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Agency Cost Assignment Help

You need to write about the agency cost, you have to select a company and apply the agency cost in that company. You need to support your report with examples such as performance related pay and executive options (share option) what are the costs of share options? And what are the risks involved? And what are the advantages and disadvantages of share options?

- You can also write other examples than share options.

- You can add some statistical figures.

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Introduction

An agency cost can be described as an expense which the company's owners would be needed to bear as a result of the actions and decision made by the management of an company ( agents) acting on behalf of the owners ( shareholders and preferably working to generate higher value for the shareholders. Agency costs can be said to have arise if there is inefficiencies on the part of themanagers disruptions which are caused by the actions of the managers and consequently the dissatisfaction raised among the shareholders. Particularly agency costs can arise if there are instances of conflicts between the position taken by the management and what is needed by the shareholders. Agency cost is thus the payment which is required to be paid to the agents by the shareholders or ownersof a company.

For example, the owners always need the management to act in a manner which would be helpful for the shareholders to increase wealth of theirs but theadministration or the management might act in a manner which is perceived to be contrary to the interests of the shareholders and thus the conflict arises between the two. Management sometimes can act in a manner in which the managers would benefit more in the form of raised salaries and commissions but the same would not increase the value of the company and shareholders wealth.

In this assignment, I would be dissecting the agency cost borne by the owners of the Apple Inc in recent years and how the same has impacted the firms valuation and interests of the firms shareholders.

Literature Review

Agency costs generally arise from the actions undertaken by the agent on behalf of the principals. And the costs arise because ofdisruptions caused, inefficiencies created and also because of shareholders dissatisfaction with the working of the management. Agency costs are the costs which would be paid to the management or the agents to keep at bay the agency risks. Agency costs are necessary expenses within any organization where the principals do not yield complete autonomous power. Because the shareowners fail to operate in amanner which does not benefit the managers working beneath them, the shareholders would be required to ay associated costs to keep the management and others interested in working for the overall benefit of the owners. If the shareholders fail to pay or agree to pay then the same might help in management inaction and indifferent decisions which hits the firms bottom lines and reduce the market value of the firm and the market value each owners portion of the firms value. Thus to avoid such a situation the shareholders would be required to pay the managers performance bonuses, offer various stock options and many other incentives to keep them motivated and work for the overall benefit of the shareholders. The agents motive must be to help the firm do well and grow and keep the interests of all the interested parties aligning in the long term (Brealey, et al., 2017).

Dissatisfied Shareholders

Howeve, it must be remembered that the management is only acting as agents on behalf of the principals and owners. Shareholders are the owners of the company and the ultimate decision making lies with them. Therefore there can be times when the shareholders don't agree with the decisions taken by the managers and might not be inclined to keep the stocks in their hands in the long term. If they are dissatisfied with the decision making and also about the results then theshareholders would be willing to sell their holdings to minimise their losses. A specific actions by the managers and not liked by the shareholders can lead to a long term chain reaction of selling of shares which has the potential to dilute the market value of the firm. If the current shareholders are willing to sell the same can also discourage potential shareholders from buying and potentially more dangerous as the prices can spiral downward more frequently and dilute the position of the forms value further. Thus unfavourable agency decisions might boomerang for both the management and also the firm (Jordan & Jr., 2010).

Howeve, if the shareholders are partially not endorsing the decisions of the board or the managers then they can make efforts to bring in more reforms to the comparison and remove managers and director who are seen as unfavourable and bring in directors who are believed to work for their benefits. However, this process might have significant financial cost ofr the shareholders in thro form of management with others, lapse of time and effort put in for making the reforms. However such abrupt changes made to a company's Board of directors can also bring in redtapes and recalibration of the managers in power and the same can be disastrous for the shareholders contrary to their expectations.

Apple Inc is a multinational company with operations over 90-100 countries and hence quite diversified. Most of the decisions undertaken by the Executives who were appointed to the Board are by the shareholders and the intention of the shareholders is to let the BOD work in a way that maximises earnings and value. However, despite being a successful company Apple Inc faces significant decision making regarding alignment of the shareholders and managers interest and hence need to pay significant agency costs and bear significantly high agency risks.

