Agency Problem – Essay

I partially agree with the statement that jitneys come a severely limited amount of discretion to pursue actions inconsistent with shareholder wealth maximization. By investing in a club, shareholders aim to maximize their wealth and achieve portfolio diversification. The objective of managers is assumed to be to further these raises by maximizing the firms share cheer. This can be achieved by taking on projects with positive NPV and good management of short- term great and long-term debt.However, shareholders and managers are assumed to want to maximize their utilities so this objective whitethorn not forever and a day be the priority for managers as they whitethorn 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 superstar agent problem. The whizz agent problem occurs repayable to two reasons. The first is the separation of ownership from control the principal or the s hareholders 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 universe 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 selective information and financial reports, whereas the shareholders would only receive annual reports, which may be subject to manipulation. Thus asymmetric information also come abouts to moral hazard and adverse natural 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(prenominal) as using company credit cards for personal expenses, jet planes etc. Empire building Managers may pursue a suboptimal expansion manner 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 agents 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 supervise and bonding. However the mana gers discretion is quite limited in practice. There are a number of internal and external solutions to agency costs for shareholders. Internal Well-written contracts batten down 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 healthy 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 firms financial statements. If the managers dont 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 cerebrate to firm performance. This includes performance related bonuses and the payments of shares and share options. Ambitious, lower managers are a threat to the jobs of inefficient, evading ones. External The lenders of a company also monitor a trust for instance would track the assets, earnings and cash flows of the company it provides a loan to. Managerial labor market Poor managers may not get other job or get a much poorer one. Ultimately the most important indicator to the labor market of managerial performance is share damage. crown Markets A falling share price increases the threat of a take-over, which can often result in redundancies. More concentrated shareholding by outsiders can lead to monitoring by them and improve managerial performance. However there are a few problems with these solutions though, which make it possible for managers to circumvent them to a small extent. In order to keep the share price high, managers may focus more on short term profitability at the cost of long term profitability. They may use gimmicks to temporarily boost the share price and neglect spending on research, development and H. R.They may also provide sub standardised products and cease providing services for old, or relatively less important products in order to contract costs and make a quick profit. This damages the companys reputation, reduces its competitiveness in the future and thus affects long-term shareholder value negatively. While block holders may act as external monitoring machines, they can also have private incentives to go along with management decisions, which may be detrimental to firm performance. Writing better contracts may reduce the problem of asymmetric information, but not fully solve it.This is because the design of such contracts is technically infeasible due to various reasons such as the fuss of foreseeing all future contingencies. Dispersed shareholders often do not exercise the few controlling rights that they have. This leads to a free rider problem where shareholders would prefer to allow other shareholders do the task of monitoring as they cannot ju stify spending on it over the few shares that they each own. In order to resist takeovers, managers may design contracts that compensate them in the event of loss of control due to the takeover.They may also undertake targeted repurchases and devise a poison pill, which changes the fundamental aspects of the unified rules without the knowledge of shareholders. While incentive schemes such as shares and share options are effective, they are still reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behavior. Managers may continue to focus mainly on quarterly goals rather than the long term as they are allowed to sell the stocks subsequently exercising their options.By focusing on quarterly performance, managers could boost the stock price and avail higher personal profits on their subsequent deal of stock. Managers may also sell their shares as soon as they are high, leading people to think that they lack confidence in their own operations. This may adversely affect share price. Share options also increase the risk of EPS dilution from an increase in shares outstanding. Managers may often window dress financial statements as the company must be seen to perform well in order to improve share valuations.They may report inaccurate information, especially if their short-term rewards surpass their long term ones such as pensions. It also encourages shareholder approval, and so would lead to less backbreaking AGMs. Many managers may hide the true value of assets in order to hide the losses they incurred while buying them. Window dressing also involves managers presenting statistics such that they highlight the perceivably best bits about the companys performance and avoid emphasis on the worst aspects of the previous years business.Other common practices of this include disguising liquidity problems and fraudulent representation of liabilities. This coarse misrepresentation of debts has been seen with Enron in the US, wh ere $billions of long-term liabilities were hidden off the balance sheet. Its executive Jeffery Skiller, initiated the use of mark to market accounting, while hoping to meet Wall Street expectations. Enron in conclusion became bankrupt while its shareholders suffered huge losses. Despite having model board of directors and a talented audit committee, Enrons managers were able to make it attract large sums of capital to fund a questionable business model and hype its stock to unsustainable levels. Worldcom, a telecommunications company in the US, inflated profits by disguising expenses as investing in assets and inflated revenues with bogus accounting entries from bodied, unallocated revenue accounts. In mid 2000, its stock price began to decline and CEO Bernard Ebbers persuaded WorldComs board of directors to provide him corporate loans and guarantees of over $400 million to cover his margin calls on Worldcom stock.The board had hoped that the loans would avert the need for Ebber s to sell the substantial amounts of WorldCom stock that he owned, as this would have further reduced the stocks price. However, the company ultimately went bankrupt and Ebbers was ousted as CEO in April 2002. The shareholders suffered massive losses as they watched World Coms stock price plummet from $60 to less than 20 cents. Thus, we can see that while there is room for managers to indulge in personal wealth maximization, it is quite difficult to do so. Usually, the solutions tend to be adequate enough to correct the conflicts, and restrict managers discretion.