Agency Problem Essay

Financial Management ( authorization problem) Prep atomic number 18d by Sami Hassan Saeed Singabi August 2008 entree Economic science teaches us that referable to their infixed needs, individuals have subjective preferences, and hence different engage. Occasion wholey different subjective interests give mount up to conflicts of interest in the midst of contracting partners. These conflicts of interest whitethorn result in turn, in one or both parties below winning actions that may be against the interest of the early(a) contracting partner.The primary reason for the divergence of objectives amidst managers and stockholders has been attributed to separation of ownership (shareholders) and control ( focusing) in corporations. As a consequence, authorization problems or principal-agent conflicts exist in the theater. berth theory deals with such problem. delegation theory is touch with how these effect problems affect the form of the contract and how they gage be minimiz ed, in particular, when contracting parties are variously informed (or uncertain). Agency problemA 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 focal point because of differing goals. It exists due to problems in corporate governance. A typical problem is that of senior anxiety of a company, who are charged with running the business in the interests of shareholders deal instead to operate to maximize their own interests. A simple compositors case is the hired anager who fills his pockets at shareholders expenses. For example, an means problem exists when watchfulness and shareholders have unlike ideas on how the company should be run. Agency problems that arise in a corporation have troubled economists for virtually time. There are a number of mechanisms that have been used to try and reduce these execution problems. many an(prenominal) of these mechanisms try to link the managers compensation to the performance of the upstanding. typical examples include performance shares, restricted stock grants, and executive stock options.This harangue is an empirical study of whether the use of executive stock options has in detail reduced the agency problems between managers and stockholders. In this dissertation, two different examen methodologies are used to address the agency problem reduction issue. angiotensin converting enzyme methodology looks at some signifi baset event such as a merger or divestiture to see if an executives prop of stock options affect what decisions are made. For example, do larger holdings of stock options make a motion managers to take on riskier investments? By increasing the risk of the loyal, 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 frankincense the value of the option holdings. An agency blood An agency relationship arises whenever one or more individuals, c on the wholeed principals, hire one or more other individuals, called agents, to perform some service and then delegate decision-making assurance to the agents. The primary agency relationships in business are those - (1) betwixt 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 c ould not physically be at all locations at the same time.Consequently, you would have to delegate decision-making authority to others. Creditors can cherish themselves by (1) Having the loan secured. (2) Placing restrictive covenants in debt agreements. (3) They charge a high than normal interest rate to compensate for risk. Agency cost A type of internal cost that arises from, or must be paid to a manger acting on behalf of shareholders. Agency cost arises because of marrow squash problems such as conflicts of interest between share holders and management.Shareholders wish for management to run the company in away that increases shareholders value, but management may wish to grow the company in away that maximize their private power and wealth that may not be in the go around interest of shareholders. Agency be are inevitable within an composition whenever shareholders are not completely in charge the cost can usually be best spent on providing proper stuff and nonsense inc entives and moral incentives for agents to properly execute their duties, thereby aligning the interests of shareholders (owners) and agents.The principals (the shareholders) have to go ways of ensuring that their agents (the managers) act in their interests. This means incurring be, agency costs, to (a) monitor managers behavior, and (b) create incentive schemes and control for managers to pursue shareholders wealth maximization. dissimilar methods have been used to try to align the actions of senior management with the interests of shareholders, that is, to get to goal congruence. Linking rewards to shareholder wealth improvements Owners can grant directors and other senior managers share options. These ermit the managers to purchase shares at some date in the future at a scathe, which is fixed in the present. If the share price rises significantly between the dates when the option was granted and the date when the shares can be bought the manager can make a fortune by purch ase at the pre-ar ambitd price and then swoping in the market place. The managers under such a scheme have a clear interest in achieving a rise in share price and thus congruence comes about to some extent. An alternative method is to allot shares to managers if they action certain performance targets, for example, growth in earnings per share or return on shares.Sackings The threat of be sacked with the accompanying dismay and financial loss may encourage managers not to diverge likewise far from the shareholders wealth path. However this method is seldom used because it is much difficult to implement due to difficulties of making a coordinated shareholder effort. Selling shares threat and the take- over Most of the large shareholders (especially institutional investors) of quoted companies are not prepared to put large resources into monitoring and controlling all the firms of which they own a part.Quite often their first response, if they observe that management is not acti ng in what they visualize as their best interest, is to sell the share rather than intervene. This will result in a write down share price, making the raising of funds more difficult. If this process continues the firm may become vulnerable to a merger bid by another group of managers, resulting in a loss of top management posts. Fear of being taken over can establish some sort of backstop position to prevent shareholder wealth considerations being totally ignored.Corporate governance regulations There is a considerable range of legislation and other regulatory pressures (e. g. the Companies Act) designed to encourage directors to act in shareholders interests. Within these regulations for example, the board of directors is not to be dominated by a single individual acting as both the chairman and head executive. Also independently minded non-executive directors should have more power to range shareholder interests in particular, they should predominate in decisions connected wi th directors remuneration and auditing of firms accounts.Information flow The accounting profession, the stock exchange, the regulating agencies and the spend public are continuously conducting a battle to encourage or force firms to release more accurate, timely and detailed information concerning their operations. An modify quality of corporate accounts, annual reports and the availability of other forms of information move to investors and analysts such as company briefings and press announcements help to monitor firms, and delineate any wealth-destroying actions by wayward managers early. ConclusionDiffuse ownership of in public held companies reduces the owners ability to monitor managers because they would have to bear the full monitoring costs while gaining only a small marginal benefit. Managers may therefrom act to maximize their wealth through personal use of corporate assets, stock manipulation and sub optimal decisions at the owners expense. Thus agency theory prac tical mechanism is weak, because it is unable to provide practical conclusions with regard to agency problems. References 1. Wikipedia, the free encyclopedia. htm 2. www. referenceforbusiness. com 3. Financial-dictionary. The free dictionary. com