Agency Theory & Corporate Governance 20 Marker

Question 1

Definitions of corporate governance

Answer 1

• the ways of which suppliers of finance to corporations assure themselves of getting a return on their investment
• the determination of the broad new uses to which organisational recourses will be deployed and the resolution of conflicts among the myriad of participants in organisations
• the of mechanisms, both institutional and market based, that induce the self- interested controllers of a company to make decisions that maximise the value of the company to its owners

Question 2

Core assumptions of agency theory

Answer 2

• individuals are expected utility maximisers (future)
• bound rationality of individuals
• individuals are motivated by self interest
• utility functions contain two arguments (wealth + leisure)
• individuals have preferences for increases in wealth and increases in leisure (reductions in effort)
• agents are risk adverse
• principles are risk neutral

Question 3

The agency problem

Answer 3

• agency theory suggest principles contract agents to run the business
• given assumptions both act in self interest how does principle ensure that agents act in their interest
• agent want short term benefits which do not benefit the principles interest
• principles need expertise from agents
• agency problem

Question 4

Principle

Answer 4

• appoints another party (agent) to look after their interests

Question 5

Agent

Answer 5

• contracted to look after the interests of the principle

Question 6

Agency cost

Answer 6

• sum of the cost of structuring, bonding and monitoring of contracts between agents

Question 7

Problems in minimising agency costs

Answer 7

• differences in attitudes to risk
• information asymmetries
• contracting problems: moral hazard (hidden action) and adverse selection (hidden info)
• cost of observation

Question 8

Agency theory research in corporate governance

Answer 8

• divide agency based research into two themes: alignment and control
• alignment= use of compensation packages to align the interests of principle and agents
• the use of equity based compensation for executives will enhance the financial performance of the firm
• control= monitoring of senior management
• more concentrated ownership facilities monitoring and leads to better financial performance of the firm

Question 9

The role of the board of directors in agency theory research in corporate governance

Answer 9

• independent board structures are prescribed in agency theory
• separate CEO chairperson
• > firms with a separate CEO chair will out perform those firms with a CEO chair duality
• majority of outside (non executive directors)
• > firms with a higher proportion of outside (non executive) directors will outperform those firms with a lower proportion

Question 10

Criticisms of agency theory research in corporate governance

Answer 10

• a narrow consideration of the role of the board of directors
• insufficient model boards and their functions
• fails to examine process, behaviours and mechanisms that link board structure to board performance
• no unequivocal support for agency theory predictions
• the logic of self interest should lead to a board solely of non- executive directors

Question 11

Issues of corporate governance

Answer 11

• corporate financial irregularities
• executive compensation
• managing financial risk
• mergers and acquisitions

Question 12

Mechanisms of corporate governance

Answer 12

• internal mechanisms
• > board of directors
• > financial (capital structure)
• > internal control system
• external mechanisms
• > legal system
• > market for corporate control
• > financial markets