Question

Corporate Financial Management

1. An investor is convinced that a corporation has a potential competitive advantage in its market sector and a capacity to realize this advantage. Nevertheless, she is concerned that corporate management may choose to pursue a less risky strategy and not to fully realize the potential of the firm. Discuss the difficulty faced by this investor. Are you aware of any arrangements which might better align the interests of this investor and management? Describe and evaluate such arrangements.

Answer 1

The difficulty faced by this investor is termed as the Agency problem or the Principal-agent problem. Agency problem refers to the conflict of interest between shareholders and the management of a company. The management is responsible for day to day operations of a company and can sometimes have a different views of where the company needs to be going based on their own incentives.

In order to align the interests of both the investor and the management, the investor might try to convey her thoughts to the management and try to convince them of the potential of this opportunity. This would not only help her cause but also might help her build a solid rapport with the management. Another way could to be somehow align the management's incentives with the investor's goal. A bonus based compensation, that incentivises management to undertake the riskier and possibly a more profitable route could do that job.

At the end of day, it is all about incentives. Both the management and the shareholders are trying to work based on their own incentives. Understanding and aligning management's incentives with the greater good of the organisation is the way to handle the agency problem.