The Agency Problem and its Solutions

Question 1

What is the agency problem?

Answer 1

• when financial managers don’t pursue the primary goal, so shareholders are not happy
• “conflict of interest between shareholders and financial manager”
• > costs for the corporation

Question 2

What is direct agency costs?

Answer 2

• “Financial managers act in their own self interest”

Question 3

What are monitoring costs?

Answer 3

• costs for monitoring financial manager to make sure they pursue primary goal, the right thing

Question 4

What are indirect agency costs?

Answer 4

• The opportunity cost of not pursuing valuable investment opportunities

Question 5

What is corporate governance?

Answer 5

• a system on how to resolve agency problem

- “System by which corporations are controlled and directed”

Question 6

What are internal mechanisms?

Answer 6

• part of corporate governance
• install a board of directors (gives orders and whatnot to for primary goal)
• shareholder meetings and voting rights
• managerial compensation (part of managerial pay in the form of equity, so they’d want to maximise firm profits to maximise that equity pay)

Question 7

What are external mechanisms?

Answer 7

• includes managerial labour markets (market of many managers, so if current one bad, they can be replaced)
• debt and legal restrictions
• mergers and acquisitions (making sure the firm does well so it doesn’t get absorbed by bigger company, making the financial manager lose their position)