E2: Agency

Question 1

Define the principal-agent problem

Answer 1

When managers do not act in the shareholder’s interest

Question 1

Give some examples of the principal agent problem

Answer 1

• overinvestment
• perks
• reduced effort
• short terminism
• risk taking

Question 2

How can you relieve the principal-agent problem?

Answer 2

Incentivsation
- ensure managers and employees are rewarded suitably when they add value to the firm- eg: stock options or generous compensation packages based on output

Question 3

Who are the principals and agents in finance?

Answer 3

principals = shareholders / owners
agents = employees / managers

Question 4

What is a benefit of incentising managers with stock options?

Answer 4

• need for monitoring and cost of it is reduced as manager’s success is tied to stock success

Question 5

What are the three kinds of stock managers might be paid with?

Answer 5

1. stock options
2. restricted stock (must be retained for an amount of time)
3. performance shares (awarded if company performs to a certain level)

Question 6

Negatives of stock-price performance

Answer 6

• events out of the managers control may effect their copensation - eg if the economy is in a bad place. and vice versa