Question

2. Agency conflicts between managers and shareholders

Remember, an agency relationship can degenerate into an agency conflict when an agent acts in a manner that is not in the best interest of his or her principal. In large corporations, these conflicts most frequently involve the enrichment of the firm’s executives or managers (in the form of money and perquisites or power and prestige) at the expense of the company’s shareholders. This usurping and reallocation of shareholder wealth is most likely to occur when shareholders do not have sufficient information about the decisions and actions being made by the firm’s management.

Consider the following scenario and determine whether an agency conflict exists:

Alexander and Akiko equally own and manage A New Beginning (ANB), a store that sells preowned clothing and furniture. Alexander is responsible for ANB’s back-office activities, and Akiko staffs the store and makes deliveries to customers. Both have equal decision-making authority and, under the terms of their partnership agreement, both are prohibited from making personal purchases using company funds without prior approval of the other partner. Alexander, without Akiko’s knowledge, used the company’s bank account recently to purchase a new sports car. Alexander has acknowledged that the car will not be used to support the business.

Is this a potential agency conflict between Alexander and Akiko?

a) No; Alexander and Akiko are both authorized to spend ANB’s money, so no conflict of interest can occur.

b) No; Alexander and Akiko co-own and co-manage ANB and have a partnership agreement that makes them equal, so an agency conflict cannot exist.

c) Yes; it should have been Akiko who purchased the car.

d) Yes; Alexander is misappropriating some of Akiko’s wealth by unilaterally purchasing a nonbusiness asset using ANB’s funds.

Consider the following scenario and determine whether an agency conflict exists:

Five years ago, Tae created a plant-care business that grew, stocked, and maintained fresh plants in office buildings throughout Houston. Over time, The Green Zone Inc. (TGZ) has grown from a proprietorship into a corporation, now reaching far beyond Houston. To finance and support this growth, TGZ issued shares that were sold to TGZ employees, Tae’s family members, and selected outsiders. Tae is TGZ’s chairman of the board of directors and CEO, but he is no longer the largest shareholder.

At the latest annual meeting, two mutually exclusive proposals were placed on the ballot for discussion and vote. The first was put forth by Tae and TGZ’s management team, and the second was proposed by a small group of other shareholders. Both groups are adamantly opposed to the other group’s proposal, even though both proposals would likely have the same effect on TGZ’s value and riskiness.

Does an agency conflict exist between TGZ’s management and the small group of opposing shareholders?

a) No; Tae was the original owner of TGZ, so he would always be sensitive to the concerns of the firm’s current owners (shareholders) and would not engage in an agency conflict.

b) Yes; an agency relationship exists, and an agency relationship always gives rise to agency conflicts, regardless of the actual behavior of the participants.

c) Yes; any conflict or disagreement between the firm’s managers and its shareholders constitutes an agency conflict.

d) No; although an agency relationship exists between TGZ’s management—including Tae as TGZ’s chairman and CEO and the firm’s shareholders—there is no agency conflict, because no expropriation or wasting of the shareholders’ wealth has occurred.

Consulting firms and human resource departments have spent innumerable hours attempting to develop executive compensation programs that will align the goals of a firm’s managers with those of the firm’s shareholders. Which of the following compensation packages is most likely to accomplish this task?

a) An annual salary of $250,000 and a stock option bonus package that provides 250,000 shares after five years

b) An annual salary of $500,000 and a stock option bonus package that provides 100,000 shares after one year

c) An annual salary of $500,000 and a stock option bonus package for a total of 250,000 shares, with 50,000 shares vesting at the end of each of the next five years

d) An annual salary of $800,000

In addition to well-designed executive compensation packages, two other motivational forces can align the interests of managers with those of their shareholders. Which of the following actions could be used to reduce the potential for these agency conflicts and ensure that the firm’s managers will pursue the long-term wealth interests of their shareholders?

a) Let the manager know that a takeover is possible if he or she doesn’t perform well.

b) Let the manager know that he or she will be fired if the company’s stock does not reach a certain target by the end of the year.

Wight Worldwide’s stock price is currently trading at $42.5 per share. The consensus among market analysts is that the stock should trade for $35 per share, given the amount, timing, and riskiness of the company’s dividends. Is Wight Worldwide more or less likely to receive a hostile takeover bid?

a) More likely

b) Less likely

Answer 1

2 (i) Is this a potential agency conflict between Alexander and Akiko?

Answer Option A) Yes, there is a potential agency conflict between Alexander and Akiro as Alexander is misappropriating some of Akiro's wealth by unilaterally purchasing a non business asset using ANB's funds. Hence the correct answer is (a).

(ii) TGZ Inc.

Answer Option D) d) No; although an agency relationship exists between TGZ’s management—including Tae as TGZ’s chairman and CEO and the firm’s shareholders—there is no agency conflict, because no expropriation or wasting of the shareholders’ wealth has occurred.

(iii) Which of the following compensation packages is most likely to accomplish this task?

Answer Option C) An annual salary of $500,000 and a stock option bonus package for a total of 250,000 shares, with 50,000 shares vesting at the end of each of the next five years

Explanation- This will ensure that management works towards wealth maximization each year.

(iv) Which of the following actions could be used to reduce the potential for these agency conflicts and ensure that the firm’s managers will pursue the long-term wealth interests of their shareholders?

Anwer Option A) Let the manager know that a takeover is possible if he or she doesn’t perform well.

(v) Is Wight Worldwide more or less likely to receive a hostile takeover bid?

Answer Option B) Less like

Explanation- Since the general perception is that the company's stock is overvalued, the chances of a hostile takeover are low.