AGENCY PROBLEM & CONTROL OF THE CORPORATION

Question 1

AGENCY RELATIONSHIPS ?

Answer 1

**occur when one party, the principal, employs another
party, the agent, to perform a task on their behalf
**
ex:
directors or
managers or management (agents) act on behalf of shareholders (principals or
owners).

the owners must delegate decision-making authority to the management. Id

Question 2

AGENCY PROBLEM ?

Answer 2

**In such relationships there is a possibility of a conflict of interest between the
principal and the agent **

Question 3

Factors

Answer 3

1. Moral hazard - manager’s incentive to obtain benefits in kind is higher when he has no
   shares in company
2. Effort level - manager may work less hard than they would if they were the owners of the
   company
3. Earnings retention – managers prefer to grow the company, and increase its sales
   turnover and assets, rather than to increase the returns to the company’s shareholders
4. Risk aversion – managers reluctant to invest in higher-risk projects to protect their job
5. Time horizon - shareholders are concerned about the long-term financial prospects of their company whereas managers might only be interested in the short-term.
   ex: annual bonuses on short term performances

Question 4

Managers will give priority to their personal interests over those of the owners
such as:

Answer 4

• Remuneration
• Empire
  building
• Creative
  accounting
• Off-balance
  sheet finance
• Takeover bids

Question 5

AGENCY COST ?

Answer 5

• The costs that the shareholders incur when professional managers run their
  company.
• Cost of resolving conflict of interest between shareholders and management.
• Do not exist when the owners and the managers are exactly the same
  individuals
• Start to arise as soon as some of the shareholders are not also directors of the
  company

Answer 6

1. Direct agency costs are:
- Cost of monitoring the action and performance of managers.
- Preparing accounts and having them audited involve cost
- Managerial reward scheme such as remuneration packages for managers incur high cost
- Cost of implementing control devices
- Established a set of contracts
- Hiring of non-executive directors as member of the Board

2. Indirect agency cost :
a lost of opportunity borne by shareholders.
Example: When the management does not want to take risky investment in view of fear of
losing jobs in case the investment turn out badly even though the new investment expected to increase the share value. Promoting the selfish investment strategy by the management cause the stockholders may lose a valuable opportunity. This becomes an indirect agency cost because it arises out of the shareholder and management conflict
but does not have a directly quantifiable value

Question 7

Control Mechanism to
Reduce the Agency
Problem

Answer 7

1. Established Set of Contract
2. Managerial Reward Scheme
3. Annual Reports & Audited Accounts
4. Stable Dividend Policy
5. Corporate Control
6. Threat of Firing
7. Gearing Ratio