2 agency theory

8/3/2019 2 Agency Theory

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Agency Issues in the ModernCorporation


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The Goal of the Corporation

Maximize Shareholder Wealth


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Why does agency problem exist?

Separation of ownership and control in moderncorporation:

Benefits: Limited liability, professional management,

shareholder diversification (allows firm to exist!)

Costs: Agency problems (Principal-Agent problem)

Key concept# 2: Agency

Theory


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What is an agency relationship?

An agency relationship arises whenever oneor more individuals, called principals, (1) hiresanother individual or organization, called anagent, to perform some service and (2) thendelegates decision-making authority to thatagent.


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There are 2 potential agencyconflicts:

Conflicts between stockholders and managers.

Conflicts between stockholders and creditors.


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Why does agency problem exist?

Agency problem exists becauseof theseparation of ownership and control

Managers do not bear the full costs of theirdecisions, since they dont own 100% of firm Example: Manager owns 10% of firm

Can decide to buy corporate jet for $2 million, whichis worth $400,000 to him and $0 to shhs

Will mgr. buy it?

Yes, since doesnt fully internalize costs of inefficientdecisions

Note if mgr owns 100%, then no separation ofownership and control no agency problemwouldnt buy the jet


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The Principal-Agent Problem

Low effort (slacking/shirking)

Expensive perks (corporate jets)

Empire building (overinvestment)

Entrenching investment (to keep job)

Avoiding risk (so as not to lose job)

How might managers interestsdiffer from shareholders interests?


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Further agency issues

1. Executives pursue growth incompany size rather than in earnings

2. Executives avoid risk

3. Managers act to optimize theirpersonal payoffs

4. Executives act to protect their status


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Moral hazard is the form of postcontractual opportunism

that arises because actions that have efficiencyconsequences are not freely observable (monitoringproblem)

so the person taking them may choose to pursue hisor her private interests at others expense

Moral hazard problem Owners have access to limited information Owners cannot monitor every executive decision

Executives often free to pursue own interests

Moral Hazard

Key concept# 3: Moral

Hazard


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Moral Hazard: Slacking Employees

Employees on wages with littleeffective monitoring.

An office employee may spend timeshirking (slacking), studying for anexam, or chatting on the phone withfriends when there is work waiting tobe done.


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Moral Hazard: Senior Executives

Senior executives may pursue theirown goals of status, high salaries,expensive perks, and job security ratherthan the stockholders interests

They may push sales growth over profits. They may treat themselves to huge

staffs and corporate jets, and

Senior executives may ignore theshareholders rightful claims, buildingexecutive offices that are not exactlyneeded.


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Moral Hazard in P-A Relationships

Moral Hazard occurs when the agent actsin behalf the principal, and is supposed toadvance the principals goals. Because

the agent and principal have differingobjectives, however, and because theprincipal cannot easily determine whetherthe agents actions are actually self-

interested misbehavior, moral hazardcharacterizes many principle-agentsituations.

2 agency theory

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