Agency Theory And Risk-Sharing Problem

Agency theory describes the relationships between principals who are shareholders and agents who are managers and how their interests can be aligned.The theory aims to solve two main problems, namely the agency problem and risk sharing problem (Eisenhardt, 1989). The agency problem exists when the aims of the principals and agents are different and when it is hard or too expensive for the principal to check what the agent is doing and whether the work is done appropriately (Jerzemowska, 2006). The risk sharing problem reflects the fact that the two sides have distinct attitude to risk and thus can make different decisions. Agency theory strives to define the most efficient form of the principal-agent relationships (Eisenhardt, 1985; 1988).

More specifically, it is assumed that the main goal of shareholders is to maximise the value of their investment in the firm, while the CEO’s goal is to keep their job and be well remunerated. Regarding their risk profile, the assumption at the basis of the standard agency perspective is that shareholders’ are risk-neutral because they can diversify their overall investment across many firms, while managers and CEOs are risk-adverse because they can only put their effort into one job. Managers and CEOs are also assumed to prefer short-term gains derived from efficiency-seeking strategies, which might dampen long-term returns. Under this view, then, shareholders should promote corporate governance practices that incentivize managers to maximize the value of their investment (Baker et al., 1988 and Agrawal and Knoeber, 1996). According to the standard agency theory view, such corporate governance practices should ultimately increase R&D intensity

Fama(1980) documents that labor market or career concern would discipline mangers to focus on the long term prospect of firms so CEOs have concern about carrying reputation cost associated with success of firms, however when CEOs approach retirement , their career concern is minimal which aggravate horizon problem (Gibbons and Murphy,1992). Based on the similar horizon hypothesis, (Dechow and Sloan 1991) with the sample of 91 R&D intensive firms from 1974 to 1988 indicate that CEOs nearing retirement would cut R&D expenditure to inflate earnings based compensation in the year prior to his departure. They do not find any evidence that R&D curtailment is driven by the poor firm performance around his departure or have a desire to leave new investment initiative to the incoming