Agency Problem - Essay
I partially agree with the statement that managers have a severely limited amount of discretion to pursue actions inconsistent with shareholder wealth maximization.
By investing in a company, shareholders aim to maximize their wealth and achieve portfolio diversification. The objective of managers is assumed to be to further these interests by maximizing the firm’s share value. This can be achieved by taking on projects with positive NPV and good management of short-term capital and long-term debt. However, shareholders and managers are assumed to want to maximize their utilities; so this objective may not always be the priority for managers as they may 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 principal agent problem.
The principal agent problem occurs due to two reasons. The first is the separation of ownership from control - the principal or the shareholders 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 being ‘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 data and financial reports, whereas the shareholders would only receive annual reports, which may be subject to manipulation. Thus asymmetric information also leads to moral hazard and adverse 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 as using company credit cards for personal expenses, jet planes etc.
• Empire building: Managers may pursue a suboptimal expansion path for the firm. They may expand the firm at a rationally unfeasible rate in order to increase their own
By investing in a company, shareholders aim to maximize their wealth and achieve portfolio diversification. The objective of managers is assumed to be to further these interests by maximizing the firm’s share value. This can be achieved by taking on projects with positive NPV and good management of short-term capital and long-term debt. However, shareholders and managers are assumed to want to maximize their utilities; so this objective may not always be the priority for managers as they may 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 principal agent problem.
The principal agent problem occurs due to two reasons. The first is the separation of ownership from control - the principal or the shareholders 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 being ‘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 data and financial reports, whereas the shareholders would only receive annual reports, which may be subject to manipulation. Thus asymmetric information also leads to moral hazard and adverse 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 as using company credit cards for personal expenses, jet planes etc.
• Empire building: Managers may pursue a suboptimal expansion path for the firm. They may expand the firm at a rationally unfeasible rate in order to increase their own