L13 - Agency Flashcards
What is the principal-agent problem?
- Shareholders (principals) = Owners
- Managers (agents) = Employees
- Managers have the power to manage day-to-day aspects of the firm.
- Managers have more information than the shareholders. –> information asymmetry, know about the project and which would be better for them or better for the owners
- Agency problems occur when managers do not act in the shareholders’ interest.
Why does not having any incentives for Financial Managers not solve the principal-agent problem?
No system of incentives is perfect…but what won’t work? Shareholders decide to pay the financial managers a fixed salary (no bonuses, no stock options,…) - this will most likely lead to:
- reduced effort - low incentive to find and invest in truly valuable (+NPV) projects;
- perks - take nonpecuniary private benefits anyway (company car, lavish office, meetings in luxury resorts,…)
- empire building - prefer running large business rather than small ones (may not be +NPV). Results in overinvesting.
- insufficient disinvestment – reluctance to disinvest, e.g. close loss-making business. Results in overinvesting.
- entrenching investment - choose investments that require or reward the skills of the existing managers. –> rather than picking investments that benefit the firm
- risk-aversion - try to avoid risk or more risky projects
All these are inefficiencies that reduce the value of the firm.
When are managers the principal in the principal-agent problem?
- Top managers are also principals vis-a-vis the rest of the firm (middle managers and other employees who are working for them). as employees objective should aline with management and by extention, as top managers objective aline with shareholders, they also must aline with the owners too
- Top management must try to ensure that…
- middle managers and employees have the right incentives to find and invest in +NPV projects.
-
Difficult to get incentives right in a large corporation.
- different employees with differing levels of responsibility and senority
- Why not bypass these difficulties, and let the top managers make the important investment decisions?
- in theory it would be easier as their objective should aline with the owners
Why would bypassing incentive and letting top management make the investment decisions not solve the principal-agent problem?
- Too many projects for top management to analyse ⇒ difficult to make intelligent decisions;
- Details are beyond the view of executives –> location, workers available, cashflow based on these various factors –> managers may not get all these details and may just get profitability calculation and cashflows - would they make the same decision if they had all the appropriate information?? - thus need employees
- Many decisions/capital investments don’t appear in the capital budget (e.g. : R&D, training, marketing,…) –> might not know these cashflows exist and havent taken them into account when deciding on an investment project
- Small decisions add up… –> inventory investment build up over time but these are dealt with lower level employees so senior management doesnt deal with this ‘lower-level’ work but its does not mean it isnt important
How can Monitoring reduce the Principal-Agent Problem?
Monitoring: Agency costs can be reduced by monitoring a manager’s efforts and actions and by intervening when the manager veers off course (shareholders, board of directors, auditors, lenders, takeovers…). –> give them a warning or remove them
But monitoring also involve costs and diminishing returns…
- you can only monitor what you observe - you dont get any reward for the time and effort spent observing senior managers - its a imperfect solution to the principal-agent problem
How to pay managers in order to reduce the cost and need for monitoring and to maximize shareholder value?
how can shareholders monitor management?
shareholders (e.g. selling shares because they dont like what they are seeing in documents or the news , doesnt bode well for managers when the share price falls)
large group of shareholders with a large amount of say, could vote to remove the manager - this is done by electing a independent board of directors to oversee the managers
How can auditors monitor management?
auditors –> look at financial statements to see if they follow generally accept accounting practices –> do not want a bad report as can affect share price
How can lenders monitor management?
lenders –> looking at cashflows and financial statements to make sure they can meet their debt obligations - if they offer a high interest rate do they not trust your organisation
How can other companies monitor management?
takeovers –> companies are always monitoring others- if companies are not efficient and management is making poor decisions, others may make takeover bids and replace senior management
How can Management Copmensation be used to reduce the Principal-Agent Problem?
Because monitoring is imperfect, compensation plans must be designed to attract competent managers and to give them the right incentives. - attracts and keeps them working in the best interest of shareholders
So… the amount of compensation may be less important than how it is structured.
The compensation package should encourage managers to maximize shareholders’ wealth.
What should Manager Compensation be based on?
- input (managers’ effort) and
- output (incomes or value-added from managers’ actions
It is very difficult to monitor the actions (effort) of managers. –M might be there all day but are they being productive
Therefore……compensation should be based on output. –> changes in earnings, profitability and output can be observed easily
What is the average Management Compensation across countries?
How has Management Compensation changed over time?
How has the Structure of Management Compensation changed over time?
- Basic Salary doesnt provide any incentive so it makes up less and less of a managers total compensation
- More and more managers are being compensated with stock price performance
- it was stock options but more recently it is restricted stock
How can give Managers stock as a form of compensation help reduce the Principal-Agent Problem?
- Capital markets do monitor managers’ actions through the price mechanism (stock prices reflect performance of a firm).
- Compensation tied to stock prices (like stock options) do reduce the cost and the need for monitoring.
Most major companies link part of their executive pay to the stock-price performance:
- stock options - give managers the right, but not the obligation, to buy their company’s shares in the future at a fixed exercise price; - hope their performance increases the stock price
- restricted stock - stock that must be retained for several yrs; - want to remain in a position that you can benefit from increasing the stock price
- performance shares - shares awarded only if the company meets an earnings or other target.