Question

Please explain the agency problem between shareholders and managers in corporate finance and how compensation plan, board of directors and takeovers can possibly mitigate the problem.

Answer 1

Agency problem arises due to conflict of interest between promoters of company or stockholders  and the management. The conflict arises due to interest of stockholder to maximize their own wealth whereas interest of manager will be to increase their own wealth.


Two ways to prevent agency problems:

1. Performance linked pay and ESOPS: By compensating for better share performance the manager can be motivated to work towards shareholder wealth maximisation . ESOP(Employee Stock options) are provided to employee so that they can also benefit from increasing share value. Since management donot want takeover bids by competitors due to job security issues but higher pay and ESOPS can align their interests with the shareholders.
2. This principal and agent conflict can be minimised by using contracts and laws and trust can be built between board f directors and managers . The covenants help to legally bind the mangers to performs according to wishes of the shareholders and . Any breach of contract can have monetary losses for the manager which can deter managers to work against the shareholders.
3. Incentives given to managers can minimize the threat of takoevers and the risk of firing to the managers as these might influence decision making of mangers.