Question

Discuss how company shareholders can encourage their managers to act in a way which is consistent with the objective of shareholder wealth maximisation.

Answer 1

The managers are appointed to act as agents of the shareholders. The interests of the shareholders and the managers differ in the sense that the managers want profit maximization but the main goal of the firm should be wealth maximization. The shareholders wealth is maximized when the dividends paid to them increases and the stock prices increases.

The managers in turn work towards increasing the firm size, so that the compensation they receive increases, in case the compensation is tied to the size of the firm.So, if we tie the compensation of managers to the share price , the managers can be made to act in the best interest of the shareholders.

For example, if we provide the managers with share options, which will give them the right to purchase the shares at a future date at a fixed price price. The higher the share price in the market when the share options are exercised, the greater will be the capital gain that could be made by managers owning the options. So, these share options will encourage the managers to make decisions which will lead to an increase in the share price.