Agency problems Flashcards
What is the principal contract design?
How to design a contract to align the goals of the manager with the owner
Why would a principal hire an agent?
If the principal is too busy to do a given job
What is the goal of managers?
To maximise stockholder wealth
What is the conflict of interest between shareholders and managers of the firm called?
The agency cost of equity
What is the agency cost of equity caused by?
- Separation of ownership from control (hidden actions)
- Asymmetric information
Why does the separation of ownership from control cause a problem?
Managers are in a position to maximise their own wealth without necessarily being “detected” by the owners of the company as they cannot be observed
Why does assymetric information cause the agency cost of equity?
Managers have access to accounting data and financial reports whereas shareholders only receive annual reports which may be manipulated
How can the agency costs of equity be mitigated?
- Corporate governance
- Direct managerial financial incentives
What is corporate governance?
The system of rules, practises and processes by which a company is directed and controlled
What are some different corporate governance approaches?
- Rules based
- Principals based
What are direct managerial financial incentives?
- Incentives can be used to align management and stockholder interests
- Stock options for example
- Tying management compensation to measures such as EPS growth
What is the agency cost of debt?
The conflict of interest between shareholders and debt holders
When does a conflict of interest between shareholders and debt holders arise?
If investment decision have different consequences for the value of equity and the value of debt
What do shareholders care about vs what do debt holders care about?
Shareholders care about equity, debt holders care about bond prices
When is the agency cost of debt likely to occur?
Conflicts of interests between shareholders and debt holders arises if investment decision have different consequences for the value of equity and the value of debt. They are most likely to occur when there is a greater likelihood of financial distress
When a firm is in financial distress, how can shareholders benefit?
Shareholders can gain at the expense of debt holders by taking a negative NPV project (excessive risk taking)
What can debt-holders do to reduce their risk exposure from excessive risk taking with their money by equity holders?
Pay less for the debt initially and implement protective covenants restricting future actions
What is debt-overhang and what does it lead to?
A situation in which equity holders choose not to invest in a positive NPV project because the value of undertaking the investment opportunity will accrue to bondholders rather than themselves.
What does debt-overhang lead to?
Under-investment as shareholders choose not to invest because profits from the investment will go to the bond holders instead of them
What you need to explain for full marks if asked to: Briefly explain the agency cost of debt and why the agency cost of debt could happen?
Explain that this occurs where there is a conflict of interest between the shareholders and the bond holders because of the differences in the value of equity and the value of bond holders. Point out that in the first case if managers take excessive risk, the equity holders might be able to gamble with the debt holders money, this is the point of conflict and may lead to over-investment into the very risky projects.
The second situation that could happen is debt-overhang where shareholders have no incentive to invest into new projects as the profit from new projects will go into the pockets of the debt holders instead of themselves resulting in under-investment.
What is cashing out?
When a firm faces financial distress, shareholders have an incentive to withdraw money from the firm if possible
Is it harder to get rid of corporate bonds or stocks and shares?
Corporate bonds
What are rewards?
Outcomes that people care about (both financial and non-financial rewards)
What is effort?
Actions that people won’t take without rewards (not just hours worked)
What are incentives?
Link between rewards and efforts (not just a compensation contract) eg. compensation that is sensitive to performance
What is another type of under-investment that occurs when a firm faces financial distress?
Cashing out, when a firm faces financial distress. If default is likely, assets may be sold below their market value
What does the role of the principal consist of?
Supply capital, bear risk and design an incentive scheme (a contract) for the agent.
What can the principal be conceptualised as?
A representative shareholder or the board of directors
What is the role of the agent?
The role of the agent is to exert effort in order to make sound managerial decisions on behalf of the principal
