Question

given the three key ways in which shareholders can best manage the agency problem and Based on these three methods, how would you rank the effectiveness of each in solving this problem? Be sure to explain why.

Answer 1

An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an "agency problem," arises when there is a conflict of interest between the needs of the principal and the needs of the agent.

To rank the effectiveness, there are two primary agency relationships:

1.Managers and stockholders

2.Managers and creditors

If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists.

Managers may make decisions that conflict with the best interests of the shareholders. For example, managers may grow their firms to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors

Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is a creditors' main concern.

Stockholders, however, have control of such decisions through the managers.

Since stockholders will make decisions based on their best interests, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows.

To explain in briefly, Motivating Managers to Act in Shareholders' via Best Interests

There are four primary mechanisms for motivating managers to act in stockholders' best interests:

1.Managerial compensation_ Managerial compensation should be constructed not only to retain competent managers, but to align managers' interests with those of stockholders as much as possible.This is typically done with an annual salary plus performance bonuses and company shares.

2.Direct intervention by stockholders_ Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders can exert influence on mangers and, as a result, the firm's operations.

3.Threat of firing_ If stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may re-elect a new board of directors that will accomplish the task.