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RUNNING HEAD: THE PRINCIPAL-AGENT PROBLEM

The principal-agent problem Name: Professor: Course: Date:

THE PRINCIPAL-AGENT PROBLEM Introduction

The principal-agent problem is an emerging issue in the contemporary business often incorporated in Agency theory. Agency theory is the relationship amid the owners (principals) who delegates power and duties to agents (managers) who act on the owners behalf. A perfect of example of the principal agency problem is well explained by the relationship amid the managers and shareholders of any organization especially those that are traded publicly. A contract exists amid the two parties with performance measures and goals clearly stipulated. The principals delegate keeping in mind that agents act in their best interests. It is, however, hard to accomplish this, as both the owners and managers hold conflicting interests, with the results maneuvered by managers to depict distorted facts. Most managers shun risks and responsibilities which results in moral hazard. The moral hazard aspects and disparities of interests arise, when an agent, employed by the principal to undertake stipulated duties does not hold the principals best interests because of high costs involved. The alignment of interests of the principal and the agent is the source of the problem amid the two parties as it is difficult to synchronize the interests. Agents receive incentives from the principals because of the existence of risks and information asymmetry to enable the agent to complete a contract effectively with the principals interests at heart. Conflicts between owners and managers Agency theory highlights the elementary problem of the self-interested behavior in an organization. The organizations manager may hold individuals goal that compete with the goals of the owner. The goal of the owners of a firm is mainly wealth maximization. With

THE PRINCIPAL-AGENT PROBLEM

authorization from the shareholders, managers oversee the organizations assets, hence the impending conflict of interests amid the two parties. Self-interested behavior Agency theory proposes that managers will opt to maximize their personal utility rather than corporate shareholders interests in case of imperfect capital and labor markets. Asymmetric information is a situation where agents have more information than the shareholder does on relevant issues. The information could be on whether or not they have the capacity to attain the objectives set by the shareholders and the underlying uncertainty. This asymmetric information gives the managers an opportunity to operate in a way that maximizes their utility in place of the owners interests. Proof of the managerial behavior exhibiting self-interest includes spending the organizations resources in perquisites form and optimal risk situation evasion. In this case, managers who are risk averse avoid profitable opportunities that shareholders would prefer to make investments. External investors note that the organization makes decisions divergent from their best interests (McEachern, 2012). Consequently, the investors reduce the prices of the firms securities they are willing to pay. A probable agency conflict materializes whenever the proportion of the firms common share owned by the manager is less than 10 percent. For a sole proprietorship where the business is owned and managed fully by the owner, the manager conducts business in a way that maximizes her or his personal welfare. In this scenario, the owner manager is likely to measure utility by individual wealth and maybe even foregoes other considerations like perquisites and leisure for personal wealth. When the owner manager trades off his fraction of his or her ownership of the corporation by trading of their common stock to external investors, then agency

THE PRINCIPAL-AGENT PROBLEM

conflict occurs. For instance, the preference of the owner manager might be a relaxed lifestyle with no rigorous work involved in the maximization of shareholders wealth as less of this wealth amasses to the owner manager. Furthermore, the owner manager may opt to increase the consumption of perquisites, as the benefits consumption costs is borne by the outside shareholders. Agency conflicts are substantial in most of the corporations, which are publicly traded and large, as the organizations manager owns a petite proportion of the entire common stock of the company (McEachern, 2012). It is likely that maximization of stockholders wealth will subordinate a variety of management goals. For example, the managers objective may involve maximizing the firms size. Through the development of a large, fast growing organization, the executive enhance their own status, and increase the opportunities for managers in the lower and middle capacities and their remunerations, in order to promote their job security avoiding the hostile takeover. Consequently, the incumbent management seeks to enhance diversification at the cost of the owners who can comfortably spread their personal portfolios through purchase of shares in other firms. Punishments, incentives and constraints, are some of the ways through which managers are propelled to act in the best interests of the owners of the firm. However, these methods are material and efficient only if the owners keenly keep track of the managers actions. The problem of moral hazard occurs with the agents undertaking in unobserved activities, promoting their individual interests, as it is infeasible and difficult for the owners to supervise all managerial activities. In an attempt to trim down the problem of moral hazard, the shareholders are compelled to contend with the agency costs.

