The Principal - Agent Problem

Question 1

Briefly explain the principle - agent problem

Answer 1

1. The separation of ownership and control.
2. Owners (shareholders) are the principles and managers are the agents.
3. The problem arises because owners and managers have different interests.
4. Owners want to maximise the value of the firm.
5. Managers want to pursue their own interests. E.g. high salary/ bonus

Question 2

What are some solutions to the principal - agent problem?

Answer 2

1. Line incentives of managers and earnings by compensating managers partly in the form of shares.
2. Managers monitored by the board of directors. Board members look after their interests.
3. Introducing external pressure by selling shares if managers are running the company badly. (Threat of takeover)
4. Shareholder activism - shareholders voice concerns to directors.

Question 3

What are “agency costs” with regards to the solutions for the principal - agent problem?

Answer 3

These are costs that are introduced for some of the solutions for the principal - agent problem

Question 4

What are some examples of agency costs that arise when the agency problem is known to exist?

Answer 4

1. Expropriation - agents (often controlling shareholders or managers) take resources from the company for their own benefit at the expense of shareholders
2. Perquisites/ perks - non-essential benefits managers give themselves—like fancy offices, company cars, or private jets—not to benefit the company but themselves.
3. Self dealing - form of expropriation where the agent makes decisions that benefit themselves personally, even at the company’s expense
4. Higher cost of capital - investors fear that managers might not act in their best interest (due to agency problems), they demand higher returns to compensate for the risk (firm’s cost increases)