Question

The agency problem costs firms and investors billions of dollars per year. Please answer the following:

• Describe the agency problem and provide an example.
• What steps can a corporation take to align management with shareholder’s interest?
• Can the debt structure of a corporation play a role in preventing an agency problem? If yes, please explain. How? Could there be drawbacks in using debt to curtail the agency problem? If yes, please explain.

Answer 1

1.

What Is the Agency Problem?

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.

For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as possible, he is given the responsibility to perform in whatever situation results in the most benefit to the principal

The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example, the plumber may make three times as much money by recommending a service the agent does not need. An incentive (three times the pay) is present, causing the agency problem to arise.

2.

Even though the independent directors on the board of directors of a public company are elected to protect the interest of the shareowners, the agency problem between the owners of the corporation and the executive management can manifest itself in a number of ways:

1 Frequently, the role of chairman of the board and chief executive officer are combined. In this dual role, the chairman of the board controls the board of directors, whose job it is to set the pay for executive management. This same chairman is also the president, and part of the executive management team that receives the compensation package. It is in the chairman’s economic interest to press the other directors to adopt a generous pay package for executive management.

2 Even when the roles of chairman and CEO are split, the chairman will often defer to the CEO’s recommendation when setting the compensation for the executive management team.

3 The chairman and the other directors typically receive information only from the executive management team with respect to their performance and recommended level of compensation.

4 Even when compensation consultants are hired, they are often hired by the executive management team and so receive their information and other input from the executive management team.

3.

financial leverage can help reduce the agency costs by impacting managers including threat of liquidation, and the pressure of making money to pay for debt interests and principals. Leverage also helps reduce the conflicts between shareholders and managers in many ways, including choosing projects to invest and payout policy. However, the relationship between leverage and agency cost is not exactly negative. When the firm uses too much debt, the increase in cost of financial distress means that bankruptcy will be bigger than the decrease in the cost from the shareholders-managers conflicts.

DRAWBACK

When the company uses debts, it has to pay for the interest and principal; the higher the debts, the greater the payment. To make more money to pay these debts puts stress on managers. If the company fails to make enough money to pay for its interest expenses and debt principal on the due dates, the company may come to default. If this happens, the managers will lose their jobs, their incomes, their perquisites, and their reputations. Thus, to protect their benefits, managers will act in a way that keeps the company alive, healthy, and prosperous. This is what the stockholders want.