THE PRINCIPAL-AGENT PROBLEM Costs of the owner-management conflict

Agency costs are costs incurred by the owners to allure the managers to conduct business in a way that maximizes the shareholders interests, as opposed to fulfilling their utilities. There are three key agency costs, which include expenses to monitor the actions of the management like audit costs. The second cost is the structuring expenses, which limit detrimental managerial behavior in the organization, or restructuring expenses of management hierarchy, and the firms business units or employment of the external board of directors members. Lastly, the opportunity costs borne from restrictions, which are shareholder imposed like stockholders votes requirement on certain matters or restrict the managers capacity to undertake activities that promote the wealth of the stockholders. Some loss will be incurred on shareholders wealth from improper managerial activities if there are no efforts to modify the behavior of the management. Alternatively excess agency costs would occur when the stockholders try to make certain that all the managerial actions are in line with the interests of the owners. From the two extreme cases, the levels of optimal agency costs incurred by shareholders are established using a cost- benefit analysis. The agency should only be increased provided each additional dollar incurred leads to at least a proportional dollar increase in the wealth of the shareholders; otherwise, the agency costs should be reduced or maintained at its current level. Mechanisms for handling shareholder-manager conflicts Dealing with agency conflicts amid the shareholder and the manager take two extreme positions. One polar position entails the compensation of the firms managers wholly based on prices on the stock prices. For this scenario, level of agency costs incurred is low as managers

THE PRINCIPAL-AGENT PROBLEM

hold immense inducements in shareholders wealth maximization. It is almost impossible to employ any talented and qualified executives under these contractual conditions, as the earnings of the firm are influenced by the economic events, which are beyond the managerial control of the executive. Another polar position involves the stockholders monitoring all the action of management and this solution is inefficient and extremely costly. Consequently, the most favorable solution falls between the two polar positions with the executive reparation tied to their performance, although controlled level of monitoring of managerial actions is also suitable. Apart from monitoring, the following approaches also persuade mangers to conduct business in the interests of the shareholders: stockholders unswerving intervention; the risk of hostile takeover, the threat of dismissal and incentive plan tied on the performance. Currently, most firms that are publicly traded have adopted the use of performance shares where executives are awarded using stock shares based on their performance. This reward is stipulated by the financial measures, which incorporate return on assets (ROA), variations in stock prices, return on equity (ROE), and earning per share (EPS). The managers of the firms earn more shares when the firms performance exceeds the set performance targets, and they get fewer shares with the performance below the set targets. Compensation plans, which are incentive based like the mentioned performance shares, are formulated to meet two objectives. Foremost, shareholders provide executives to compel the executive undertake activities that promote the wealth of shareholders. Secondly, these plans enable organizations to attract and retain executives with adequate confidence to sacrifice their financial future based on their own capabilities resulting to improved performance. In corporate America, investors that institutionally based like mutual funds, pension funds and insurance companies own a greater proportion of common stock. The institutional

THE PRINCIPAL-AGENT PROBLEM

fund managers have the influence, which can be willingly put forth substantial pressure over the operations of the firm. These institutional investors can manipulate the executives of the firms in two key ways. First, they can convene a meeting with management of the firm and propose suggestions concerning the operations of the organization. Second, the institutional stockholders can propose a suggestion to be voted on at the stockholders annual meeting regardless of managements opposition. The proposals sponsored by these stockholders kind mostly entail issues outside daily operations and are nonbinding, hence significantly manipulating opinion of the management (McEachern, 2012). Historically, the probability of the management of a large corporation being overthrown by its shareholders posed insignificant threat as it was remote. This was possible as most firms ownership was distributed extensively with a considerable control of the management through voting, making it difficult for the owner to gather necessary votes requisite to remove the sitting executive. This has changed with time as institutions are increasingly investing in the market for equities and because of their large amounts of funds; they own significant proportion of firms. A hostile takeover by rival companies competing in a similar line of business takes place in cases of inadequate management. The managers of the companies never intend to sell the firm, but the takeover possibly occurs when the stocks of the firm is undervalued in comparison to its standard or potential value. Prior to takeover, the company is always at the verge of collapse and almost bankrupt, although there are fewer cases where the government steps in, and saves the dying company. An example is the case of General Motors in the U.S. bailed out financial difficulty by the Obamas government. In some cases, large shareholders, as the institutional investors threaten to pull out and this preempt a hostile takeover. In the cases of hostile takeover, the senior management of the firm under acquisition is discharged of their duties. However, the

THE PRINCIPAL-AGENT PROBLEM

individuals retained lose the independence they enjoyed before the acquisition. Managerial behavior is disciplined through hostile takeover threat prompting the executive to try to maximize the value of the stockholders. The thought of losing a job or the position held is an incentive that addresses the problem associated with the agency theory. Conclusion In the contemporary world, it is common for businesses and individuals to appoint an individual to act on their behalf mostly because of the expertise of the agent. Therefore, the problem between principal and agents is inevitable. It is impossible to appoint an agent who will fully serve the interests of the principal as both parties hold divergent interests that cannot be synchronized. Most agents hold more information their principal because of their qualifications, which are the reasons for their services being sought, and the fundamental cause of the agency conflict. It is impossible to solve the agency conflict, but there are mechanisms that are employed to reduce the effects of this problem considerably. The goal of these mechanisms is to streamline the action of agents so that there is a close relationship between their actual and expected actions. This narrows the gap amid the management action and the realization of the interests of the principals.

THE PRINCIPAL-AGENT PROBLEM Reference

McEachern, W. A. (2012). Microeconomics: A contemporary introduction. Mason, OH: SouthWestern Cengage Learning.