ECON 2130 Agency problem

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ECON 2130Agency problem

• Tam Lai Ying 08028796
• Law Tsz Yeung 08031916
• Au Man Hung 08026130

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Agency Theory
An agency relationship exists when
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Agency Theory

• Equity Potential conflict between shareholders
  and managers (principal-agent problem)
• Traditional Outside (non-management)
  shareholders
• Overvalued equity
• Debt Potential conflict between shareholders
  and debt holders

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Agency Problem of Outside Equity

• Managers expropriate wealth from shareholders
• Moral hazard problems
• Excessive perquisite consumption
• Underinvestment due to risk aversion/short
  horizon
• Accept poor investment projects (NPVlt0)

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Examples of Agency Problems/Costs

• Direct expropriation
• Take cash out
• Looting assets, low transfer pricing
• Indirect expropriation by non-optimal investing
• Empire building excess firm expansion
• Underinvestment/Overinvestment
• Not maximizing shareholder wealth
• Making poor capital budgeting decisions
  (incorrect method, execution, etc.)
• Decision making based on managers wealth
  maximization not shareholders
• Inefficient actions
• Shirking (too little effort)
• Excess consumption of perks
• Illegal actions
• Misleading statements
• Insider Trading

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Encourage excess risky investments
Expected Profit200 with two
possible outcomesPossible Outcomes 100 or 300
Possible Outcomes 0 or 400

• Realized Profit 100
• Debt 50
• Management 30
• Employees 20
• Shareholders 0
• 100-50-30-20 0

• Realized Profit 0
• Debt 0
• Management 0
• Employees 0
• Shareholders 0
• 0-50-30-20-100
• BANKRUPT!

• Realized Profit 300
• Debt 50
• Management 30
• Employees 20
• Shareholders 200
• 300-50-30-20 200

• Realized Profit 400
• Debt 50
• Management 30
• Employees 20
• Shareholders 300
• 400-50-30-20 300

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Earnings Game

• CFOs were asked if they were not on target for
  earnings which actions would they consider doing
  (Graham, Harvey Rajgopal, 2004).
• 80 would delay discretionary spending
• 55 would sacrifice small value projects

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Agency Problem of Overvalued Equity

• Overvalued When management knows they can not
  sustain value
• Managers more likely to behave sub-optimally
• Target based corporate budgeting systems
• Manipulation of both target and realized result
• Skew preference for short term cash flows
  (earnings)
• Excessive risk taking Place high risk bets
• Earnings management More likely and higher
  error
• Jensen (2005)

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Agency Problem of Debt

• Equityholders expropriate wealth from debtholders
• Moral hazard problems
• Overinvestment, risk shifting, asset substitution
• Debt overhang, underinvestment
• Claim dilution
• Take the money and run!

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Corporate Governance
Corporate Governance is a relationship among
stakeholders that is used to determine and
control the strategic direction and performance
of organizations
Concerned with identifying ways to ensure that
strategic decisions are made effectively
Used in corporations to establish order between
the firms owners and its top-level managers
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Governance Mechanisms
Board of Directors
Recommendations for more effective Board
Governance

• Increase diversity of board members backgrounds

• Strengthen internal management and accounting
  control systems

• Establish formal processes for evaluation of the
  boards performance

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Governance Mechanisms
Executive Compensation
Salary, Bonuses, Long term incentive compensation
Many factors intervene making it difficult to
establish how managerial decisions are directly
responsible for outcomes
In addition, stock ownership (long-term incentive
compensation) makes managers more susceptible to
market changes which are partially beyond their
control

• Incentive systems do not guarantee that managers
  make the right decisions, but they do increase
  the likelihood that managers will do the things
  for which they are rewarded

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Empirical Evidence Effective Governance

• Board Composition Should have a majority of
  outside directors, i.e. independent board
• CEO/Chairman should be separate role
• Number of boards a director sits on

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Corporate Governance and Ethical Behavior