agency problems in finance

8/2/2019 Agency Problems in Finance

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Agency Problems in Finance

Contracting & Corporate Governance



Agency Problems

Incentives and information

– No problems if either is perfect

Two possibilities

– Owner is sole employee

– Principal/Owner hires agent



Owner-managed

Maximize Individual Utility

– Tradeoff profits against own interests

– Discount cash flows at “personal” rates Firm risk = Personal risk

Capital constrained manager might sacrifice long

term cash flow for short term cash flow



Firm with Outside Investors

Shareholders own the company, so prioritizetheir interests

– All shareholders like Money so, by law – Managers have a fiduciary duty to maximize

wealth of shareholders



Goal of Maximizing

Shareholder Wealth What about other stakeholders?

Often (not always) goals overlap

„Nexus of Contracts‟

– Labor

– Customers

– Creditors

Legal and regulatory constraints



Moral Hazard

Hidden Action

Solutions:

– Write contracts to mitigate problem

– Monitor

– Align incentives

– Don‟t delegate



Adverse Selection

Hidden Information

Solutions: (signaling and screening)

– Guarantees/warranties

– Reputation/brand names

– Lemon laws



Agency Problems in Corporate

Finance Capital providers

– What firm will do with capital

– Quality of firms seeking capital

Capital seekers need to consider these

concerns



Types of Conflicts

Intra-firm conflicts

Reorganization conflicts

Stockholder/Bondholder conflicts

Stockholder/Manager conflicts



Intra-firm Conflicts

Firms aren‟t monolithic

Divisions raise capital from HQ

– analogous to problem of firms raising capital

from external markets

Corporate socialism



Reorganization Conflicts

Going Public

Liquidation vs. Restructuring

– Creditors

– Managers

– Stockholders



Stockholder/Bondholder

Conflicts Increase dividends

Subordination of claims

Asset substitution



Solutions

Direct monitoring

Bond covenants

Reputations

Contract design



Stockholder/Manager

Conflicts Shirking

Perquisites

Entrenchment

Outright theft



Solutions

Carrots – Compensation contracts

– Larger ownership stakes

Sticks – Pressure from inside the firm

– Pressure from outside the firm



Role of Governance

Capitalism requires reliable information

Good governance

– Oversight

Formal & informal

– Competition Firms that minimize costs survive



Corporate Governance

Cash rich firms with excess capacity

– No pressure to use equity capital efficiently

TakeoversChanges in Compensation

– 1980: <20% of total CEO comp. was equity based

– 1994: ~50% of total CEO comp. was equity based

Accounting Scandals – 2002: Sarbanes Oxley

No loans to management

Required auditor independence

Penalties for incorrect financial statements



Concluding Thoughts

Agency problems arise frequently

Contracts and markets evolve to mitigate

problems

Legal system and political/regulatory system

have an important role

agency problems in finance

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