By investing in a company, shareholders aim to maximize their wealth and achieve portfolio diversification. The objective of managers is assumed to be to further these interests by maximizing the firm’s share value. This can be achieved by taking on projects with positive NPV and good management of short-term capital and long-term debt. However, shareholders and managers are assumed to want to maximize their utilities; so this objective may not always be the priority for managers as they may rather prefer to maximize their own wealth or further other personal interests of theirs. This conflict of interest between the two is an example of the principal agent problem.
The principal agent problem occurs due to two reasons. The first is the separation of ownership from control - the principal or the shareholders may own a corporation but it is the agent or manager who holds control of it and acts on their behalf. This gives managers the power to do things without necessarily being ‘detected’ by shareholders. The second is that shareholders may not possess the same information as the manager. The manager would have access to management accounting data and financial reports, whereas the shareholders would only receive annual reports, which may be subject to manipulation. Thus asymmetric information also leads to moral hazard and adverse selection problems.
The following are areas where the interests of shareholders and managers often conflict:
•Managers may try to expropriate shareholders’ wealth in a number of ways. They may over consume perks such as using company credit cards for personal expenses, jet planes etc. •Empire building: Managers may pursue a suboptimal expansion path for the firm. They may expand the firm at a rationally unfeasible rate in order to increase their own benefits at the cost of shareholders’ wealth. •Managers may be more risk averse than shareholders who typically hold diversified portfolios. •Managers may not have the same motivation as shareholders, likely due to a lack of proper incentives. •Managers may window dress financial statements in order to optimize bonuses or justify sub optimal strategies
The principal agent problem normally leads to agency costs. This has been identified by Jensen and Meckling(1976) as the sum of:
1.Monitoring costs: Costs incurred by the shareholders when they attempt to monitor or control the actions of managers. 2.Bonding costs: Bonding refers to contracts that bond agents' performance with principal interests by limiting or restricting the agent’s activity as a result. The cost of this to the manager is the bonding cost. 3.The residual loss: Costs incurred from divergent principal and agent interests despite the use of monitoring and bonding.
However the manager’s discretion is quite limited in practice. There are a number of internal and external solutions to agency costs for shareholders.
•Well-written contracts ensure that there are fewer opportunities for managers to over consume perks. •An external board of directors could be appointed to monitor the efforts and actions of managers. This board would have access to information and considerable legal authority over management. It could thus safeguard information and represent shareholder interests in the company. •The board could hire independent accountants to audit the firm’s financial statements. If the managers don’t agree to changes proposed by auditors, the auditors issue a qualified opinion. This signals that managers are trying to hide something, and undermines investor confidence. •Compensation packages where the reward to the manager is linked to firm performance. This includes performance related bonuses and the payments of shares and share options. •Ambitious, lower managers are a...