T7 Agency

Question 1

Principal agent problem

Answer 1

Shareholders (principals) = owners
Managers (agents) = employees
Managers have power to manage day to day aspects of the firm and have more information than shareholders
Agency problems occur when managers do not act in shareholders interest

Question 2

How does agency issue occur

Answer 2

Shareholders pay FM fixed salary:
Reduced effort - low incentive to invest in truly valuable NPV projects
Overinvestment - risk taking, short terms (short term action at expense of long term value)

Question 3

Incentives to reduce Agency problem

Answer 3

Governance system - rules aimed at ensuring managers maximise value
Monitoring - managers efforts & actions by intervening includes: board of directors, shareholders, auditors lenders
Bcs monitoring is imperfect, compensation plans must be designed. This should encourage managers to maximise shareholders wealth. Compensation should be based on output as input is hard to measure

Question 4

Incentives - Stock price performance

Answer 4

Capital markets monitor managers actions through price mechanism
Compensation tied to stock prices do reduce cost and need for monitoring
Performance shares - only awarded if company meets earnings or other targets relative to industry peers
However if economy tumbles share price may fall even with good performance alternatively share price may rise due to oil prices

Question 5

Short termism

Answer 5

Forgoing R&D spending to meet more immediate targets
Focusing on targeted measures and less on workplace safety
May tempt managers to withhold bad news to manipulate earnings & increase stock price

Question 6