Agency Problem

Question 1

Agency Problem (3/5)

Answer 1

• Ownership & control separated when principle hires agent to represent his/her interest.
  > Managers manage the co for the owners (SH’s) - they not necessarily monitored.
• Asymmetric Info - one side has greater info than the other
  > Management act for salary / bonus, SH’s act for development of the co..
• Type I Agency Problem - conflict between SH & management interest.

Question 2

Agency Conflicts (Jensen & Meckling, 1976) (5)

Answer 2

• Investor View - Managers hold less than 100% of stocks but enjoy 100% of benefits of controlling the co.
• Manager View - Managers bear 100% of the cost of running the Co. but don’t enjoy 100% of the financial benefits (stock holding)
• Managers interested in private benefits, don’t put 100% in (Moral Hazard Problem)
• Selling house e.g. agent work harder for commission than for a flat rate.
• Type II Agency Problem -Managers act in the interest of the dominant SH at expense of smaller SH’s, conflict between large & small SH’s.

Question 3

Moral Hazard Problem (1/6)

Answer 3

• Info asymmetry makes it difficult to monitor managers (agents) so they may pursue own goals at owners expense, e.g.:
  > Insufficient Manager Effort
  > Wasteful Investment
  > Entrenchment Strategy
  > Self-Dealing
  E.G. Jordan Thain, CEO of Merrill Lynch, spent $1.2m on office refurbishment

Question 4

Insufficient Manager Effort

Answer 4

Executives distracted so don’t pay attention

E.g. Managers paying higher salaries to avoid trouble from trade unions & strikes

Question 5

Wasteful Investment

Answer 5

When excess cash - E.g. empire building & pet projects

Question 6

Entrenchment Strategy

Answer 6

• Invest in area of managers expertise & strategies to resist hostile takeovers
  E.g. Shliefer & Vishny (1996) - manager-specific investments reduces chance of being replaced

Question 7

Self-Dealing

Answer 7

Hiring family / social ties
Insider Trading
E.g. Healy & Palepu (2003) - Share options encouraged self-dealing

Question 8

Corporate Governance (1/5)

Answer 8

• Align managers incentives with SH goals, mechanisms to do this:
  > Salary, bonus, stock incentives (stock options)
  > Board of directors
  > Legal protections
  > External market forces

Question 9

Salary, bonus, stock incentives (1/3)

Answer 9

• Use correct performance measures
  E.g. Gordon (2003) stock packages became popular in 90’s, help align managers interest with SH as they become a SH.
  E.g. Shliefer & Vishny (1996) - salary increases may entice managers to manipulate acc. figures & inv. policies to increase their pay.

Question 10

Board of directors

Answer 10

Pressure on managers, board can fire them, important to have independent board so SH can be confident in manager controls

Question 11

Legal protections (1/2)

Answer 11

Managers responsible for their own actions, poten tial jail time
E.g. BBC news (2007), takeaway restaurant, manager jailed for 3 years following nut allergy death

Question 12

External market forces

Answer 12

Threat of takeover, if takeover, managers may be sacked as to outside firms, the management must be poor if co. struggling.