A corporation is a legal entity thathas limited liability and is separate from its owners. Large corporations aremade up of numerous shareholders who are the owners of that company and sharethe firm’s profits and losses. The separation of ownership and management inlarge firms is essential. Control of a corporation is separate as the thousandsof 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 becausethey have the abilities to carry out the necessary tasks in running thebusiness 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 aswell as increasing the value of its shares. The agency relationship is the relationshipbetween the principals who are the shareholders and the agents who are themanagers. Management is hired by the shareholders to oversee the firm’s affairsand to act within the shareholder’s best interest. The principle agency problemarises when there is a conflict of interest between the managers and the shareholdersof the company. It is financial manager’s responsibility to maximise the wealthof the shareholders as well as increasing the value of the firm. Principle agency problems arise asa result of asymmetric information.
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The managers gain a larger level of informationin 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 themanagers, as they are not involved in running the business daily. Shareholdershave access to annual reports, whereas managers deal with the financial reportsdaily and have the ability to exploit the data. Managers would have anincentive to exploit the data to optimize their performance related rewards. Itis also difficult for the shareholders to keep track of the manager’s actionsdue to the separation of control in the business. These lead to agency costsbeing incurred.
Agency costs are experiencedwhen managers do not do their job at trying to maximize the value of the firm. Anexample of an agency cost is when the managers decide to make a purchase ofanother firm to increase their market power, as opposed to boosting thecorporation’s value. Shareholders sustain both indirect and direct costs as aresult of trying to keep managers and their activities under observation. It is the managers’ job to makefinancial 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 theagents could be more risk adverse than the principals, or visa versa. Shareholderswould ideally want the corporation to pay out more dividends, see an increasein 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 moreconservative with their investments, it could lead to the company investing inless risky investments, which would result in a lower return.
An example of these conflicting investmentissues would be the bankruptcy of Lehman Brothers. The corporation was a high-leverage,risk taking business that was sustained by limited equity. To increase theirgrowth, Lehman Brothers relied on uncertain investments such as derivatives aswell as the real estate market. The crash of the corporation can be trackeddown to the poor control of the management. The corporation took on a largeamount of unnecessary debt and did not have its funds invested in a diversifiedportfolio. These problems were all causedby 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 promisethat they would make decisions with the stockholders’ best interest in mind.
Instead,the management decided to act in their favour, as they had performance basedpayments. They wanted to see the company grow in the short term, which proveddetrimental in the long run.