The Agency Problem

The Agency Problem

• Agency relationship
– Principal hires an agent to represent their interest
– Stockholders (principals) hire managers (agents) to run the company
• Agency problem
– Conflict of interest between principal and agent
• Management goals and agency costs

Managerial Goals

• Managerial goals may be different from shareholder goals
– Expensive perquisites
– Survival
– Independence
• Increased growth and size are not necessarily the same thing as increased shareholder wealth.

Do Shareholders Control Managerial Behavior?

• Shareholders vote for the board of directors, who in turn hire the management team.
• Contracts can be carefully constructed to be incentive compatible.
• There is a market for managerial talent—this may provide market discipline to the managers—
they can be replaced.
• If the managers fail to maximize share price, they may be replaced in a hostile takeover.

Managing Managers

• Managerial compensation
– Incentives can be used to align management and stockholder interests
– The incentives need to be structured carefully to make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better management
• Other stakeholders

Summary

• Forms of Business Organization
– Proprietorship
– Partnership
– Corporation
• Goals of the Corporate Firm
• Agency Problem

Upcoming Topics

• Firm and the Financial Markets
• Financial Statements
– Balance Sheet
• Assets
• Liabilities and Owners Equity
• Working Capital
• Liquidity
• Market Value vs Book Value
– Income Statement
• GAAP
• Non-cash Items
• Time and Costs