Business Theory: The Definition Of Agency Theory

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The Definition of Agency Theory Agency theory is defined as the branch of financial economics that focus on conflicts of interest or goal between people with different interest on same assets. Agency theory explains the relationship between principal and agent in business. Principal is shareholders and agent of principal is the management of business. This theory is applied at agency relationship when one party directs work to another agent that performs the task. Therefore, this theory works using the metaphor of a contract. Literally, agency theory reviews about the contracts held between resource holders. There are two main problems that cause the conflict in agency relationships. First is when the principal and agent have different perceptions…show more content…
This theory states that the cost of financing is positively related to asymmetric information. According to the assumption of this theory, there is no target capital structure. There are three sources of financing which are internal funds, debt and new equity. Based on this theory, firms will prioritize those source according to order. At first, the company will prefer internal financing and then debt at second place, and lastly raise new equity. When there is no longer wish to issue debt, equity will be replaced and issued. Pecking-order theory encourages firm to maintain their business to stick on financing sources hierarchy where internal financing are preferred at first place, then followed by debt and equity if the external financing is needed. The type of debt a firm chooses is important because it shows the signs for need of external…show more content…
Yet, the collateral value expected to be positively correlated to the debt ratio. This hypothesis of pecking-order theory has been supported in many previous carried on studies such as the study in industrialized by Rajan and Zingales (1995) and also study in Malaysia by Suto (2003). A study by Sheikh and Wang (2011) proved tangibility is negatively correlated to the debt ratio when the cause influence manufacturing firms’ capital structure is tested in Pakistan. Even though this result does not match the static trade-off theory, yet those relationship fits the agency theory. By using agency theory’s statement, we can assume that the consumption of managers tend to be more than the perquisites’ optimized level where collateral assets is negatively related to level of debts. Tangibility of a firm was measured by tangible non-current assets over total assets in several studies (Bevean and Danbolt, 2002; Suto, 2003). As those proxy showed a significant result for their studies, we also adopt this proxy in our

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