If you are the sole owner of a business, then you make the decisions that affect your own well-being. But what if you are a financial manager of a business and you are not the sole owner? In this case, you are making decisions for owners other than yourself. You, the financial manager, are an agent. An agent is a person who acts for and exerts power of another person or group of persons. The person (or group of person) the agent represents is referred to as the principal. The relationship between the agent and his / her principal is an agency relationship agency problem or relationship may be defined as a potential conflict for own interest between stockholder versus manager and stockholder versus creditors. Important agency relationships exist: (1) between stockholders and managers. (2) Between stockholders and creditors.
1. stockholders and manager
A potential agency problem arises whenever the manager of firm owns less then hundred present of the firm's common stock . if a firm is a proprietorship managed by the owner. the owner - manager will presumable operate so as to improve his own welfare, with welfare measured in the form of increased personal wealth . there are four commonly used machanisms that help align manager interest with investor interests so that managers will be motivated to act in ways that are in the best interests of investors:
(1) Intervention: Directly intervene in cases where management is underperforming. institutional investors often have enough knowledge to provide reasonable oversight of managerial actions and decision making processes. they also have sufficient clout to be able to get managers to act in ways that are in the investors best interest by threatening to make proposals at shareholder meeting that would force management changes or at least bring management shortcoming to the attention of other investors.
(2) Replacement: replace manages that are not performing well or that are not making decisions that are in the best interest of investors. again, institution investors may have the knowledge and sufficient clout to initiate such actions.
(3) management compensation: structure management's compensation so that good managers will be attracted to the firm and be motivated to make decisions that maximize investor wealth. some obvious way of doing this is to offer managers a basic salary, plus bonuses, performance share, and executive stock options that are based on how well the company performs. if managers are also shareholders they have a financial interest in maximizing the value of the shares.
(4) Takeover threats: Takeover threats are always possible when the management of a form is not maximizing the wealth of its investors. when management is not making decisions that will maximizing share value, the market price of the corporation's securities will tend to leg behind the securities price of rival firms. takeover specialist may see an opportunity to take control of an under performing company by offering a premium price for existing share, replacing the management, changing the way the company is being operated, and increasing the firm's value. the threat of a takeover, therefore, will tend to keep managements motivated to operate the firms they manager well enough so that the publicly traded securities will be priced close enough to their optimum value that a takeover effort would not be warranted.
2. stockholders and creditors
A second agency problem involves conflict between stockholders and creditors. creditors lend funds to the firm at rates that are based on
(1) The riskiness of the firm's existing assets.
(2) Expectations concerning the riskiness of future asset additions.
(3) The firm's existing capital structure.
(4) Expectations concerning future capital structure changes.
creditors provided the portion of capital and receive a fixed interest in return. while stockholders emphasize maximizing the value of their investment by taking high risk, creditors oppose high risk as it exposes them to more risk for no additional risk premium. creditors interest is to earn fixed return on their investment and recover their capital up on maturely. creditors receive just a fixed interest and have no right over the extra returns that are expected from additional risk taking.
providing higher risk premium to creditors for higher level of risk generally solves this problem. the market interest rate is risk adjusted and the creditors are compensated for the level of risk they assume.
1. stockholders and manager
A potential agency problem arises whenever the manager of firm owns less then hundred present of the firm's common stock . if a firm is a proprietorship managed by the owner. the owner - manager will presumable operate so as to improve his own welfare, with welfare measured in the form of increased personal wealth . there are four commonly used machanisms that help align manager interest with investor interests so that managers will be motivated to act in ways that are in the best interests of investors:
(1) Intervention: Directly intervene in cases where management is underperforming. institutional investors often have enough knowledge to provide reasonable oversight of managerial actions and decision making processes. they also have sufficient clout to be able to get managers to act in ways that are in the investors best interest by threatening to make proposals at shareholder meeting that would force management changes or at least bring management shortcoming to the attention of other investors.
(2) Replacement: replace manages that are not performing well or that are not making decisions that are in the best interest of investors. again, institution investors may have the knowledge and sufficient clout to initiate such actions.
(3) management compensation: structure management's compensation so that good managers will be attracted to the firm and be motivated to make decisions that maximize investor wealth. some obvious way of doing this is to offer managers a basic salary, plus bonuses, performance share, and executive stock options that are based on how well the company performs. if managers are also shareholders they have a financial interest in maximizing the value of the shares.
(4) Takeover threats: Takeover threats are always possible when the management of a form is not maximizing the wealth of its investors. when management is not making decisions that will maximizing share value, the market price of the corporation's securities will tend to leg behind the securities price of rival firms. takeover specialist may see an opportunity to take control of an under performing company by offering a premium price for existing share, replacing the management, changing the way the company is being operated, and increasing the firm's value. the threat of a takeover, therefore, will tend to keep managements motivated to operate the firms they manager well enough so that the publicly traded securities will be priced close enough to their optimum value that a takeover effort would not be warranted.
2. stockholders and creditors
A second agency problem involves conflict between stockholders and creditors. creditors lend funds to the firm at rates that are based on
(1) The riskiness of the firm's existing assets.
(2) Expectations concerning the riskiness of future asset additions.
(3) The firm's existing capital structure.
(4) Expectations concerning future capital structure changes.
creditors provided the portion of capital and receive a fixed interest in return. while stockholders emphasize maximizing the value of their investment by taking high risk, creditors oppose high risk as it exposes them to more risk for no additional risk premium. creditors interest is to earn fixed return on their investment and recover their capital up on maturely. creditors receive just a fixed interest and have no right over the extra returns that are expected from additional risk taking.
providing higher risk premium to creditors for higher level of risk generally solves this problem. the market interest rate is risk adjusted and the creditors are compensated for the level of risk they assume.
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