Lesson 3.2 Flashcards
what do we assume managers goal is?
to maximize value for shareholders
define principal agent issues
when managers (agents) make decisions that affect the wealth of shareholders (principals)
what is another way to explain principal agent issues
Managers may face situations where personal utility function conflicts with that of being an agent of the firm
when do we not worry about principal agent issues
When interests of principal and agent are identical
one form of uncertainty in principal agent issue
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
2 asymmetrical info issues
hidden action or moral hazard
most common hidden action issue
determining effort of agents
explain effort value to principal and agent
Effort has a disutility to agent but has a value to the principal because it increases probability of a favorable outcome
6 goals that may prevent managers from always taking actions to maximize firm value
1) minimizing effort
2) maximizing job security
3) avoiding failure
4) enhancing reputation and employment opportunities
5) consuming perquisites
6) pay
explain manager goal - minimizing effort
There is disutility to work given the opportunity cost of leisure
explain manager goal - maximizing job security
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
explain manager goal - avoiding failure
If risky project is undertaken, managers are rewarded if results are favourable and penalized if results are unfavourable
explain manager goal - enhancing reputation and employment opportunities
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.
explain manager goal - consuming perquisites
Luxury travel, expensive art in office, etc
explain manager goal - pay
Level and structure of compensation package becomes important parts of principal-agent story
what does level of output depend on?
Level of output depends on quality and quantity of effort provided by agent
why can effort not be directly rewarded?
Effort cannot be perfectly monitored by the principal and therefore cannot be directly rewarded
what happens because effort cannot be perfectly monitored?
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
explain what effort mean
Achieving a target level of profit requires that managers incur some personal cost, which we call effort.
cost to manager of effort
value of time
profit formula when S is flat salary
profit(e) = R(e) - (S+C)
what does S mean
managerial compensation
what does C mean
other costs
when S is flat salary - profit(e) graph
upward curve with decreasing slope
objective of manager explain in terms of employment
maximize net benefit of employment
what is u(e)
the cost to the manager of supplying effort (disutility of effort),
flat salary - u(e) graph and why
upward curve with linear slope (slopes upward since more effort means more opportunity cost/cost/disutility)
define disutility of effort
a measure of the cost to the manager of supplying effort
flat salary - B(e) formula
S - u(e)
what is B(e)
is the net benefit to the manager of working at a given level of effort
flat salary - B(e) graph and why
downward curve with linear slope, since disutility increases with effort
with a flat salary, what does principal and agent choose?
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
flat salary - what happens when S and u(e) is 0?
B(e) is 0
what happens when manager pay is scaled to effort?
Manager is now persuaded to increase effort since it will increase manager pay
pay scaled to effort - explain compensation scheme structured in 2 parts
K is fixed amount, U(e) is additional amount that varies with managerial effort
pay scaled to effort - when is manager fully compensated for effort and happy to supply any effort level?
When U(e) = u(e), then B(e) = K
pay scaled to effort - what is S(e)
K + U(e)
pay scaled to effort - what is profit
profit(e) = R(e) - S - C = R(e) - K - U(e) - C
pay scaled to effort - how do owners identify preferred effort level which maximizes output?
find derivative of profit(e) with respect to e = 0, note that only R(e) and U(e) depend on effort
explain MB = MC
Marginal benefit from effort in terms of increased revenue must equal marginal cost of compensating managers for effort
what is marginal benefit?
Marginal benefit is derivative of R(e) wrt e
what is marginal cost?
marginal cost is derivative of u(e) with respect to e
pay scaled to effort - B(e) graph
linear line with y intercept at K
pay scaled to effort - S(e) graph
S(e) is increasing graph with linear slope with Y intercept at K
pay scaled to effort - profit(e) graph
profit(e) is upside down u
pay scaled to effort - R(e) - C graph
R(e) - C is increasing graph with decreasing slope
pay scaled to effort - B(e) formula
Now, B(e) = S(e) - u(e) = K + U(e) - u(e)
incentive compatibility - what do we assume about R(e)?
