How can we reduce agency problem

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The goal of the financial manager should be to maximize the wealth of the firm’s owners. Thus managers can be observed as agents of the owners who have hired them and given the decision-making power to lead the firm.

In theory, most financial managers would agree with the goal of owner wealth maximization. In practice. However, managers are also worried about their personal wealth, job safety, and fringe benefits. From this conflict of interest between owners and management, agency problems have occurred.

So, the agency problem refers to the conflict of interest arising between creditors, shareholders, and management because of differing goals. The agency problem emanates from the arrangement where the interest of the agent differs substantially from those of the principal because of the impossibility of perfect contraction for every possible act of an agent whose decisions affect both his own welfare and the welfare of the principal.

How can we reduce agency problem

There are two polar positions for dealing with agency problems. At one extreme, the firm’s managers are compensated entirely on the basics of stock price changes. In this case, agency costs will be low because managers have high incentives to maximize shareholder wealth.

It would be extremely difficult. However, to hire talented managers under these contractual terms because the firm’s earnings would be affected by economic events that are not under managerial control. At the other extreme, stockholders could monitor every managerial action, but it would be extremely costly and inefficient.

The optimal solution lies between the extremes, where executive compensation is tried to perform, but monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders’ interests: (1) performance-based incentive plans, (2) direct intervention by institutional investors, (3) the threat of firing, and (4) the threat of takeover.

Performance based incentive plans:

Most publicly traded firms now employ performance shares, which are shares of stock given to executives no the basis of performance as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes.

If corporate acting is above the performance targets, the firm’s managers win more shares. If performance is under the target, however, they accept less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives.

First, they offer executives incentives to take actions that will prolong shareholder wealth. Second, these plans help companies attract and retain managers who have the confidence to risk their financial future on their own abilities- which should lead to better performance.

Direct intervention by institutional investors:

An increasing percentage of common stock in the corporate sector is owned by institutional investors such as insurance companies, pension funds, and mutual funds. The institutional money managers have the clout, if they choose, to exert considerable influence over a firm’s operation.

Institutional investors can impact a firm’s managers in two initial ways. First, they can meet with a firm’s management and offer a suggestion regarding the firm’s operations.

Second, institutional shareholders can sponsor an offer to be voted on at the annual stockholders’ meeting. Even if the proposal is opposed by management. Although such a shareholder-sponsored proposal is nonbinding and involves issues outside day-to-day operations. The results of these votes clearly influence management options.

Threat of firing:

In the past, the likelihood of a large company’s management being ousted by its stockholders was so remote that it posed little threat. This was true because the ownership of most firms was so large distributed. And management’s control over the voting mechanism is so strong. That it was almost impossible for dissident stockholders to obtain the necessary vote required to remove the managers.

In recent years, however, the chief executive officers at American Express Co., General Motors Corp., IBM, and Kmart. Have all resigned in the midst of institutional opposition and speculation that their departures were linked with their companies, poor managing performance.

The threat of takeover:

A hostile takeover, which occurs when management does not wish to sell the firm, is most likely to develop when a firm’s stock is undervalued relative to its potential because of inadequate management.

In a hostile takeover, the senior managers of the acquired firm are typically sacked. And those who are retained lose the independence they had prior to the acquisition. The threat of a hostile takeover disciplines managerial behavior and induces managers to attempt to maximize shareholder value.

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