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EC 260 > Lesson 3.2 > Flashcards

Lesson 3.2 Flashcards

1
Q

what do we assume managers goal is?

A

to maximize value for shareholders

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2
Q

define principal agent issues

A

when managers (agents) make decisions that affect the wealth of shareholders (principals)

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3
Q

what is another way to explain principal agent issues

A

Managers may face situations where personal utility function conflicts with that of being an agent of the firm

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4
Q

when do we not worry about principal agent issues

A

When interests of principal and agent are identical

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5
Q

one form of uncertainty in principal agent issue

A

One form of uncertainty occurs because outcomes of agents actions are not linked in a totally deterministic way with their effort. Knowledge of results does not necessarily imply anything about effort. This is caused by info asymmetry

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6
Q

2 asymmetrical info issues

A

hidden action or moral hazard

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7
Q

most common hidden action issue

A

determining effort of agents

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8
Q

explain effort value to principal and agent

A

Effort has a disutility to agent but has a value to the principal because it increases probability of a favorable outcome

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9
Q

6 goals that may prevent managers from always taking actions to maximize firm value

A

1) minimizing effort
2) maximizing job security
3) avoiding failure
4) enhancing reputation and employment opportunities
5) consuming perquisites
6) pay

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10
Q

explain manager goal - minimizing effort

A

There is disutility to work given the opportunity cost of leisure

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11
Q

explain manager goal - maximizing job security

A

Managers may be disinclined to make risky choice that could jeopardize employment but risky projects are characterized by high potential reward or large potential loss

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12
Q

explain manager goal - avoiding failure

A

If risky project is undertaken, managers are rewarded if results are favourable and penalized if results are unfavourable

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13
Q

explain manager goal - enhancing reputation and employment opportunities

A

Sometimes reputation is promoted by doing things that benefit shareholders however this is not always the case. He may lower prices or give another firm that might be a potential employer a good deal.

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14
Q

explain manager goal - consuming perquisites

A

Luxury travel, expensive art in office, etc

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15
Q

explain manager goal - pay

A

Level and structure of compensation package becomes important parts of principal-agent story

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16
Q

what does level of output depend on?

A

Level of output depends on quality and quantity of effort provided by agent

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17
Q

why can effort not be directly rewarded?

A

Effort cannot be perfectly monitored by the principal and therefore cannot be directly rewarded

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18
Q

what happens because effort cannot be perfectly monitored?

A

Since the principal cannot observe and therefore cannot reward effort, the agent tends to shirk or reduce effort which in turn reduces output for principal

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19
Q

explain what effort mean

A

Achieving a target level of profit requires that managers incur some personal cost, which we call effort.

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20
Q

cost to manager of effort

A

value of time

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21
Q

profit formula when S is flat salary

A

profit(e) = R(e) - (S+C)

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22
Q

what does S mean

A

managerial compensation

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23
Q

what does C mean

A

other costs

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24
Q

when S is flat salary - profit(e) graph

A

upward curve with decreasing slope

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25
Q

objective of manager explain in terms of employment

A

maximize net benefit of employment

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26
Q

what is u(e)

A

the cost to the manager of supplying effort (disutility of effort),

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27
Q

flat salary - u(e) graph and why

A

upward curve with linear slope (slopes upward since more effort means more opportunity cost/cost/disutility)

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28
Q

define disutility of effort

A

a measure of the cost to the manager of supplying effort

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29
Q

flat salary - B(e) formula

A

S - u(e)

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30
Q

what is B(e)

A

is the net benefit to the manager of working at a given level of effort

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31
Q

flat salary - B(e) graph and why

A

downward curve with linear slope, since disutility increases with effort

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32
Q

with a flat salary, what does principal and agent choose?

A

With a flat salary, principal chooses pay to maximize revenue - pay - costs but then agent chooses to minimize effort since effort does not correlate with higher net benefit

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33
Q

flat salary - what happens when S and u(e) is 0?

A

B(e) is 0

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34
Q

what happens when manager pay is scaled to effort?

