonding reinforce each other in a “negative cycle such that monitoring leads to increased pay, which in turn leads to increased monitoring due to complaints of excessive pay” (Hoskisson, Castleton & Withers, 2009). Agency costs should be higher at firms managed by an outsider, following the agency theory of Jensen and Meckling (1976). This represents the extreme case where the manager gains 100 percent of perquisite consumption, but hardly any of the firm’s profits. (Ang, Cole and Lim, 2000). The study found that: 1. Agency costs are higher when an outsider manages the firm 2. Agency costs vary inversely with the manager’s ownership share 3. Agency costs increase with the number of nonmanager shareholders 4. To a lesser extent, external monitoring by banks produces a positive externality in the form of lower agency costs. Importance of research topic Agency cost is a particularly significant topic, at this time of widespread corporate failure and bankruptcy. For public companies in particular, shareholders are clamouring for managers to account for the deterioration of their company’s value in the face of nearly scandalous executive compensation packages. The government’s bailout package during this financial crisis, which in effect represents trillions of dollars of taxpayers’ money being channelled to companies badly managed by highly paid managers, justifies an inquiry into the agency problem at this point in the economic recession. While the time limitation of this study may qualify the conclusions arrived at, nevertheless this study should contribute to the body of knowledge on agency costs, and provide a valuable basis for similar future studies during periods of economic recession. Methodology The study shall employ quantitative and qualitative methods of analysis. Quantitative methods will be employed in the sourcing of data from the financial statements of the subject firms. Data on operating costs and sales, ownership structure, and dividend declarations and policy shall be used in the quantitative analysis consisting of correlational analysis and hypothesis testing. The qualitative analysis shall use data to be gathered by interview of firms’ managers or owners concerning their dividend policies, as well as hiring and compensation practices during a period of recession. This is to provide corroboration in the interpretation of the final results. The Calculation of Agency Costs Some studies, such as Depken, Nguyen and Sarkar (2006) are of the view that agency costs are primarily of an unquantifiable nature. However, other studies sought a method by which proxy data may be utilized to observe the behaviour, if not the magnitude, of agency costs. A particularly helpful method is suggested by Ang, Cole and Lin, based on two fundamental assumptions: 1. A firm managed by a 100 percent owner incurs zero agency costs; and 2. Agency costs can be measured as the difference in the efficiency of an imperfectly aligned firm and the efficiency of a perfectly aligned firm. Ang, et al. made use of the following data inputs in their statistical regressions: 1. Data on firm efficiency measures 2. Data on firm ownership structure, including a set of firms that are 100 percent owned by managers; and 3. Data on control variables such as firm size, characteristics and monitoring To measure agency costs of the firm, two alternative efficiency ratios were used by the researchers. These ratios frequently appear in the accounting and financial economics literature. These are: 1. Operating expense scaled by annual sales – This measures how effectively the firm’s management controls operating costs, including excessive perquisite consumption, and other direct agency costs. The difference in the ratio of a firm (Firm A) with a certain ownership and management structure, and the no-agency-cost base case firm (Firm B), multiplied by the assets of Firm A, yields the agency cost related expense in dollars; and 2. The asset utilization ratio, arrived at by dividing annual sales by total assets – This is a measure of the effectivity of a firm’s management in deploying its assets. In contrast to the expense ratio, agency costs are inversely related to the sales-to-asset ratio. If the firm has a sales-to-asset ratio that is lower than that of the base case firm, the first firm is then said to experience a positive agency cost. These costs materialize because management acts in some or all of the following ways: a. Makes poor investment decisions b. Exerts insufficient effort, resulting in lower revenues c. Consumes executive perquisites, so that some of the firms purchases are unproductive assets like excessive or fancy office space, office furnishing, automobiles, and resort properties Limitations Inasmuch as by its nature, agency costs are not specifically quantifiable, then this study should be understood to be operating under the following limitations: 1. Measurement error may result from differences in accounting methods chosen with respect to the recognition and timing of revenues and costs; 2. There is an element of poor or inadequate adherence to strictly accurate record-keeping; 3. In small and medium-scale businesses managed by its principal stakeholder, owners have a tendency to exercise flexibility and personal discretion with respect to certain cost items; and 4. The period of recession most immediate began in mid-2007 through 2008 to the present, hence the shortness of the time duration is necessarily a limiting factor to the study. Data collection methods and type of data The study will adopt the quantifying method used by Ang, et al., and will therefore make use of the following data, pertaining to the period immediately before and during the present economic recession (2005-2009): 1. Data on the firm’s efficiency, as shown by turnover ratios and other financial indicators 2. Data on firm ownership structure, including a set of firms that are 100 percent owned by managers, which shall be gleaned from companies’ financial reports and compliance reports submitted to the Securities and Exchange Commission; and 3. Data on control variables such as firm size, characteristics and monitoring, to be taken from available documents and interviews to be conducted with the firms’ managers or owners. 4. Additionally, data will be gathered concerning the firm’s dividend policy and actual dividends declared Hypothesis This study intends to test the following hypotheses: H10: There is no significant difference between levels of agency costs during and prior to a period of recession. H20: There is no correlation between levels of agency costs incurred by a company, and the dividend declarations made by the same company. REFERENCES Agency Theory. Accessed 20 October 2009 from http://www.referenceforbusiness.com/encyclopedia/A-Ar/Agency-Theory.html Ang, J A; Cole, R A; & Lin, J W 2000 Agency Costs and Ownership Structure. The Journal of Finance, vol. LV, no. 1, February. Block, S B & Hirt, G A 2006 Foundations of Financial Management, Eleventh Edition. McGraw-Hill International Edition. Boivie, S; Lange, D; McDonald, M L; and Westphal, J D 2009 Me or We: The Effects of CEO Organizational Identification on Agency Costs. Academy of Management Proceedings, p. 1-6 Depken, C A; Nguyen, G X; & Sarkar, S K 2006 Agency Costs, Executive Compensation, Bonding and Monitoring: A Stochastic Frontier Approach. Journal of Executive Leadership. Accessed 20 October 2009 from www.fma.org/Orlando/Papers/agencycosts9.pdf Frank, D H & Obloj, T 2009 Ability and Agency Costs: Evidence from Polish Banking. INSEAD Working Papers Collection, 2009, Issue 17, preceding p1-50 Hoskisson, R E; Castleton, M W; & Withers, M C 2009 Complementarity in Monitoring and Bonding: More Intense Monitoring Leads to Higher Executive Compensation. Academy of Management Perspectives, May2009, Vol. 23 Issue 2, p57-74 Mishkin, F S & Eakins, S G 2003 Financial Markets and Institutions, Fourth Edition. Addison-Wesley International Edition. Read More