The Principal - Agent Problem

Question 1

Briefly explain the principle - agent problem

Answer 1

1. The separation of ownership and control.
2. Owners (shareholders) are the principles and managers are the agents.
3. The problem arises because owners and managers have different interests.
4. Owners want to maximise the value of the firm.
5. Managers want to pursue their own interests. E.g. high salary/ bonus

Question 2

What are some solutions to the principal - agent problem?

Answer 2

1. Line incentives of managers and earnings by compensating managers partly in the form of shares.
2. Managers monitored by the board of directors. Board members look after their interests.
3. Introducing external pressure by selling shares if managers are running the company badly. (Threat of takeover)
4. Shareholder activism - shareholders voice concerns to directors.

Question 3

What are “agency costs” with regards to the solutions for the principal - agent problem?

Answer 3

These are costs that are introduced for some of the solutions for the principal - agent problem

Question 4

What are some examples of agency costs that arise when the agency problem is known to exist?

Answer 4

1. Expropriation - taking company resources for personal gain at the expense of shareholders
2. Perquisites - extra benefits given to employees beyond their salary
3. Self dealing - managers making deals/ decisions that benefit them instead of the company
4. Higher cost of capital - increased expense for raising funds due to more risk