A

Manager is now persuaded to increase effort since it will increase manager pay

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35
Q

pay scaled to effort - explain compensation scheme structured in 2 parts

A

K is fixed amount, U(e) is additional amount that varies with managerial effort

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36
Q

pay scaled to effort - when is manager fully compensated for effort and happy to supply any effort level?

A

When U(e) = u(e), then B(e) = K

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37
Q

pay scaled to effort - what is S(e)

A

K + U(e)

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38
Q

pay scaled to effort - what is profit

A

profit(e) = R(e) - S - C = R(e) - K - U(e) - C

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39
Q

pay scaled to effort - how do owners identify preferred effort level which maximizes output?

A

find derivative of profit(e) with respect to e = 0, note that only R(e) and U(e) depend on effort

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40
Q

explain MB = MC

A

Marginal benefit from effort in terms of increased revenue must equal marginal cost of compensating managers for effort

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41
Q

what is marginal benefit?

A

Marginal benefit is derivative of R(e) wrt e

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42
Q

what is marginal cost?

A

marginal cost is derivative of u(e) with respect to e

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43
Q

pay scaled to effort - B(e) graph

A

linear line with y intercept at K

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44
Q

pay scaled to effort - S(e) graph

A

S(e) is increasing graph with linear slope with Y intercept at K

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45
Q

pay scaled to effort - profit(e) graph

A

profit(e) is upside down u

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46
Q

pay scaled to effort - R(e) - C graph

A

R(e) - C is increasing graph with decreasing slope

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47
Q

pay scaled to effort - B(e) formula

A

Now, B(e) = S(e) - u(e) = K + U(e) - u(e)

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48
Q

incentive compatibility - what do we assume about R(e)?

A

Assume R(e) is riskless and determined solely by effort of manager

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49
Q

incentive compatibility - what do shareholders need to figure out?

A

Shareholders then figure out what level of effort is necessary to produce this level of revenue (Solve R for e)

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50
Q

incentive compatibility - S(e) formula

A

S(e) = U(e) + a*profit(e) where a is the share of profits for managers

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51
Q

incentive compatibility - bonus that owners choose

A

Owner does not receive bonus until end of period, so owners choose a level of bonus so overall package is competitive and attracts skilled managers

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52
Q

incentive compatibility - profit(e) formula

A

profit(e) = R(e) - U(e) - C

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53
Q

incentive compatibility - B(e) formula

A

B(e) = S(e) -u(e) = U(e) + aprofit(e) - u(e) = aprofit(e)

54
Q

incentive compatibility - what do owners get?

A

Owners get portion (1-a)*profit(e)

55
Q

incentive compatibility - what are shareholders and managers happiest?

A

Whatever the level of a, both shareholders and managers are happiest if profit(e) is maximized

56
Q

incentive compatibility - what does manager choos?

A

manager chooses level of effort to maximize profit(e). This is achieved where marginal benefit of effort = marginal disutility of cost of effort

57
Q

incentive compatibility - what do owners choose?

A

firm’s owners choose a level of a such that compensation package is competitive

58
Q

define incentive compatibility

A

when the agent and owners share in the profit of the firm and the agent’s effort maximizes the principal’s profit

59
Q

revenue split - what do we assume about revenue?

A

Now we assume revenue is risky.

60
Q

with no risk, how can owners infer manager effort?

A

firm’s profit

61
Q

with risk, how can owners infer manager effort?

A

When profit/revenue/output is risky, owners are rarely certain whether high profit is due to high effort or simply good luck (strong economy)

62
Q

revenue split - 2 ideas owners structure compensation around

A

risk sharing and efficiency

63
Q

revenue split - explain market risks

A

should be shared

64
Q

revenue split - explain manager vs owners

A

Managers are much less diversified than owners. The compensation and the equity stake in that employer is a large portion of manager wealth. So fluctuation in bonuses or stock options can have big impact on manager net worth. So we expect managers to be averse to risk in compensation plan

65
Q

revenue split - when will managers accept risky compensation plan?

