What is the agency problem and give an example?
Separation or conflict of interest between the principal and the agent.
A classic example is a car dealership where the sale people are paid a fixed commission, while the owner wants to get top dollar for the car the salesperson is only incentivized to sell the car and more willing to give a lower price to customers
What does the agency problem create?
Agency cost: The cost of conflict between principal and agent.
In a large corporation who would be the principal and the agent?
Principal: Shareholders
Agent: Managers
What is a tactic many corporations use to reduce interest differences between managers and shareholders?
You can mitigate the separation of interests of managers and shareholders by giving managers ownership options as compensation, which aligns the shareholders’ and managers’ interest
What are the severities of agency costs? (5)
- Reputational & Financial Damages
- Bankruptcy
- Class action lawsuits
- Violations of the Foreign Corrupt Practices Act
- Massaging earnings & Financial restatements
What is the highest version of agency cost?
Corporate fraud: Just one dimension of agency costs
where managers willingly break the law
**How do we make sure that decision-
makers are doing what they’re
supposed to be doing?
Slide 12
What are the different definitions of what a corporation is? (4)
- Lawyers: a corporation is a legal business structure that establishes the business as being a separate entity from the owners.
- Economists: a corporation is a bundle of contracts.
- Corporation: a mechanism established to allow different parties to contribute capital, expertise and labour for their mutual benefit
*Shareholders view a corporation is A nexus of relationship and don’t necessarily need to have a formal obligation
What is one major difference between small and large firms?
There is often a small separation between control and ownership is a small firm
What are the essential characteristics of a public corporation?
- Limited liability for investors
- Transferability of investor ownership
- Through the trading of shares of stock on exchanges
- Legal personality
- Has legal rights and obligations
- Separation of legal ownership and management control
How do investors delegate day-to-day decision-making for the organization?
- The shareholders elect directors to act as their agents in supervising the firm
- The directors appoint officers (or executives) to actually run the firm on a day-to-day basis
What is the problem with the separation of ownership and control?
- Problems arise in corporations because the agents (top management) are not willing to bear responsibility for their decisions unless they own a substantial amount of stock in the corporation
Slides 32-33
Principle-agent problem
Define adverse selection and moral hazard and give an example.
Adverse Selection
* Increases the likelihood of selecting inferior alternatives
for someone selling insurance and customers fill out the form saying they have no medical issues. And the customer in reality has medical issues
Moral hazard
* Increases the incentive of one party to take undue risks or shirk other responsibilities
* The costs incur to another party
Someone selling insurance and the customer doesn’t lie on the form but the customer changes their behaviour as soon as the insurance covers them
Agency problem of diversification?
- Diversification reduces these risks because a firm and its managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses
This can result in 2 manager benefits shareholders “don’t enjoy”
* 1. Increase in firm size
* 2. Firm portfolio diversification which can reduce top executives’ employment risk (i.e.,job loss, loss of compensation and loss of managerial reputation)
What are the types of agency costs?
Direct
* Corporate expenditure: Benefits the management but costs the shareholders
* Monitoring expenditure: Incurred to monitor and
incentivize managers
Indirect
* Lost opportunities: Management inaction to
protect their job
*Indirect is very difficult to calculate and is often impossible to figure out
Agency problem of FCF?
- Firm’s free cash flow
- Resources remaining after the firm has invested in all projects that have positive net present values within its current businesses
Available cash flows
* Managerial inclination to over-diversify can be acted upon
* Shareholders may prefer distribution as dividends, so they can control how the cash is invested
*Slide 39-40 Building empires
*Slides 41-42 refusing to sell
*Slide 43 Other agency costs
*Slide 55 What is corporate governance
How did contemporary corporate governance start?
Contemporary corporate governance started in 1992 with the
`Cadbury report in the UK.
* Cadbury was the result of several high-profile company collapses.
*titled Financial Aspects of corporate governance, is a report that sets out recommendations on the arrangement of company boards and accounting systems to lessen corporate governance risks and failures.
Principals of corporate governance
- Accountability.
* Ensure that management is accountable to the Board of Directors.
* Ensure that the Board of Directors is accountable to shareholders. - Fairness.
* Protect Shareholders rights.
* Treat all shareholders including minorities, equitably.
* Provide effective redress for violations. - Transparency.
* Ensure timely, accurate disclosure on all material matters, including the financial situation, performance, ownership and corporate governance. 4. Independence.
* Independent Directors and Advisers i.e. free from the influence of others.
