Principal Agent Problem

Question 1

Owners and Managers of Listed company

Answer 1

When the ownership of a company is dispersed through the issue of shares, owners do not control the company

Managers run the company on behalf of the owners funds

Owners = Principal
Managers = Agents (of the owners)

Question 2

Principal Agent problem (Agency problem) and Agency Costs

Answer 2

Owners and Managers have different interests

Owners want to maximise a firm’s value

Managers want to maximise salary, vanity projects etc

Results in ’agency costs’, particularly in emerging countries where investors are less protected by regulation (embezzling, assets to family etc)

Agency costs in developed countries may be bigger expenses and corporate jets etc

Question 3

Solutions to PA problem

Answer 3

1. Align incentives of managers and owners by compensating with shares or stock options
2. Owners appoint board members to monitor managers
3. External pressure by selling shares If managers are running badly
4. Shareholder activism - groups of shareholders voice concerns to directors

However, implementing these solutions involves ’agency costs’

Question 4

Examples in industry (Front-running)

Answer 4

Investor (principal) appointing broker (agent)

Broker places a large order for client and benefits off the anticipated price rise

Question 5

Dual Capacity and Trust in Industry

Answer 5

When a firm operates as both a broker and a dealer (broker-dealer)

Expose themselves to PA problem, however should mostly put broking interests of client first

Finance professionals acting in own interest can cause a lack of trust in the industry, which results in less savings and funds for lending = slow economic growth