A

if they are compensated with a risk premium

66
Q

define risk premium

A

the minimum difference a manager requires to be willing to take a risk

67
Q

revenue split - optimal compensation plan but what does this ignore

A

the optimal compensation plan would place all risk on shareholders and pay managers a flat salary but this ignores effort

68
Q

2 methods owners can use to pay managers

A

1) aligns interests of principal and agent, contracts are incentive-compatible
2) assigns risk to party who can bear it most easily

69
Q

revenue split - explain this method

A

integrates 2 methods owners can use to pay managers

70
Q

revenue split - explain revenue in words

A

Divide revenue into 2 parts. R1(e) depends on efforts of managers. tildeR2 is beyond control of manager and depends on interest rates, economic movements etc. tilde shows component of revenue is risky

71
Q

revenue split - revenue formula

A

R(e) = R1(e) + R2(tilde)

72
Q

revenue split - S formula

A

S = K + a*profit(e).

73
Q

revenue split - what can compensation not depend on and why

A

Since owners cannot observed effort and it can’t be inferred from profit, compensation cannot depend directly on effort

74
Q

revenue split - profit formula

A

profit(e) = R(e) - K - C = R1(e) +R2(tilde)-K-C

75
Q

revenue split - why does net benefit change and explain it

A

Net benefit changes because manager is exposed to risk if she receives a bonus. 2 parts: first part shows expected utility of manager from wealth. The second element is disutility of effort

76
Q

revenue split - B(e) formula

A

B(e) = EU(s) - u(e) = EU[K + a*profit(e)] - u(e)

77
Q

revenue split - principal view

A

compensation cannot solely depend on effort. They want to make compensation to align their interests with that of agent

78
Q

revenue split - agent view

A

having seen compensation terms, agent selects level of effort

79
Q

revenue split - result

A

profit from agent’s activities is revealed. The agent’s bonus is paid and remaining profit is paid to principal.

80
Q

what does disutility of effort result in?

A

lowers overall satisfaction

81
Q

utility and effort of flat salary

A

With a flat salary of B, manager chooses low effort and realizes utility equal to U(B) = EU

82
Q

with profit sharing, what is manager just as well off having?

A

With profit sharing, the manger is just as well of receiving compensation for working hard as having a flat salary and shirking

83
Q

profit sharing - expected compensation

A

flat salary is premium necessary to compensate manager for risk and disutility of effort. expected compensation is D

84
Q

stock options - explain

A

Owners pay a salary floor of E and a stock option which has a small chance of paying a large amount of money F

85
Q

stock options - expected utility

A

Expected utility from this plan is same as expected utility as from flat salary of B and shirking and same from profit sharing plan

86
Q

stock options - explain reduces downside risk

A

But this scheme reduces downside risk compared to profit sharing since manager risks a percent change of fall in income from B to A with profit sharing. And now the manager receives flat salary of E and E is higher than A, which are the lowest possible compensation from schemes)

87
Q

define call option

A

option that gives managers the right to purchase the firm’s shares at some future date

88
Q

define strike price

A

fixed price at which stock can be purchased

89
Q

define indexed stock option

A

manager is given stock option but strike price is not fixed, it is expressed in relation to an index of stock prices

90
Q

what does indexed stock option ensure?

A

This ensures manager is not rewarded simply because market performs well and ensures manager is not penalized because market performs poorly

91
Q

net effect of indexed stock option

A

Net effect is manager is rewarded if stock price rises relative to market

92
Q

does manager have to buy stock option?

A

Manager has no obligation to buy stock if price falls below striking price

93
Q

define moral hazard

A

when a party insured against risks behaves differently from the way it would behave if it were uninsured against these risks

94
Q

if you are insured, what is there a separation of

A

If you are insured, there is a separation of costs and benefits of safety

95
Q

define ex-ante moral hazard

A

tendency of insures people and firms to take less care to prevent future losses when they have insurance

96
Q

define ex-post moral hazard

A

reluctance of policyholders who have already suffered some misfortune to keep the cost of the event under control

97
Q

define face value

A

principal amount of bond

98
Q

define residual claim

A

what is left of the dividend value of the firm

99
Q

why must senior debt be paid first?

