B. Agency conflicts arise when there are differences in the goals of the firm ve
ID: 2728544 • Letter: B
Question
B. Agency conflicts arise when there are differences in the goals of the firm versus the personal goals of managers. What Qualitative considerations are important for the mitigation of agency conflicts in relation to the acceptance and completion of capital projects? Indicate the types of monitoring costs and why these are critical. What monitoring activities are required to ensure that project acceptance and outcomes benefit shareholders? What approaches might be necessary to ensure managers make ethical project investment decisions?
Explanation / Answer
An agency relationship arises whenever one or more individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision-making authority to the agents.
The primary agency relationships in business are those (1) between stockholders and managers and (2) between debtholders and stockholders
These relationships are not necessarily harmonious; indeed, agency theory is concerned with so-called agency conflicts, or conflicts of interest between agents and principals. This has implications for, among other things, corporate governance and business ethics.
CONFLICTS BETWEEN MANAGERS AND
SHAREHOLDERS:
Agency theory raises a fundamental problem in organizations—self-interested behavior. A corporation's managers may have personal goals that compete with the owner's goal of maximization of shareholder wealth.
Since the shareholders authorize managers to administer the firm's assets, a potential conflict of interest exists between the two groups: -
A) SELF-INTERESTED BEHAVIOR
B) COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT
SELF INTERESTED BEHAVIOUR: Agency theory suggests that, in imperfect labor and capital markets, managers will seek to maximize their own utility at the expense of corporate shareholders. Agents have the ability to operate in their own self-interest rather than in the best interests of the firm because of asymmetric information and uncertainty.
COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT: Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests.
There are three major types of agency costs: (1) expenditures to monitor managerial activities, such as audit costs; (2) expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside members to the board of directors or restructuring the company's business units and management hierarchy; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth.
MECHANISMS FOR DEALING WITH
SHAREHOLDER-MANAGER CONFLICTS
There are two polar positions for dealing with shareholder-manager agency conflicts. At one extreme, the firm's managers are compensated entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers under these contractual terms because the firm's earnings would be affected by economic events that are not under managerial control. At the other extreme, stockholders could monitor every managerial action, but this would be extremely costly and inefficient. The optimal solution lies between the extremes, where executive compensation is tied to performance, but some monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders' interests: (1) performance-based incentive plans, (2) direct intervention by shareholders, (3) the threat of firing, and (4) the threat of takeover.
Most publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If corporate performance is above the performance targets, the firm's managers earn more shares. If performance is below the target, however, they receive less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives.
An increasing percentage of common stock in corporate America is owned by institutional investors such as insurance companies, pension funds, and mutual funds
First, they can meet with a firm's management and offer suggestions regarding the firm's operations. Second, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders' meeting, even if the proposal is opposed by management.
Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clearly influence management opinion.
Hostile takeovers, which occur when management does not wish to sell the firm, are most likely to develop when a firm's stock is undervalued relative to its potential because of inadequate management. In a hostile takeover, the senior managers of the acquired firm are typically dismissed, and those who are retained lose the independence they had prior to the acquisition. The threat of a hostile takeover disciplines managerial behavior and induces managers to attempt to maximize shareholder value.
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