Assume R(e) is riskless and determined solely by effort of manager
incentive compatibility - what do shareholders need to figure out?
Shareholders then figure out what level of effort is necessary to produce this level of revenue (Solve R for e)
incentive compatibility - S(e) formula
S(e) = U(e) + a*profit(e) where a is the share of profits for managers
incentive compatibility - bonus that owners choose
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
incentive compatibility - profit(e) formula
profit(e) = R(e) - U(e) - C
incentive compatibility - B(e) formula
B(e) = S(e) -u(e) = U(e) + aprofit(e) - u(e) = aprofit(e)
incentive compatibility - what do owners get?
Owners get portion (1-a)*profit(e)
incentive compatibility - what are shareholders and managers happiest?
Whatever the level of a, both shareholders and managers are happiest if profit(e) is maximized
incentive compatibility - what does manager choos?
manager chooses level of effort to maximize profit(e). This is achieved where marginal benefit of effort = marginal disutility of cost of effort
incentive compatibility - what do owners choose?
firm’s owners choose a level of a such that compensation package is competitive
define incentive compatibility
when the agent and owners share in the profit of the firm and the agent’s effort maximizes the principal’s profit
revenue split - what do we assume about revenue?
Now we assume revenue is risky.
with no risk, how can owners infer manager effort?
firm’s profit
with risk, how can owners infer manager effort?
When profit/revenue/output is risky, owners are rarely certain whether high profit is due to high effort or simply good luck (strong economy)
revenue split - 2 ideas owners structure compensation around
risk sharing and efficiency
revenue split - explain market risks
should be shared
revenue split - explain manager vs owners
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
revenue split - when will managers accept risky compensation plan?
if they are compensated with a risk premium
define risk premium
the minimum difference a manager requires to be willing to take a risk
revenue split - optimal compensation plan but what does this ignore
the optimal compensation plan would place all risk on shareholders and pay managers a flat salary but this ignores effort
2 methods owners can use to pay managers
1) aligns interests of principal and agent, contracts are incentive-compatible
2) assigns risk to party who can bear it most easily
revenue split - explain this method
integrates 2 methods owners can use to pay managers
revenue split - explain revenue in words
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
revenue split - revenue formula
R(e) = R1(e) + R2(tilde)
revenue split - S formula
S = K + a*profit(e).
revenue split - what can compensation not depend on and why
Since owners cannot observed effort and it can’t be inferred from profit, compensation cannot depend directly on effort
revenue split - profit formula
profit(e) = R(e) - K - C = R1(e) +R2(tilde)-K-C
revenue split - why does net benefit change and explain it
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
revenue split - B(e) formula
B(e) = EU(s) - u(e) = EU[K + a*profit(e)] - u(e)
revenue split - principal view
compensation cannot solely depend on effort. They want to make compensation to align their interests with that of agent
revenue split - agent view
having seen compensation terms, agent selects level of effort
revenue split - result
profit from agent’s activities is revealed. The agent’s bonus is paid and remaining profit is paid to principal.
what does disutility of effort result in?
lowers overall satisfaction
utility and effort of flat salary
With a flat salary of B, manager chooses low effort and realizes utility equal to U(B) = EU
with profit sharing, what is manager just as well off having?
With profit sharing, the manger is just as well of receiving compensation for working hard as having a flat salary and shirking
profit sharing - expected compensation
flat salary is premium necessary to compensate manager for risk and disutility of effort. expected compensation is D
stock options - explain
Owners pay a salary floor of E and a stock option which has a small chance of paying a large amount of money F
stock options - expected utility
Expected utility from this plan is same as expected utility as from flat salary of B and shirking and same from profit sharing plan
stock options - explain reduces downside risk
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)
define call option
option that gives managers the right to purchase the firm’s shares at some future date
define strike price
fixed price at which stock can be purchased
define indexed stock option
manager is given stock option but strike price is not fixed, it is expressed in relation to an index of stock prices
what does indexed stock option ensure?
