Question

a) What relationship does the agency theory examine in a firm? What is/are the associated problem/costs of agency theory that would arise and affect the value of a firm? Why is it more important in a public corporation than in a private corporation?

b) “The higher the standard deviation, the lower the risk premium should be”? Do you agree? Explain based on systematic risk principle under CAPM.

Answer 1

a). Agency theory examines the relationship between principals and agents (or managers and owners) of a company. Agency problems arise because the goals of owners and managers of a company are different. Managers are concerned with running a business efficiently and expanding it, as much as possible where as owners are concerned with profitability. So, for example, if management decides to spend on R&D for a new product, in the short run, it will only eat into profits which the owners can be against. Agency theory is more important for public corporations than privates ones because in private companies, usually the owners are the managers so there is no conflict of interest. However, that is not the case for public companies where the management is different from the shareholders.

b). Standard deviation measures total risk for an asset. However, CAPM is based on the premise that the expected return depends only systematic risk which is measured by beta. Beta measures the volatility of the asset with respect to the market. Greater the volatility, greater will be the uncertainty associated with the asset and so, higher will be the risk premium demanded by investors for investing in a risky asset.