Agency

Question 1

The Principle Agent Problem

Answer 1

Managers have the power to manage day-to-day aspects of the firm

Managers have more information than the shareholders

Agency problems occur when managers do not act in the shareholders’ interest

Question 2

Incentive bypass problem

Answer 2

Too many projects for top management to analyse => difficult to make intelligent decisions

Details are beyond the view of executives

Many decisions/capital investments don’t appear in the capital budget

Question 3

Incentives: Monitoring

Answer 3

Agency costs can be reduced by monitoring a manager’s efforts and actions and by intervening when the manager veers off course

Question 4

Incentives: Management Compensation

Answer 4

Because monitoring is imperfect, compensation plans must be designed to attract competent managers and to give them the right incentives

The compensation package should encourage managers to maximise shareholder’s wealth

Compensation could be based on:

• input (managers’ effort)
• output (incomes or value-added from managers’ actions)

Question 5

Incentives: Stock Price Performance

Answer 5

Most major companies link part of their executive pay to the stock-price performance:

• stock options - give managers the right, but not the obligation, to buy their company’s shares in the future at a fixed exercise price
• restricted stock - stock that must be retained for several years
• performance shares - shares awarded only if the company meets an earnings or other target

Question 6

Accounting measures of performance advantages

Answer 6

• Based on absolute performance rather than on performance relative to investors’ expectations
• Make it possible to measure the performance of junior or lower-level managers whose responsibility extends to only a single division or plant

Question 7

Accounting measures of performance disadvantages

Answer 7

• Temptation to pump up short-term profits, leaving longer-run problems to successors
• Accounting earnings can be biased measures of true profitability
• Growth in earnings does not necessarily mean that shareholders are better off

Question 8

What do ROI and EVA stand for?

Answer 8

Net Return on Investment and Economic Value Added

Question 9

EVA =

Answer 9

Net pound return after deducting (a charge for) the cost of capital

Question 10

ROI and EVA advantages

Answer 10

• Encourages managers and employees to concentration increasing value, not just on increasing earnings.
• Managers are motivated to only invest in projects that earn more than they cost
• Implies delegated decision making
• Makes cost of capital visible to managers

Question 11

ROI and EVA disadvantages

Answer 11

• Difficult to judge whether a low value is a consequence of bad management or of factors outside the managers’ control