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1

AGENCY PROBLEM
THE PRINCIPAL-AGENT
PROBLEM

By: Hardeepika Singh Ahluwalia

Agency Problem
2

Conflict of interest between Companys management


(Agents) and Stockholders(Principals) .

Principal- Agent Problem

SelfInterest

Management
(Agents)
Stockholders
(Principals)
Main Objective:
Maximizing stockholders wealth

Agency Problem
3

Widely-diffused ownership, scattered and ill-organized


shareholders hardly exercise control/ influence on
management which is inclined to work in its self interest.

Shareholders have right to change management.


Due to this threat management try to achieve minimum
acceptance level of performance to satisfy shareholders,
while focusing on personal goals.

Shift of AIM from Maximizing shareholders wealth to


Satisfying shareholders.

Resolving Agency Problem


4

Market Forces

Hostile Takeover

Agency Cost

Behavior of Security
Market participants

Monitoring
Expenditure
Bonding Expenditure
Opportunity cost
Structuring
Expenditure

Incentive Plans

Performance Plans

Hostile Takeover
5

Acquisition of Target company by acquiring company


without agreement with the former.

No Agreement
Acquiring Company (A)

Target Company (B)

Hostile takeover (Cont.)


6

Tender offer: Making a public offer for acquiring the shares


of target company to gain management control over
company.
The acquiring firm offers higher prices than the target firm
market price, thus inviting shareholders to tender their
shares.
Shareholders of B
(target co.)

Acquisition

Acquiring Company (A)

Behaviour of Security Market


Participants
7

Security market participants/ shareholders and


institutional investors like mutual funds who hold
large block of shares, actively participate in
management.

Exercise voting rights to replace more


competent management in place of underperforming management.

Opportunity Cost

Agency Cost
8

Inability of the organization to respond to new


opportunities.

Due to organization structure, Decision


hierarchy and control mechanism management
may face difficulty in seizing upon profitable
investment opportunity quickly.

Monitoring Expenditure

Agency cost
9

Continuous monitoring of management (agents)


to prevent satisfying in contrast to share price
maximizing behavior.
Monitoring cost includes: Audit and control

Bonding Expenditure

Agency Cost
10

Firm pays to obtain fidelity Bonds from third-party


bonding company to the effect that the latter will
compensate the former up to a specified amount of
financial losses caused by dishonest acts of
manager.

Agents working
their self-interest.
( Insider Trading)

in

Third Party Bonding


Company
Compensation for financial
losses
caused
by
dishonest
acts
of
managers

Shareholders

Structuring Expenditure

Agency Cost
11

Relating managers compensation with share


price maximization.
Objective:

To offer incentives/compensation to management to act


in the best interest of the owners.
Higher compensation packages to managers enable
corporate to higher the best available managers.

Compensation Plans
12

Incentive Plan

Performance Plan

INCENTIVE PLANS:
Tie management compensation to share prices.
Stock Option: Stock option allow management to purchase shares at
a special/ concessional price.
A higher future price would result in larger management compensation.
Note: Share prices may be affected by economic and behavioral market
forces over which management has no control.

Compensation Plans (cont.)


13

Performance Plans:

Performance plans compensate management on the


basis of proven performance.
Form of compensation:
Performance Shares: Performance shares are given to
management for meeting the stated performance goal.

Bonus: Cash payment tied to achievement of certain


performance goals.

Reference Book
14

MY Khan and PK Jain (Chapter 1: Pg 1.19-1.20)

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