Question

1. If the proper goal of a finance manager is to maximise shareholder wealth how does managing the agency problem contribute to this goal? Discuss whether you believe purely financial incentives are enough to manage the agency problem?     

Answer 1

Profit maximization lays emphasis on maximizing the calculated profits of the enterprise where as Wealth maximization is lays emphasis on increasing the overall value of the business by increasing the value of the stocks. A lot other factors contribute to wealth maximization than just increasing the profit of the business venture.

Agency problem- can be defined as the conflict of priorities and interest that arises between the two parties of the entity the management of the company and the company's stockholders. The agency problem arises in business when the manager, acting in the capacity of the agents of the shareholders who are the principals are supposed to act in the best interest of shareholders where as that is not personally best gaining opportunity for him.

Since the managers of an entity are under the direction and guidance of Board of Directors who actually have no direct benefit from wealth maximization goal of the enterprise; there may may sometime occur conflict with the stock holders who are the direct beneficiaries from this goal. It is in the personal interest of management to maximize their own profit.This particular conflict is known as the agency problem.

If there is an agency problem, it is extremely important to find a solution at the earliest to avoid problems within the business as they can hamper the smooth performance of the business.

In case the finance manager decides to set goal of the entity to maximize shareholder's wealth managing the agency problem is a big task and the goal can be affected highly by this. In order to manage agency problems a proper blend of appreciating financial incentives and executive contract design is necessary.

Financial incentives though are most basic factor to resolve this problem; I believe that not just the financial incentives but a proper plan or contract design to resolve is needed to overcome the agency problem. The following can be the driving factors for the same-

• Transparency- The agent or the manager should inform and educate the principal that is the shareholders for everything. There should not be any room for doubting integrity between the two parties.

• Restrictions on the Power- Too much power can be misused. Most agency experts design contracts in a manner that best suits the interests of each party. Not too much power should be handed to the agents. A proper contractual proof should be available in order to solve the conflicts if arising.