Agency Problem – Essay

I partially agree with the statement that omnibuss redeem a severely limited amount of discretion to come actions inconsistent with sh arowner wealth maximization. By investing in a conjunction, allocateholders aim to maximize their wealth and achieve portfolio diversification. The object of managers is as jointureed to be to neverthe little these interests by maximizing the sures share value. This can be achieved by taking on projects with positive NPV and good management of short- limitinal working capital and long-term debt.However, shareowners and managers are assumed to want to maximize their utilities so this objective whitethorn not always be the priority for managers as they may rather prefer to maximize their own wealth or barely other personal interests of theirs. This conflict of interest between the both is an congressman of the head teacher performer problem. The principal agent problem occurs due to two reasons. The first is the separation of ownership from control the principal or the shareholders may own a corporation but it is the agent or manager who holds control of it and acts on their behalf.This gives managers the power to do things without necessarily being detected by shareholders. The second is that shareholders may not possess the same reading as the manager. The manager would have access to management accounting selective information and financial reports, whereas the shareholders would only receive annual reports, which may be heart-to-heart to manipulation. Thus asymmetric information also leads to moral hazard and adverse selection problems. The following are areas where the interests of shareholders and managers a great dealtimes conflict Managers may effort to expropriate shareholders wealth in a number of ways. They may all oer consume perks such as using company credit separate for personal expenses, jet planes etc. Empire building Managers may pursue a suboptimal expansion path for the firm. They may expand the firm at a rationally unfeasible rate in effect to cast up their own benefits at the cost of shareholders wealth. Managers may be more assay averse than shareholders who typically hold diversified portfolios. Managers may not have the same motivation as shareholders, likely due to a deprivation of proper incentives. Managers may window dress financial statements in outrank to optimize bon commits or justify sub optimal strategies The principal agent problem normally leads to theatrical costs. This has been identified by Jensen and Meckling(1976) as the sum of 1. Monitoring costs Costs incurred by the shareholders when they attempt to monitor or control the actions of managers. 2. Bonding costs Bonding refers to contracts that bond agents public presentation with principal interests by limiting or restricting the agents activeness as a result. The cost of this to the manager is the bonding cost. 3.The residual privation Costs incurred from divergent principal a nd agent interests despite the use of monitor and bonding. However the managers discretion is sooner limited in practice. There are a number of internal and external solutions to agency costs for shareholders. Internal Well-written contracts ensure that there are fewerer opportunities for managers to over consume perks. An external display plug-in of directors could be appointed to monitor the efforts and actions of managers. This board would have access to information and considerable legal authority over management.It could thus safeguard information and represent shareholder interests in the company. The board could hire independent accountants to audit the firms financial statements. If the managers simulatet agree to changes proposed by auditors, the auditors issue a qualified opinion. This signals that managers are trying to hide something, and undermines investor effrontery. Compensation packages where the reward to the manager is linked to firm performance. This includ es performance related bonuses and the payments of shares and share options. Ambitious, lower managers are a menace to the jobs of inefficient, evading ones. External The lenders of a company also monitor a imprecate for instance would track the assets, earnings and cash flows of the company it provides a impart to. Managerial labor market Poor managers may not crap another job or get a much poorer one. at last the most important indicator to the labor market of managerial performance is share equipment casualty. Capital Markets A falling share price increases the little terror of a take-over, which can often result in redundancies. More severe shareholding by outsiders can lead to monitoring by them and improve managerial performance. However there are a few problems with these solutions though, which sterilise it contingent for managers to circumvent them to a small extent. In order to keep the share price high, managers may focus more on short term profitability at the cost of long term profitability. They may use gimmicks to temporarily pass on the share price and neglect spending on research, development and H. R.They may also provide sub standard products and part with providing services for old, or relatively less important products in order to reduce costs and make a quick profit. This damages the companys reputation, reduces its competitiveness in the future and thus affects long-term shareholder value negatively. While block holders may act as external monitoring implements, they can also have private incentives to go along with management decisions, which may be detrimental to firm performance. Writing infract contracts may reduce the problem of asymmetric information, but not richly solve it.This is because the design of such contracts is technically infeasible due to unlike reasons such as the difficulty of foreseeing all future contingencies. Dispersed shareholders often do not exercise the few controlling rights that they have. This leads to a palliate rider problem where shareholders would prefer to let other shareholders do the delegate of monitoring as they cannot justify spending on it over the few shares that they each own. In order to resist takeovers, managers may design contracts that incubate them in the event of loss of control due to the takeover.They may also undertake targeted repurchases and devise a poison pill, which changes the fundamental aspects of the corporate rules without the fellowship of shareholders. While incentive schemes such as shares and share options are effective, they are still reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behavior. Managers may continue to focus mainly on quarterly goals rather than the long term as they are allowed to cheat the stocks after exercising their options.By focusing on quarterly performance, managers could boost the stock price and avail higher personal profits on their subsequent sale of st ock. Managers may also sell their shares as in short as they are high, leading people to think that they lack confidence in their own operations. This may adversely affect share price. partake in options also increase the risk of EPS dilution from an increase in shares outstanding. Managers may often window dress financial statements as the company must be seen to perform well in order to improve share valuations.They may report inaccurate information, especially if their short-term rewards outweigh their long term ones such as pensions. It also encourages shareholder approval, and so would lead to less difficult AGMs. Many managers may hide the true value of assets in order to hide the losses they incurred bandage buying them. Window get dressed also involves managers presenting statistics such that they highlight the perceivably best bits about the companys performance and avoid emphasis on the worst aspects of the previous years disdain.Other common practices of this include disguising liquidity problems and fraudulent design of liabilities. This gross misrepresentation of debts has been seen with Enron in the US, where $billions of long-term liabilities were hidden off the balance sheet. Its executive Jeffery Skiller, initiated the use of mark to market accounting, while hoping to meet groin Street expectations. Enron ultimately became bankrupt while its shareholders suffered huge losses. Despite having exercise board of directors and a talented audit committee, Enrons managers were able to make it attract large sums of capital to fund a questionable business model and hype its stock to unsustainable levels. Worldcom, a telecommunications company in the US, high-minded profits by disguising expenses as investment in assets and inflated revenues with faux accounting entries from corporate, unallocated revenue accounts. In mid 2000, its stock price began to moderate and CEO Bernard Ebbers persuaded WorldComs board of directors to provide him corp orate loans and guarantees of over $ cd million to cover his margin calls on Worldcom stock.The board had hoped that the loans would avert the requirement for Ebbers to sell the substantial amounts of WorldCom stock that he owned, as this would have further reduced the stocks price. However, the company ultimately went bankrupt and Ebbers was ousted as CEO in April 2002. The shareholders suffered massive losses as they watched World Coms stock price plummet from $60 to less than 20 cents. Thus, we can see that while there is room for managers to indulge in personal wealth maximization, it is quite difficult to do so. Usually, the solutions tend to be adequate enough to be the conflicts, and restrict managers discretion.