A corporation is a legal entity that
has limited liability and is separate from its owners. Large corporations are
made up of numerous shareholders who are the owners of that company and share
the firm’s profits and losses. The separation of ownership and management in
large firms is essential. Control of a corporation is separate as the thousands
of shareholders cannot be involved in the daily management of the company. Therefore,
the company is run by a board of directors and management. Managers are hired because
they have the abilities to carry out the necessary tasks in running the
business that the principles may not be able to, due to lack of expertise,
knowledge or time. The main objective of a firm is to maximise its value as
well as increasing the value of its shares.
The agency relationship is the relationship
between the principals who are the shareholders and the agents who are the
managers. Management is hired by the shareholders to oversee the firm’s affairs
and to act within the shareholder’s best interest. The principle agency problem
arises when there is a conflict of interest between the managers and the shareholders
of the company. It is financial manager’s responsibility to maximise the wealth
of the shareholders as well as increasing the value of the firm.
Principle agency problems arise as
a result of asymmetric information. The managers gain a larger level of information
in the company as they are involved in the company operations on a daily basis.
The shareholders do not have the same information that is available to the
managers, as they are not involved in running the business daily. Shareholders
have access to annual reports, whereas managers deal with the financial reports
daily and have the ability to exploit the data. Managers would have an
incentive to exploit the data to optimize their performance related rewards. It
is also difficult for the shareholders to keep track of the manager’s actions
due to the separation of control in the business. These lead to agency costs
being incurred. Agency costs are experienced
when managers do not do their job at trying to maximize the value of the firm. An
example of an agency cost is when the managers decide to make a purchase of
another firm to increase their market power, as opposed to boosting the
corporation’s value. Shareholders sustain both indirect and direct costs as a
result of trying to keep managers and their activities under observation.
It is the managers’ job to make
financial decisions that would benefit the firm the most and thus maximise its wealth,
as well as that of its shareholders. However, problems could rise here as the
agents could be more risk adverse than the principals, or visa versa. Shareholders
would ideally want the corporation to pay out more dividends, see an increase
in their equity over a long-term period as well as taking on riskier projects,
with the potential of a higher return. However, if the managers were more
conservative with their investments, it could lead to the company investing in
less risky investments, which would result in a lower return.
An example of these conflicting investment
issues would be the bankruptcy of Lehman Brothers. The corporation was a high-leverage,
risk taking business that was sustained by limited equity. To increase their
growth, Lehman Brothers relied on uncertain investments such as derivatives as
well as the real estate market. The crash of the corporation can be tracked
down to the poor control of the management. The corporation took on a large
amount of unnecessary debt and did not have its funds invested in a diversified
portfolio. These problems were all caused
by poor operations of the agents and is a prime example of the agency problem.
The employees had a small portion of shares in the company, which did not promise
that they would make decisions with the stockholders’ best interest in mind. Instead,
the management decided to act in their favour, as they had performance based
payments. They wanted to see the company grow in the short term, which proved
detrimental in the long run.