Agency: formula sheet

Key formulas

Agency relationship

Principal (shareholders) → delegates authority → Agent (directors)

The agent acts on behalf of the principal. In companies, ownership and control sit with different people.

Source of the agency problem

Separation of ownership and control + differing objectives + information asymmetry

Use this as a three-part checklist when explaining why the problem arises.

Accountability chain

Shareholders → board → senior managers → staff

Each link can be an agency relationship, so the agent at one level is the principal at the next.

Agency relationship

Principal → delegates authority → Agent

Identify both parties from the scenario. Shareholders and directors is common, but directors and managers, or lenders and the company, can also fit.

Total agency costs

Agency costs = monitoring costs + bonding costs + residual loss

Monitoring is borne by the principal. Bonding is borne by the agent. Residual loss is the value lost that remains despite both.

Causes of the problem

Divergent interests + information asymmetry + moral hazard

Divergent interests create the conflict. Information asymmetry and moral hazard let it continue.

Agency costs

Agency costs = monitoring costs + bonding costs + residual loss

Monitoring: paid by principal (audit, controls). Bonding: agent shows commitment (reports, contract terms). Residual loss: value still lost after both.

Goal congruence test for a reward scheme

Reward scheme works if: manager's pay rises when shareholder wealth rises

Use this to judge any pay package in a scenario. Ask what the manager is actually paid for.

Share option value to holder at exercise

Gain per option = market price at exercise − exercise price (only if positive)

If the market price is below the exercise price, the option is not exercised and the gain is zero.

Balanced pay package

Total pay = fixed salary + short-term bonus + long-term incentive (options or shares) + benefits

Not a mathematical rule. It is the structure most governance codes expect: a significant part should be performance-linked and long term.

Quick revision

• The principal owns the business or its interest. The agent acts on the principal's behalf.
• Agency problem: the agent may put personal interests ahead of the principal's.
• Information asymmetry means managers know more than owners, which makes the problem harder to control.
• Agency costs include monitoring costs, bonding costs and the residual loss from decisions that still go against owners.
• Typical conflicts: short-termism, risk preferences that differ, excessive perks, empire building.
• Monitoring tools: audit, independent non-executive directors, board committees, and reporting.
• Incentive tools: performance-linked pay, bonuses and share-based schemes, tied to long-term value.
• Incentives can backfire if targets are narrow, easy to manipulate or encourage excess risk.
• Bonding means the agent commits to act in the owners' interest, for example through contract terms or shareholding.
• Other stakeholders such as employees, lenders and communities also have claims that agency theory largely ignores.
• The theory assumes self-interested, rational agents. Real managers may also act as stewards or be driven by ethics.
• In answers, always tie theory to the case facts and finish with a practical recommendation.

Common mistakes

• Writing a textbook definition without using the case. Fix: Name the actual company, the directors and the shareholders. Tie every point to a fact in the scenario.
• Confusing who is the principal and who is the agent. Fix: The principal delegates and the agent acts. Shareholders delegate to directors, so directors are agents.
• Treating agency problem and moral hazard as the same thing. Fix: Say the agency problem is the overall conflict. Moral hazard is one behaviour within it, where the agent takes risk or lowers effort because someone else bears the cost.
• Giving only textbook definitions of the three agency costs. Fix: For each cost, give an example from the scenario, such as an external audit as monitoring or a director shareholding commitment as bonding.
• Listing mechanisms without applying them to the scenario. Fix: Link each mechanism to a named fact: who the directors are, how they are paid, what has gone wrong.
• Saying performance-related pay always solves the agency problem. Fix: Always give a limit: short-termism, manipulation of profit, targets outside the manager's control, or excess risk.
• Writing a theory essay with no link to the scenario. Fix: Every paragraph must cite a fact from the case. Name the people and decisions involved.
• Treating stewardship and agency theory as always opposites, with one right and one wrong. Fix: Say that the better fit depends on the people, culture and risk. Often a blend of trust and controls is best.

Exam tips

• Always name the principal and agent from the case. Generic answers score poorly.
• Use agency theory as a lens on case facts such as bonuses, share options, board dominance and weak reporting.
• Show professional skills by giving a balanced view. Note both the risks of agent self-interest and the value of good stewardship.
• Keep the theory short and spend most of your time applying it. Most marks are for application.
• If the requirement asks for advice, move from the problem to a practical response, such as monitoring or incentives.
• Always name the principal and agent from the case before using theory. Generic answers lose application marks.
• Use the exact terms monitoring, bonding and residual loss, and give a scenario example for each.
• Keep moral hazard and information asymmetry separate. Define each in one line and show it in the case.