This ensures manager is not rewarded simply because market performs well and ensures manager is not penalized because market performs poorly
net effect of indexed stock option
Net effect is manager is rewarded if stock price rises relative to market
does manager have to buy stock option?
Manager has no obligation to buy stock if price falls below striking price
define moral hazard
when a party insured against risks behaves differently from the way it would behave if it were uninsured against these risks
if you are insured, what is there a separation of
If you are insured, there is a separation of costs and benefits of safety
define ex-ante moral hazard
tendency of insures people and firms to take less care to prevent future losses when they have insurance
define ex-post moral hazard
reluctance of policyholders who have already suffered some misfortune to keep the cost of the event under control
define face value
principal amount of bond
define residual claim
what is left of the dividend value of the firm
why must senior debt be paid first?
Senior debt must be paid first because it was borrowed first
asset substitution - what happens when firms have significant amount of debt
When firms have a significant amount of debt, shareholders tend to favour unusually risky investment decisions
asset substitution - who is the victim
bondholders
asset substitution - what happens if there is a risky project and non risky project
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
asset substitution - what happens when bondholders anticipate bait and switch
If bondholders anticipate bait and switch, they pay only what the bonds are worth and have a net payoff of 0
3 solutions to asset substitution problem
1) fund with equity
2) establish rep for protecting creditors
3) precommit to hedge or insure risk
solution to asset substitution - explain fund with equity
if managers can pay for project with internal funds ro by making a new issue of shares, then the problem is mitigated or disappears
solution to asset substitution - explain establish rep for protecting creditors
if they do this, a promise not to undertake risky projects in the future might be viewed as credible
2 purposes of laws to protect consumers
1) compensate injured consumers
2) incentive for firm to make safer products because they must pay compensation
what type of law is product liability law and why
Product-liability law is incentive compatible because it aligns the interests of the principal (consumer) and the agent (producer)
explain principal agent issue with consumer safety
firm makes decisions on safety but consumer bears costs if product causes injury
consumer safety - what is s
s denotes expenditure undertaken to make safer products
product liability law - total cost of safety
s
product liability law - marginal cost of safety
Marginal cost of safety = derivative of s / derivative of s = 1
product liability law - what happens as s increases and why
As s increases, expected cost of accidents fall. Expected cost of accidents depend on firm choice of s
product liability law - explain expected benefit of safety formula
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
product liability law - what is benefit of safety
reduction in cost
what happens without product liability law?
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
what does product liability law do?
provides incentive for managers to make safer products
product liability law- optimal level of safety (s) for firms
where marginal cost = marginal benefit
what happens without product liability law in prices
Without product liability law, consumers bear cost of accidents and safety would be reflected in demand for and therefore the price of products
market mechanism - profit of firm
Profit of firm = total revenue - cost of safety - other production costs
market mechanism - level of safety firm chooses
Firm chooses level of safety that maximizes profit so set derivative of profit wrt s equal to 0
market mechanism - what is the same level of safety firm chooses as here
same result as with product liability law
market mechanism - how does price align interests
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.
how to find percentage profit if manager needs net benefit of x
percentage profit = x / weekly profit
how to find disutility of effort from utility for both high and low effort?
disutility is difference between utilities for high and low wealth
formula for value of equity
value of firm - old debt - new debt = value of equity
given 2 projects, which do shareholders choose?
the project that results in higher value of equity
how to find weekly profit
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
formula to find % of profit manager should be paid
expected utility with flat salary and low effort = expected utility with bonus of x profit and high effort
how to find value of new debt
value of firm - old debt. if > capital cost, then only do capital cost
how to find how much investors will pay for the bond?
this is the value of the new debt
how to find what percentage of profit manger must get to receive net benefit of B
profit(e) = R(e) - u(e) - C and take derivative and solve for e. Plug e into profit(e). Then B/profit(e) = percentage