Performance Related Pay

Apple Inc has almost perfected the compensation linked to performance. Apple Inc has traditionally been paying the CEO and others comparably to what others in the same industry pay. But since 2012 it has shown a tendency to pay higher to the Board members and CEO/CFO etc on the back of higher sales growth, earnings growth and market capitalisation. Most of the bigger companies peg the payments to employees and mangers in way in which the revenue and growth of revenue very weakly related to the payments made to leadership group and the returns generated by shareholders. Usually, the shareholders return is very low as compared to growth in pay. However, in the case of Apple Inc, the growth of pay to the leadership group is quite similar to the shareholders returns. Apple Inc's pay packages are modified in a manner under which the shareholders return is quite related to growth of sales and growth of compensation. The total shareholders return and sales growth for apple Inc is many times higher (10X) than the peers in S&P 500 (ROSS and Westerfield, 2012).

Firstly because Apple Inc's stock prices has been demonstrated to have no correlation with the industry. It tends to work faster and generate higher returns and growth than the immediately comparable industry because of the favourable branding it has created. Secondl, the sales growth is very uniquely and positively correlated to the stock prices. Because of the stronger correlation between the TSR and the sales growth at Apple Inc and a very weak correlation between company's performance and the performance of theindustry, Apple Inc's practice of paying the CEO and CFO mostly in stock works perfectly and derives a higher correlation between executive pay and TSR. This trend is pretty unique as the same is not prevalent in the industry.

Share Options

A stock option is made as an offer to the managers and board members in the form of a right under which the employees and managers can buy the stocks directly form the company at a discounted but specified price. However, the employee would be under no obligation to buy all the stocks under the stock option plan. Under certain stock option plans, the employees can be provided with a scheme under which the employee can convert the stock options into capital gains (Jordan & Jr., 2010).

Share options are provided to managers and directors including the CEOS and CFO etc to incentivise their work and they would need to work to grow the stock price because they could also realise the growing value of the stock prices in the form of stocks provided to them. This method tries to align the interest of the shareholders with that of the managers and directors of the companies including that of Apple Inc.

As of 2018 September 30, the Apple Inc has reserved 280.2 million shares which can be issued under ESOP or employee stock options plan pursuant to a company decisions made in 2013-2014. During the last three fiscal year, the company has vested stock options worth $5.1 billion in 2016, $6.1 billion in 2017 and a further stock options worth $7.6 billion were made in 2018 at their fair value on the vested dates. This amounted to approx. 12-15% of the net earnings made by the company in these periods.

Als, the company's proceeded to make share based compensation to the BOD and other managerial staff and innovation officers and designers as sated below:

a) A total of $5340 million was paid in 2018 as share based compensation

b) The same amounted to $4840 million in 2017

c) A total of $4210 million was paid in 2018 as share based compensation

The general trend points towards growing payments of compensation in stock awards and the same is commensurate with the growth of earnings and potential earrings of the company. Als, the company was able to raise its market value significantly during the last three years.

In the last three years the market price and the market value of the stock and the Apple Inc as a whole is produced below:

image.pngIt can clearly be seen that the stock options paid (considerably high cost to reduce agency risk) has been pretty successful in increasing earnings and stock prices and thereby maximising the firms value on a very consistent basis. Because the owners of the company themselves are not capable of such skillset and decision making themselves they could be prepared to pay the cost to remain a growing company and as a result of which the management is taking decisions and working towards maximisation of shareholders benefit and also their own benefits in the long term thereby aligning interests of both groups (Fabozz & Drake, 2009. ).

Advantages of share options plans

a) As the stock option plan provides the opportunity to own stocks in a company to the involved employees in the form of stocks, they would feel connected to the business growth and work in a concerted manner.

b) Theaddition of the stock options in the package of the employees would make them more attractive.

c) Staff retention would increase as vesting period would not allow a lot of employees to leave their jobs and this means staff related issues would be solved and labour turnover would decline.

d) Financial rewards in the long term would motivate employees to work for the achievement of group goals and work towards accomplishments in a group set up. They would be more interested in results and maximisation fo revenue and profits would materialise.

e) Employees, managers ad Board members of acompany such as Apple Inc often perceive the stock options as long term investments and which can be fruitful if they achieve the desired results. The stock options are oftenfinancially beneficial as they tend togenerate higher returns than other open market investments. They also come up with several income tax benefits which can further incentivise employees to go for the same. In the case of Apple Inc, the stock options can be extremely useful as the stock prices are on the rise on a consistent basis and annual returns in excess fo 20-25% can be realised over a long period of time (Eugene Brigham & Michael Ehrhardt, 2010).

