Agency Problem

Why conflict of interest between owners and management?

The control of the modern corporation is frequently placed in the hands of professional non-owner managers. We have seen that the goal of the financial manager should be to maximize the wealth of the owners of the firm and given them decision-making authority to manage the firm. Technically, any manager who owns less than 100 percent of the firm is to some degree an agent of the other owners. In theory, most financial managers would agree with the goal of owner wealth maximization. In practice, however, managers are also concerned with their personal wealth, job security, and fringe benefits, such as country club memberships, limousines, and posh offices, all provided at company expense. Such concerns may make managers reluctant or unwilling to take more that, moderate risk if they perceive that too much risk might result in a loss of job and damage to personal wealth. The result is a less-than-maximum return and a potential loss of wealth for the owners.

Why conflict of interest between shareholders and management?

To address the conflict of interest between shareholders and management, it is important to stress that even within the same class of shareholders, there may be conflicts, this conflict may relate to what proportion of the company’s profit should be paid in the form of dividend and what proportion should be retained for future investments and for capital investment purposes. Other potential conflicts may involve company’s ethical policies, its corporate and social responsibilities policies. The agency theory, considering the potential conflicts of interest between shareholders and management may arise as a result of several factors, some of such factors include:

  • Reward to management
  • Risk attitudes of management and shareholders
  • Takeover decisions by management
  • Time horizon of management

From this conflict of owners with management and shareholders with management arises what has been called the agency problem-the likelihood that managers may place personal goals ahead of corporate goals.

The agency problem generally refers to the conflict of interest between management and ownership in a business enterprise. Ownership is primarily focused on maximizing its wealth through the business, while management is primarily interested in maximizing and stabilizing its income without incurring significant risk.

Two factors-market forces and agency costs-act to prevent or minimize agency problems.

  1. Market Forces: One market force is major shareholders, particularly large institutional investors, such as mutual funds, life insurance companies, and pension funds. These holders of large block of a firm’s stock have begun in recent years to exert pressure on management to perform. When necessary they exercise their voting rights as stockholders to replace under performing management. Another market force is the threat of takeover by another firm that believes that it can enhance the firm’s value by restructuring its management, operations, and financing. The constant threat of takeover tends to motivate management to act in the best interest of the firm’s owners by attempting to maximize share price.
  2. Agency Costs: To minimize agency problems and contribute to the maximization of owners’ wealth, stockholders incur agency costs. These are the costs of monitoring management behavior, ensuring price. The most popular, powerful, and expensive approach is to structure management compensation to correspond with share price maximization. The objective is to compensate managers for acting in the best interests of the owners. This is frequently accomplished by granting stock options to management. These options allow managers to purchase stock at a set market price; if the market price rises, the higher future stock price would result in greater management compensation. In addition, well-structured compensation packages allow firms to hire the best managers available. Today more firms are tying management compensation to the firm’s performance. This incentive appears to motivate managers to operate in a manner reasonably consistent with stock price maximization against dishonest acts of management, and giving managers the financial incentive to maximize share.

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