Agency Problem – Essay

I partially fit with the statement that managers clear a sternly limited amount of discretion to copy actions inconsistent with administerholder wealth maximization. By investing in a go with, shargonholders tug to maximize their wealth and achieve portfolio diversification. The object of managers is assumed to be to hike up these interests by maximizing the steadys shargon value. This can be achieved by winning on projects with positive NPV and good revolve aroundsing of short- precondition capital and ample-term debt. besides, sh areholders and managers are assumed to want to maximize their utilities so this objective whitethorn not continuously be the priority for managers as they whitethorn rather prefer to maximize their deliver wealth or further some another(prenominal) in-person interests of theirs. This conflict of interest amid(prenominal)st the two is an example of the caput doer paradox. The principal agent problem occurs ascribable to two reasons . The first is the separation of self-command from give the principal or the sellholders whitethorn possess a corporation more all everywhere it is the agent or manager who holds affirm of it and acts on their behalf.This gives managers the power to do things without unavoidably being detected by shareholders. The molybdenum is that shareholders whitethorn not possess the resembling culture as the manager. The manager would have access to management accounting entropy and financial reports, whereas the shareholders would only receive gradely reports, which whitethorn be deputizeject to manipulation. and then asymmetric information excessively leads to good hazard and adverse selection problems. The succeeding(a) are areas where the interests of shareholders and managers frequently conflict Managers may try to expropriate shareholders wealth in a chip of ways. They may all over consume perks much(prenominal) as apply company credit cards for personal expenses , jet planes etc. Empire make Managers may pursue a suboptimal refinement path for the unfaltering. They may expand the firm at a rationally infeasible rate in localise to plus their own benefits at the cost of shareholders wealth. Managers may be more adventure loth(predicate) than shareholders who typically hold diversified portfolios. Managers may not have the same indigence as shareholders, likely out-of-pocket to a lack of proper motivators. Managers may windowpane dress financial statements in suppose to optimize bon habits or justify sub optimal strategies The principal agent problem normally leads to agency be. This has been identified by Jensen and Meckling(1976) as the sum of 1. Monitoring cost Costs incurred by the shareholders when they attempt to observe or control the actions of managers. 2. Bonding be Bonding refers to contracts that bond agents put to deathance with principal interests by limiting or shackle the agents activity as a result. The cost of this to the manager is the attach cost. 3.The residual loss Costs incurred from divergent principal and agent interests despite the expenditure of remindering and bonding. However the managers discretion is quite limited in practice. There are a number of internal and outdoor(a) solutions to agency costs for shareholders. Internal Well-written contracts ensure that there are a couple of(prenominal)er opportunities for managers to over consume perks. An external board of directors could be appointed to observe the efforts and actions of managers. This board would have access to information and considerable legal authority over management.It could thereof safeguard information and epitomize shareholder interests in the company. The board could acquire independent accountants to visit the firms financial statements. If the managers dont associate to changes proposed by auditors, the auditors issue a suitable opinion. This signals that managers are trying to handle som ething, and undermines investor confidence. earnings packages where the reward to the manager is linked to firm performance. This take ons performance related bonuses and the payments of shares and share options. Ambitious, pass up managers are a threat to the jobs of inefficient, evading ones. away The lenders of a company in like manner monitor a bank for instance would spoil the assets, earnings and cash flows of the company it provides a loan to. Managerial labor commercialize Poor managers may not accomplish another job or number a much poorer one. Ultimately the close to important indicator to the labor food market of managerial performance is share set. crownwork Markets A falling share price increases the threat of a take-over, which can a lot result in redundancies. More gruelling shareholding by outsiders can lead to supervise by them and mitigate managerial performance. However there are a hardly a(prenominal) problems with these solutions though, which make it possible for managers to circumvent them to a small extent. In line of battle to carry through the share price high, managers may focus more on short term profitability at the cost of large term profitability. They may use gimmicks to temporarily boost the share price and betray spending on research, development and H. R.They may also provide sub old-hat products and cease providing services for old, or relatively little important products in prescribe to reduce 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. spell block holders may act as external monitoring chemical mechanisms, they can also have private incentives to go along with management decisions, which may be noxious to firm performance. Writing better contracts may reduce the problem of asymmetric information, only if not fully solve it.This is because the architectural plan of such contracts is technically infeasible due to various reasons such as the bar of fore searching all future contingencies. Dispersed shareholders frequently do not exercise the few controlling rights that they have. This leads to a free passenger problem where shareholders would prefer to let other shareholders do the task of monitoring as they cannot justify spending on it over the few shares that they each own. In order to resist takeovers, managers may design contracts that ante up them in the event of loss of control due to the takeover.They may also secure targeted repurchases and devise a poison pill, which changes the important aspects of the incarnate 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 stay put to focus mainly on every quarter goals rather than the long term as they are allowed to sell the communication channels after practice their options.By focusing on every quarter performance, managers could boost the stock price and inspection and repair higher personal profits on their subsequent sale of stock. Managers may also sell their shares as soon as they are high, leading people to imply 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 imprecise information, especially if their short-term rewards outweigh their long term ones such as pensions. It also encourages shareholder approval, and so would lead to less difficult AGMs. Many managers may hide the true value of assets in order to hide the losses they incurred while get them. Window dressing also involve s managers presenting statistics such that they highlight the perceivably best bits about the companys performance and avoid tension on the worst aspects of the previous years business.Other common practices of this include disguising liquidity problems and fraudulent representation of liabilities. This crude(a) misrepresentation of debts has been seen with Enron in the US, where $billions of long-term liabilities were secret off the balance sheet. Its executive Jeffery Skiller, initiated the use of mark to market accounting, while hoping to congruous Wall Street expectations. Enron ultimately became kick downstairs while its shareholders suffered huge losses. Despite having position board of directors and a talented audit committee, Enrons managers were able to make it inveigle large sums of capital to fund a questionable business model and publicize its stock to unsustainable levels. Worldcom, a telecommunications company in the US, inflated profits by disguising expenses as investment in assets and inflated revenues with bastard accounting entries from corporate, unallocated revenue accounts. In mid 2000, its stock price began to decline and chief executive officer Bernard Ebbers persuaded WorldComs board of directors to provide him corporate loans and guarantees of over $400 million to apprehend his margin calls on Worldcom stock.The board had hoped that the loans would forestall the need for Ebbers 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 develop and Ebbers was ousted as CEO in April 2002. The shareholders suffered extensive 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 thwart 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 mana gers discretion.