Corporate Governance

We've seen that the financial manager acts in the best interests of the stockholders by taking actions that increase the value of the stock. However, in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders' expense? In the following pages, we briefly consider some of the arguments relating to this question.
Agency Relationships
The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his/her interests. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of a conflict of interest between the principal and the agent. Such a conflict is called an agency problem.
Suppose you hire someone to sell your car and you agree to pay that person a flat fee when he/she sells the car. The agent's incentive in this case is to make the sale, not necessarily to get you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way in which an agent is compensated is one factor that affects agency problems.
Management Goals
To see how management and stockholder interests might differ, imagine that the firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If