Chapter 2 Flashcards
(12 cards)
What are agency problems?
Managers have the ability to realize so-called „private benefits “, even when they are inconsistent with the goal of maximizing share value. Cost arising from differing interests are „agency costs “
- Managerial shirking (playing golf instead of working)
- Managerial consumption of perquisites (plush offices, corporate jets)
o Excessive and/or “unproductive “perk consumption hurts shareholders - Entrenchment: desire to remain in power (family firms, or famous CEOS)
- Managerial risk aversion (more often young CEOs)
- Free cash flow and empire building (Pecking order theory of financing sources, M&A Activity)
3 to 5 are less obvious but much more costly
Agency cost solutions
- Bonding solutions:
a. Bond managers contractually to behave in shareholders interest
b. Only partial solution as complete contracts do not exist
c. Contracts may provide crude guidelines and compensate shareholder if manager does take such actions - Monitoring solutions:
a. Requires effective monitors who present a credible threat
b. Most shareholders lack the experience and incentive to monitor (free rider problem)
c. More effective monitors are: board of directors, large shareholder, competing management - Incentive alignment solutions
a. By providing performance dependent on compensation, managers become shareholders and the interests between principal and agents are better aligned
Agency cost composition?
- Monitoring and incentive expenditures by the principal (budget restrictions, compensation policies, monitoring the behavior )
- Bonding expenditures by the agent (contractual guarantees to have financial accounts audited by public account , limitations on mangers decision making)
- Residual loss
Cash equivalent of reduction in welfare experienced by owner-manager due to this divergence is called : residual loss
Agency Problems of debt and equity
If taking debt, debtholders bear an increasing fraction of the risk but managers still control the company and decisions
- Managerial incentives to transfer the wealth from debtholders to themselves ( even stronger when in financial distress)
Asset substitution problem
- If managers realize the firm will not fulfil its obligations to debtholders, they may be tempted to gamble with debtholders money
Shareholders may have incentives to adopt neg NPV projects with large risks
Shareholders receive largest profit, debtholders bear most of the losses
Debt Overhang Problem
- Alternatively, equity holders not motivated to invest in projects, if the returns largely accrue to debtholders
Shareholders may have incentives to forgo + NPV projects
Returns from the project largely to debtholders
RoW have Expropriation problems
Main conflict between large shareholders and minority shareholders
Exproriation via tunneling or transfer pricing
Other forms of minority shareholder expropriation include nepotism and infighting
− Nepotism consists of the (controlling) family shareholder appointing family members to top management
positions rather than the most suitable candidates on the job market
− Infighting is likely to deflect management time as well as other firm resource
Hidden Information (Adverse Selection)
One party has relevant information about the contractual item that the other party lacks
o Unobserved (hidden) characteristics
“A worker applying for a job typically has a clearer idea of her skills than potential employers”
This is the problem created by asymmetric information before the contract is made!!
Ex: used car market (Akerlof)
Hidden Information (Adverse Selection) Solution
- Screening: Principal acquires information to assess the quality of the agent/ product (e.g., venture capitalist collects information about the start up, management team etc.)
- Signaling: The agent reveals quality/product quality by sending a signal (e.g., sellers of used cars can offer warranties)
- Self selection: Principal can offer different contracts → the principal can infer the quality from the agent’s choice
Hidden Action (Moral Hazard)
Principal cannot observe and/or verify activities of the agent unobserved action
After conclusion of the contract it may no longer be optimal for agent to stick to the rules
This problem is created by asymmetric information after the contract is made!!
Ex: Manager of a large corporation may divert the firm’s resources into perks rather than in hiring new engineers
Hidden Action (Moral Hazard) Solution
- Bonding: Contracts may provide crude guidelines and help ensure that managers will not take certain actions that would harm the principal or that the principal will be compensated if such action is take
- Monitoring: Principal monitoring the agent
- Incentive alignment: Contractual clauses to align the interests of the principal and the agent(e.g., stock ownership, variable compensation
Hold-up (Hidden Intention)
Other parties post-contractual intentions remain hidden
Principal has to make an irreversible investment ends up being dependent on agent
After contract has been made, the agent has bargaining power to change the terms
Risk of exploitation
Ex: A car parts manufacturer invests in equipment to build a component that only fits a Toyota. This is a relation specific investment (RSI). Once a firm makes a RSI, the other firm holds a great deal of bargaining power because the firm cannot use the assets for alternative customer
Solution: Incentive alignement (vertical integration)
