Principal Agent Problem Flashcards
What is the principal-agent problem?
A conflict of interest where the principal (shareholders) and the agent (managers) have misaligned goals, compounded by information asymmetry.
Why is information asymmetry a problem?
It can lead to a lack of trust and accountability, making it difficult for the principal/shareholder to ensure the agent/manager acts in their best interest.
What is information asymmetry?
A situation where the agent/manager has more information about their actions and intentions than the principal/shareholders.
What is moral hazard?
When one party (agent) takes more risks because another party (principal) bears the consequences.
How can the principal-agent problem be mitigated?
Establishing strong oversight bodies, like boards of directors, to monitor and hold agents accountable. Also through incentive alignment like performance based bonuses. Contracts.
What are some methods to monitor and report agent actions?
Implementing audits, performance reviews, and transparent reporting systems.
What are a few different incentives that are used to ensure managers are rewarded suitably when they add value to the firm?
Monitoring.
Management compensation - performance related bonuses.
Stock-price performance - performance related bonuses.
(Last two linked)
How does monitoring incentivise managers?
By providing feedback and setting clear expectations, they motivate managers to meet or exceed performance standards. If these are not met can be fired.
A governance system would ensure managers maximise value.
Costly
How does management compensation incentivise managers?
Because monitoring is imperfect, compensation plans are designed to attract talented managers.
Designed to encourage managers to maximise shareholders wealth.
Compensation based on input (managers effort) and output. Difficult to monitor input so compensation should be based on output.
How does stock-price performance incentivise managers?
Stock-price performance refers to the movement and change in price of company’s stock/value. Stock price reflect performance of firm.
Compensation is tied to stock prices (company’s wealth) and this reduces cost and need for monitoring.
What are stock options and how do stock options incentivize managers?
Stock options are options allowing managers to buy company stock at a predetermined price, incentivising them to increase the stock’s market value.
They offer the potential for financial gain if the stock price increases, aligning managers’ interests with shareholders.
What is the risk of stock-based compensation?
Managers may prioritize short-term stock price gain to hit performance targets over long-term value creation, leading to risky or unethical behaviour.
Incentive plans may tempt managers to withhold bad news or manipulate earnings to
pump up stock prices.
Also stock - price performance may depend on events outside managers control (recession)
What are restricted stocks and performance shares?
restricted stock - stock that must be retained for several years.
performance shares - shares awarded only if the company meets an earnings or other target relative to industry
peers.
