Question

a)Why do firms closely monitor the price at which their shares and bonds trade in the secondary market?

b)What are agency problems in the context of the firm? Describe some ways in which they be addressed. Give examples.

Answer 1

Part a)

Firms closely monitor the price at which their shares and bonds trade in the secondary market because it directly affects the Enterprise value & market capitalization of the firm as market capitalization = Number of shares outstanding x Price per share.

Enterprise value & market capitalization are very important metrics for any firm because these not only indicates the investor's view about a company but also is an important part of various stock valuation techniques used by analysts & lenders. Lenders such as banks use this to determine how much they should lend to any firm, so a falling market capitalization may also reduce the amount that the company will be able to borrow from such banks. Also, many firms & promoters use their shares as collaterals of various loans they take. If the prices of such shares or bonds fall, the collateral value will also fall below the threshold level such that lenders may resort to liquidating the collateral. This can set off further downfall in the stock price of the firm and can lead it into big financial distress.

Managers also monitor the price of shares as their (especially top-level managers) salary packages are closely linked to the share price of the firm to a significant extent.

Part b)

Agency problems in the context of the firm refer to the difference in the goals of the agents (the employed managers of the company) and the owners (the shareholders). Many a time it has been seen that managers tend to take actions which are more beneficial to them rather than the shareholders. Ideally, managers should work only to increase the shareholders' wealth (while working within legal & ethical boundaries), but it sometimes happens that managers tend to skew the processes by first prioritizing their own bonuses, etc. even if that means taking decisions which may tend to be detrimental for the firm in the long term.

Some ways in which these can be addressed are:

1. Long term Employee stock options (ESOPs): These are stock options provided to employees (managers) as a part of their salary compensation but they can only be redeemed in a longer-term like 3 to 10 years. So managers get incentivized to make decisions that benefit firms in the long term.
2. Link greater part of the salary of top management to share price or other metrics of success of the firms- Performance-based pay ensures that employees (the agents) have their own interests linked to the interests of the firm and thus the conflict of interest is avoided.