A

Senior debt must be paid first because it was borrowed first

100
Q

asset substitution - what happens when firms have significant amount of debt

A

When firms have a significant amount of debt, shareholders tend to favour unusually risky investment decisions

101
Q

asset substitution - who is the victim

A

bondholders

102
Q

asset substitution - what happens if there is a risky project and non risky project

A

If there is 1 non-risky option and 1 risky option, firm would not be able to undertake either project because bondholders would anticipate shareholders temptation to choose risky negative NPV project

103
Q

asset substitution - what happens when bondholders anticipate bait and switch

A

If bondholders anticipate bait and switch, they pay only what the bonds are worth and have a net payoff of 0

104
Q

3 solutions to asset substitution problem

A

1) fund with equity
2) establish rep for protecting creditors
3) precommit to hedge or insure risk

105
Q

solution to asset substitution - explain fund with equity

A

if managers can pay for project with internal funds ro by making a new issue of shares, then the problem is mitigated or disappears

106
Q

solution to asset substitution - explain establish rep for protecting creditors

A

if they do this, a promise not to undertake risky projects in the future might be viewed as credible

107
Q

2 purposes of laws to protect consumers

A

1) compensate injured consumers

2) incentive for firm to make safer products because they must pay compensation

108
Q

what type of law is product liability law and why

A

Product-liability law is incentive compatible because it aligns the interests of the principal (consumer) and the agent (producer)

109
Q

explain principal agent issue with consumer safety

A

firm makes decisions on safety but consumer bears costs if product causes injury

110
Q

consumer safety - what is s

A

s denotes expenditure undertaken to make safer products

111
Q

product liability law - total cost of safety

A

s

112
Q

product liability law - marginal cost of safety

A

Marginal cost of safety = derivative of s / derivative of s = 1

113
Q

product liability law - what happens as s increases and why

A

As s increases, expected cost of accidents fall. Expected cost of accidents depend on firm choice of s

114
Q

product liability law - explain expected benefit of safety formula

A

Expected benefits of safety are the negative of the expected cost of accidents since marginal cost of safety is 1 so expected marginal benefit of safety is derivative of expected benefit of safety / s

115
Q

product liability law - what is benefit of safety

A

reduction in cost

116
Q

what happens without product liability law?

A

expected benefit to managers for safer products is 0 so firm pays all costs of safety and receives none of the benefits. Profit-maximizing firm pays s = 0

117
Q

what does product liability law do?

A

provides incentive for managers to make safer products

118
Q

product liability law- optimal level of safety (s) for firms

A

where marginal cost = marginal benefit

119
Q

what happens without product liability law in prices

A

Without product liability law, consumers bear cost of accidents and safety would be reflected in demand for and therefore the price of products

120
Q

market mechanism - profit of firm

A

Profit of firm = total revenue - cost of safety - other production costs

121
Q

market mechanism - level of safety firm chooses

A

Firm chooses level of safety that maximizes profit so set derivative of profit wrt s equal to 0

122
Q

market mechanism - what is the same level of safety firm chooses as here

A

same result as with product liability law

123
Q

market mechanism - how does price align interests

A

Consumers reward or punish firms by varying the price they are willing to pay according to level of product safety. So price becomes way of aligning interest of firm and consumers.

124
Q

how to find percentage profit if manager needs net benefit of x

A

percentage profit = x / weekly profit

125
Q

how to find disutility of effort from utility for both high and low effort?

A

disutility is difference between utilities for high and low wealth

126
Q

formula for value of equity

A

value of firm - old debt - new debt = value of equity

127
Q

given 2 projects, which do shareholders choose?

A

the project that results in higher value of equity

128
Q

how to find weekly profit

A

profit = R(e) - u(e) - C where C is net benefit, and e is solved for by setting derivative of R(e) wrt e and u(e) wrt e equal

129
Q

formula to find % of profit manager should be paid

A

expected utility with flat salary and low effort = expected utility with bonus of x profit and high effort

130
Q

how to find value of new debt

A

value of firm - old debt. if > capital cost, then only do capital cost

131
Q

how to find how much investors will pay for the bond?

A

this is the value of the new debt

132
Q

how to find what percentage of profit manger must get to receive net benefit of B

A

profit(e) = R(e) - u(e) - C and take derivative and solve for e. Plug e into profit(e). Then B/profit(e) = percentage

EC 260 (11 decks)

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