term 2 - lecture 4 Flashcards
where does the conflict of interest between managers and investors come from?
they come from seperation of ownership and control
when do agency costs arise?
when the manager does not bear the full cost of his or her actions
what does the seriousness of the conflict depend on?
it depends on the degree of misalignment between the interests of manager and shareholders
what are examples of agency problems?
how can different risk preference be an example of agency problem?
how can different time horizon be an example of agency problem?
what is the standard solution to the principal agent problem>?
making the managerial compensation dependent on firm performance
what is the cost of the standard solution to the principal agent problem
it increases the risk exposure of the manager (the firm might do poorly for reasons unrelated to the managers performance)
if the compensation contract entails too much risk, the corporation might have a hard time finding a manager who is willing to accept the terms of the contract
what is the role of corporate governance?
the role of corporate governance is to mitigate the conflict of interest without unduly burdening the managers with the risk of the firm.
the system attempts to align these interests by providing incentives for taking the right action and punishments for taking the wrong action
what do the incentives come from for the manager?
the incentives come from owning stock in the company and from compensation sensitive to performance
where do the punishments come from for the manager?
punishments come when a manager is fired for poor performance or shareholders launch a contest to replace the board of directors
where do the additional powerful incentives come from?
Additional powerful incentives also come from the
managers’ concern about their future: current
performance is tied to the prospect of receiving offers
from more prestigious companies
what is the trade off between the use of rewards and punishment to control the manager?
As a manager owns more stock in the firm, her incentives become better aligned, but the manager becomes harder to fire because the block of stocks gives her significant voting rights.
what is another way to control the behaviour of managers without incentives and punishments?
through monitoring. When the ownership of a corporation is widely held, the board of directors is charged with monitoring the
manager. But the board of directors, themselves, have a similar conflict of interest: monitoring is a costly activity and
in many cases, boards do not get significant benefits from monitoring.
what is contract design used for?
Contract design can be used to align the managerial incentives with the interests of business owners in order to mitigate agency costs.
what is the set up of the basic agency model?
two individuals, the principal and agent. role of principal is to supply capital, bear risk and design an incentive scheme for the agent. the principal can be thought of as a representative shareholder or the board of directors. the role of agent is to exert effort in order to make sound managerial decisions on behalf of the principal.
what is the sequence of events in the basic agency model?
what is the formula for the agents utility for the benchmark observable case?
what is the formula for the principal expected profit when effort is unobservable?
what is the optimal contract for the principal?
what is the solution for the optimal contract for the principal and how do they do this?
what are options?
options are derivative securities whose value depend on the value of the underlying asset ie the company stock
what do stock options provide the manager?
stock options give managers the right to purchase a specified number of shares for a specified period of time (option maturity date) for a specified price (exercise price)
what are the managers of a long call option?
what are the incentive structures in the form of a graph?
what are non economics incentives?
what does bonus based compensation create a strong incentive for?
it creates a strong incentive for a manager to favour short term performance.
what is the tradeoff between bonuses and shareholders?
an increase in the bonus creates a preference for current profit leading to imbalance of incentives. this imbalance would further be aggravated by a reduction in stock based incentives
how does the timing of financial forecasts affect options?
what is backdating?
backdating is the practice of manipulating the grant date of a stock option so that the date of the grant would coincide with a date when the stock price was lower than its price at the time the grant was actually awarded
