Question 1.
Discuss how agency problems between shareholders and management might be controlled and reduced.
The agency problem arises due to the separation of ownership and control of business firms. In theory the shareholders, being the owners of the firm, control its activities. In practice, however, due to a diffuse and fragmented set of shareholders, the latter appoints a board of directors to manage and direct the affairs of the company.
The following are some of the agency problems that exist in firms and their solutions:
i. Running of the Company
This problem exists when management and shareholders have conflicting ideas on how the company should be run.
ii. Earnings retention conflicts
Managers may increase retained earnings in order to finance some projects which would not necessarily enhance shareholder wealth. Such grandiose managerial investment policies may not produce results that are clearly apparent to the shareholders as it may be to management. On the other hand, shareholders would prefer higher levels of cash distributions/dividends.
iii. Time Horizon Agency Conflicts
This conflict of interest may arise between shareholders and managers with respect to the timing of cash flows. Shareholders will be concerned with all future cash flows of the company into the indefinite future. However, management may only be concerned with company cash flows for their term of employment, leading to a bias in favor of short term high accounting returns projects at the expense of long-term positive NPV projects.
iv. Conflict of Interest
Conflict of interest happens when both parties want to maximize each benefit. The shareholders want to see higher profits as more dividends can be yield from it whilst the managers are more interested in higher revenue because it means more expenses can be made that are beneficial to them.
v. Self interest behavior
This occurs when managers seek to maximize their own utility at the expense of corporate...