Agency Problem Essay

Financial Management (Agency problem) Prep atomic number 18d by Sami Hassan Saeed Singabi August 2008 Introduction Economic scientific discipline teaches us that due to their inseparable needs, individuals make up subjective preferences, and hence different interest. Occasionally different subjective interests give rise to conflicts of interest betwixt contracting partners. These conflicts of interest may settlement in turn, in one or both parties undertaking actions that may be against the interest of the some other contracting partner.The autochthonic reason for the divergence of objectives between managers and sellholders has been attributed to separation of takeership (shareholders) and defend ( perplexity) in corporations. As a consequence, substance problems or principal-agent conflicts exist in the solid. Agency theory deals with such problem. Agency theory is concerned with how these representation problems affect the form of the contract and how they house be minimized, in particular, when contracting parties are variously assured (or uncertain). Agency problemA problem arising from a conflict of interest between principals such as investors and agents acting for them, such as brokers or managers. Agency problem refers to a conflict of interest arising between creditors, shareholders and management because of differing goals. It exists due to problems in corporate governance. A typical problem is that of senior management of a play along, who are keepingd with running the credit line in the interests of shareholders choose instead to operate to maximize their own interests. A simple example is the hired anager who fills his pockets at shareholders expenses. For example, an office problem exists when management and shareholders have contrast ideas on how the company should be run. Agency problems that arise in a corporation have troubled economists for some time. There are a number of mechanisms that have been utilise to try and reduce these influence problems. Many of these mechanisms try to link the managers compensation to the exercise of the star sign. Typical examples include performance shares, restricted stockpile grants, and executive stock options.This dissertation is an empirical study of whether the use of executive stock options has in fact reduced the influence problems between managers and stockholders. In this dissertation, two different testing methodologies are used to address the agency problem reduction issue. One methodology looks at some probative event such as a merger or divestiture to see if an executives guardianship of stock options affect what decisions are made. For example, do larger holdings of stock options motivate managers to take on riskier investments? By increasing the risk of the firm, managers can increase the value of the stock options.A nonher question of interest is whether in taking on risky investments do executives increase the leverage of the firm? By incr easing the leverage of the firm, the executive might increase the risk of the firm and thus the value of the option holdings. An agency descent 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 debt holders 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. These relationships are not necessarily harmonious indeed, agency theory is concerned with so-called agency conflicts, or conflicts of interest between agents and principals. Expansion increase effectiveness agency problems, if you expanded to additional locations you could not physically be at all locations at the similar time.Consequently, you would have to delegate decision-making authority to others. Creditors can protect themselves by (1) Having the loan secured. (2) Placing restrictive covenants in debt agreements. (3) They charge a higher than normal interest rate to compensate for risk. Agency cost A attribute of internal cost that arises from, or must be paid to a manger acting on behalf of shareholders. Agency cost arises because of core problems such as conflicts of interest between share holders and management.Shareholders wish for management to run the company in away that increases shareholders value, but management may wish to grow the company in away that maximize their personal power and wealth that may not be in the best interest of shareholders. Agency costs are inevitable within an organization whenever shareholders are not completely in charge the cost can usually be best spent on providing proper material incentives and moral incentives for agents to properly execute the ir duties, thereby aligning the interests of shareholders (owners) and agents.The principals (the shareholders) have to find shipway of ensuring that their agents (the managers) act in their interests. This means incurring costs, agency costs, to (a) monitor managers behavior, and (b) create incentive schemes and control for managers to pursue shareholders wealth maximization. Various methods have been used to try to align the actions of senior management with the interests of shareholders, that is, to light upon goal congruence. Linking rewards to shareholder wealth improvements Owners can grant directors and other senior managers share options. These ermit the managers to bargain for shares at some date in the future at a price, which is fixed in the present. If the share price rises significantly between the dates when the option was granted and the date when the shares can be bought the manager can make a fortune by buying at the pre-arranged price and then selling in the mar ket place. The managers under such a scheme have a clear interest in achieving a rise in share price and thus congruence comes about to some extent. An substitute method is to allot shares to managers if they achieve certain performance targets, for example, growth in earnings per share or return on shares.Sackings The bane of being sacked with the accompanying humiliation and financial loss may boost managers not to diverge too far from the shareholders wealth path. However this method is seldom used because it is often difficult to implement due to difficulties of making a coordinated shareholder effort. Selling shares threat and the take- over Most of the large shareholders (especially institutional investors) of quoted companies are not prepared to put large resources into monitor and controlling all the firms of which they own a part.Quite often their first response, if they observe that management is not acting in what they regard as their best interest, is to sell the shar e rather than intervene. This will result in a lower share price, making the raising of funds more difficult. If this process continues the firm may become vulnerable to a merger bid by another group of managers, resulting in a loss of top management posts. Fear of being taken over can form some sort of backstop position to prevent shareholder wealth considerations being totally ignored. collective governance regulations There is a considerable range of legislation and other regulatory pressures (e. g. the Companies Act) designed to encourage directors to act in shareholders interests. Within these regulations for example, the board of directors is not to be dominated by a mavin individual acting as both the chairman and chief executive. Also independently minded non-executive directors should have more power to represent shareholder interests in particular, they should predominate in decisions connected with directors remuneration and auditing of firms accounts.Information flow T he accounting profession, the stock exchange, the regulating agencies and the investing public are endlessly conducting a battle to encourage or force firms to release more accurate, timely and detailed selective information concerning their operations. An improved quality of corporate accounts, annual reports and the availability of other forms of information flowing to investors and analysts such as company briefings and press announcements help to monitor firms, and identify any wealth-destroying actions by wayward managers early. Conclusion dispel ownership of publicly held companies reduces the owners ability to monitor managers because they would have to bear the full monitoring costs objet dart gaining only a small marginal benefit. Managers may therefore act to maximize their wealth through and through personal use of corporate assets, stock manipulation and sub optimal decisions at the owners expense. Thus agency theory practical mechanism is weak, because it is unable t o provide practical conclusions with regard to agency problems. References 1. Wikipedia, the surplus encyclopedia. htm 2. www. referenceforbusiness. com 3. Financial-dictionary. The free dictionary. com