Risks and disadvantages of Share Options Plans

The principal disadvantages of the stock option based plans are as follows:

a) Even if it brings monetary benefits in thelong term the tax consequence of a stock option can be cumbersome and expensive.

b) Shareholders of the company can face issues of dilution of ownership and control in the long term future.

c) The valuation of the stock options can be extremely difficult and tedious.

d) Sometimes stock option plans would be too difficult for small and medium level business as the same can be too costly for them.Mostly suitable for large firms.

e) A bonus under the stock option plan can be received by the particular employee only if the other co-workers must have acooperative work focus and growth oriented team work.

Have performance related pay improved the efficiency of the selected company?

Yes. They have. Apple Inc has retraced the stock based compensation and stock options in manner under which the CEO/CFO and others would be provided with stock compensations as per the performance they achieve on an annual basis. If apples TSR or total shareholders return is among the top 33% of the S&P 500 list then the executives would be expected to receive higher compensation and if the performance of the company is in the bottom 33% then they would be paid less. This clearly has aligned the compensation based on stocks with the company's performance and since then the amount of the overall stock compensation ahs gone down ( not stock options). While before the period the stock based compensation used to be approx. 90-100million per year the same now has gone little under $66-70 million. To achieve more stock based compensation the executives would thus need to do more and achieve more results. The higher they go in the S& P 500 list the better and large the compensation would be and this has set a bigger benchmark and performance has improved in the last 6 years from the new plan was being implemented (Damodaran, 2011).

How Apple has tried to avoid and reduce Agency Risks in recent years?

In 2013, the shareholders of the Apple Inc produced a reform which was clever and also demanded long term compliance and allegiance formexecutives to be able to benefit from stock options. More than $20 billion worth stock options were till date distributed to executives but these executives frost would need to subscribe 3 times of their base salary to stocks of the company and they have five years to do so form the date of their vesting starts. The chief executives were told to hold ten times the base salary as stock holdings and they cant divest the stock options within five years. Non-employee executive directors would need to hold five times of their base salaries. This was a clever ploy to make sure the executives (agents) were actually interested in increasing stock prices and value of the firm rather than just increasing their earnings and commissions. The scheme was simple but had merit in getting the agents to work for the maximisation of stock prices as they were also in the boat as the stock owners and they were needed to show allegiance to the company for five years before they can divest the stock options. Als, the simple clause made sure the agents were also needed to become significantly intersected shareholders and act like principals even if they were acting on behalf of the shareholders. They probably behaved like owners since then as their fortune were tied to the results they generate and it was a win-win for both since 2013 as the company not only increased growth of revenue but also both net profit and EPS ahs increased to increase the stock prices YOY and overall market value of the firm was flying upwards making Apple Inc the first ever company to reach $1 trillion in value in the mid-2018 (Bodie, 2012).

Conclusion

Stock options are being used by smallcompanies in which long term growth is expected and also apt for public companies like Apple Inc which offers stocks to executives to increase employee involvement. However as suggested by some scholars in recent times (Fortt, 2016), the stock options must not use as an alternative to fair cash salary and instead be used as incentives. Steve jobs the late CEO and co-founder of the Apple Inc has always favoured stock compensation in addition to cash salaries and always advocated payment of less cash salary and higher compensations in non-cash incentives. As a result of the clear cut thinking on the part of the company's management fro, an early period the development of stock bases compensation and stock options became popular at Apple and it was now structured in such a manner that would compel the managers to think long term. Good and reliable workers can be kept at the company and more talented workers can be drawn through long term growth of stock options and stock compensation and the same has worked in favour of Apple Inc as it has outpaced most rivals in the last decade or so.

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