Los 22.a Flashcards
(10 cards)
What is a principal-agent relationship?
When one party (the agent) is hired to act on behalf of another party (the principal), but their interests may not align perfectly.
How might an insurance agent create a conflict of interest?
By writing risky policies to maximize commissions, contrary to the insurance company’s interest in avoiding bad risks.
What are agency costs?
Costs from principal-agent conflicts, either direct (e.g., monitoring expenses) or indirect (e.g., lost opportunities).
Why might shareholders and managers have conflicting interests?
Shareholders might prefer higher risk for higher returns, while managers prefer lower risk to protect their employment.
How does information asymmetry create conflict between shareholders and managers?
Managers know more about the firm’s operations and strategy than shareholders, making monitoring difficult.
What are common ways managers may act against shareholder interests?
Insufficient Effort:
Managers may not work as hard as they should, leading to poor investment decisions and higher costs.
Risk Manipulation (too high or too low):
Managers compensated with options might take excessive risks (no downside for them), while those paid in cash might avoid risks even when it’s good for shareholders.
Empire Building:
Managers may push for unnecessary mergers or expansions to increase the size of the company (and their own power) rather than focusing on shareholder value.
Entrenchment:
Managers might make the company harder to take over or mimic competitors just to keep their jobs safe, even if it’s not in the best interest of shareholders.
Self-Dealing:
Managers could misuse company resources for personal gain, like awarding themselves perks or engaging in unfair transactions.
How can conflicts arise between different groups of shareholders?
Controlling shareholders act in self-interest:
Example: Forcing the company to expand into unrelated businesses just to protect their personal wealth, even if it’s a bad move for others.
Dual-class structures:
Example: Founders holding special shares with 10x voting rights, letting them control decisions despite owning a small % of the company.
→ CFA Institute opposes dual-class shares because it weakens shareholder fairness.
What is a dual-class structure, and why is it controversial?
Definition:
Company issues two types of shares: one with more voting power than the other.
Example:
A founder holds “Class A” shares (10 votes each), while public investors hold “Class B” shares (1 vote each).
Problem:
Founders can control the company even if they own only a small portion of total shares.
How do shareholder and creditor interests conflict?
Shareholders prefer more risk:
Example: A company takes on risky new projects to boost returns, but this raises the chance of bankruptcy for creditors.
Management actions that hurt creditors:
Issuing more debt:
Example: A company borrows heavily, increasing the default risk for current bondholders.
Increasing dividends:
Example: Paying out large dividends to shareholders reduces company assets, making it harder to pay creditors later.
