Agency Problem Essay 9

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Financial Management

(Agency problem)

Prepared by: Sami Hassan Saeed Singabi

August 2008


Economic science teaches us that due to their subjective needs, individuals have subjective preferences, and hence different interest. Occasionally different subjective interests give rise to conflicts of interest between contracting partners. These conflicts of interest may result in turn, in one or both parties undertaking actions that may be against the interest of the other contracting partner. The primary reason for the divergence of objectives between managers and shareholders has been attributed to separation of ownership (shareholders) and control (management) in corporations. As a consequence, agency problems or principal-agent conflicts exist in the firm. Agency theory deals with such problem. Agency theory is concerned with how these agency problems affect the form of the contract and how they can be minimized, in particular, when contracting parties are variously informed (or uncertain).

Agency problem

A 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 company, who are charged with running the business in the interests of shareholders; choose instead to operate to maximize their own interests. A simple example is the hired manager who fills his pockets at shareholders' expenses. For example, an agency problem exists when management and shareholders have conflicting 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 used to try and reduce these agency problems. Many of these mechanisms try to link the manager's compensation to the performance of the firm. Typical examples include performance shares, restricted stock grants, and executive stock options. This dissertation is an empirical study of whether the use of executive stock options has in fact reduced the agency 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 significant event such as a merger or divestiture to see if an executive's holding 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. Another question of interest is whether in taking on risky investments; do executives increase the leverage of the firm? By increasing the leverage of the firm, the executive might increase the risk of the firm and thus the value of the option holdings.

An agency relationship

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 potential agency problems, if you expanded to additional locations you could not physically be at all locations at the same time. Consequently, you would have...
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