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Agency problem The principal-agent problemBy: Hardeepika Singh Ahluwalia1Agency ProblemConflict of interest between Companys management (Agents) and Stockholders(Principals) .Management(Agents)Stockholders(Principals)Self- InterestPrincipal- Agent ProblemMain Objective:Maximizing stockholders wealth2Agency ProblemWidely-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. 3Resolving Agency ProblemMarket ForcesAgency CostHostile TakeoverBehavior of Security Market participantsMonitoring ExpenditureBonding ExpenditureOpportunity costStructuring ExpenditureIncentive PlansPerformance Plans4Hostile Takeover

Target Company (B)Acquiring Company (A)

No Agreement Acquisition of Target company by acquiring company without agreement with the former.

5Hostile takeover (Cont.)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.

Acquiring Company (A)

Shareholders of B (target co.)6Acquisition premiumBehaviour of Security Market ParticipantsSecurity 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 under-performing management.7Agency CostInability 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.Opportunity Cost8 Agency costContinuous monitoring of management (agents) to prevent satisfying in contrast to share price maximizing behavior. Monitoring cost includes: Audit and controlMonitoring Expenditure9Agency CostFirm 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.Bonding Expenditure

ShareholdersThird Party Bonding CompanyCompensation for financial losses caused by dishonest acts of managers10

Agents working in their self-interest. ( Insider Trading)Agency CostRelating managers compensation with share price maximization.Objective:

Structuring Expenditure 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.11Compensation PlansIncentive PlanPerformance PlanINCENTIVE 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.12Compensation Plans (cont.)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.13Reference BookMY Khan and PK Jain (Chapter 1: Pg 1.19-1.20)14