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CORPORATE FINANCE

School of business and law


6/22/2011

Submitted by: Khawaja Asad Farooq
I.D. B0601GGGG0410















Submit to:
Makailla McConnel

CORPOR E FI CE

h usi ss w P g 2


TABLE OF CONTENTS
Sr. No
Contents
puge
1 Introductlon 3
2 Relutlonshlp between prlnclpul und ugent 4
3 Prlnclpul ugent theory 5
4 Exumple und self lnterest behuvlour 6
5 Issues reluted to prlnclpul und ugent 6
6 Control mechunlsm und lmpuct on shureholders
weulth muxlmlzutlon
7
7 A secondury ugency confllct 9
8 Muxlmlzutlon of shureholders weulth 11
9 Concluslon 12
10 References 12
11 Blbllogruphy 13
12 Journuls 13
13 Books 13
14 Others 13










Sh t summ ry:
CORPORATE FINANCE

Sch of busi ss and law Pag 3
This report will examine the principal and agent relationship and its impact on shareholders
wealth maximization. Further how the conflicts between them arise and what will be the
solution of these conflicts. Also discussion on the shareholders profit maximization and some
other objectives.
1.0 INTRODUCTION:
1.1 Agency:
The organisation or business, established in a way to provide a particular service, or in
general that involves organising transaction between two parties.
Business of one which is initiated with apprehension of other is known as agency.
An agency is something which acts as an intermediary between the seller and buyer without
taking any financial risk as a firm and charging commission for providing services.
1.2 Principal:
A person who has a legal capability to carry out an act (means that they are not insane, or in
certain cases a minor) is a principal. A principal may hire an agent to perform that act.
Principal is one who employs any individual to act for him. Even as renowned from an agent.

1.3 Principal-agent Problem:
When a business set prices and outputs to increase the profit, the conflict arises when the
decisions are about to be made between the ownership where the control could be difficult to
monitor. How do owners of the business know about their manager day to day decision
making, that these are operating well in order to maximize the shareholder values?
This lack of information is known as the principal-agent problem. In other words, a person,
the principal, employ an agent (e.g. a finance or sale manager) to carry out the task on his
behalf but the principal cannot certify that the agent is performing the act in the same way as
the principal would like him to do. The performance of the agent is expensive to monitor and
the incentive of agent differ from those of the principal.

2.0 R lationship between principal
and agent:
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A principal is one who hires another (agent), which has the capability to act for the
principal¶s interest. For example if a car owner (principal) employ a person to his car, then
the owner (principal) will give him a house free. In this case the agent¶s interest is to just sell
the car and not to get best price of it. If on the other side the owner (principal) put forward a
commission offer like 20% on price of sale, instead of alternative offer of a house, then this
problem might not exists, because the agent will put his whole effort to sell the car on best
price, so that the agent can get more benefit. This example points up that the way the agents
are remunerated is one factor that affects agency problems.
Any individual or firm which has the capability to comprehend that work is qualified to
serve an agent/agency.
These phrases illustrate the relationship between a principal and agent. This relationship is
defined as the arrangement that exists when one person or an entity (called as a agent) acts on
the behalf of another (called a principal). For example a company choose accountants to do
the company¶s audit, the shareholders (principal) choose a manager (agent) to act on their
behalf, a security company (principal) hires a security guard (agent) to provide services on
their behalf. In general a contract is used to specify the principal-agent relationship.
2.1 Purpose of the relationship:
The contract to be made by the agent on behalf of principal is measured to be the contract of
the principal not that of an agent. It let the principal to empower somebody to perform on
his/her behalf, either for general purposes (i.e. for conducting many transactions) or for
specific purpose (i.e. selling or purchasing the house). The agency relationship generally
entered into by informal agreement, or it can be enter through formal agreement as well (i.e.
the relationship must be précised in writing). However the act must be legal i.e. principal
cannot hire an agent to kill the CEO of Competitor Company.
2.2 Basis of agency relationship:
The main element in the relationship of principal and agent is a consideration that agent will
perform on in accordance with principal interest. The agent presumes a commitment of
loyalty that they will obey the principal¶s order and will neither intentionally nor neglectfully
act through improper way while performing the act. An agent cannot take personal advantage
through business occasions that the agency situation not covers. Principal in response, repose
the trust and confidence on agent. These commitments will bring a fiduciary relationship
between principal and agent, which is of trust and confidence.
3.0 Principal-agent theory:
If an individual (as a principal) employ a Gardner (agent) to clean up your lawn while the
individual (principal) is going away, all individual can examine that how the lawn looks like
when you return home. As individual agreed that Gardner could clean it up every 15 days or
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he can mowed it in two days before when you were due for only once. By prevailing on a
neighbour to monitor the employee¶s performance, principal can identify what employee
actually did, although at the same cost.
Further it is easy in that way that if you hire a lawyer, it is not easy for you to judge that how
much effort the lawyer put in the case. Because of the fact that you have not study the law
and much of what he does will be mystery to you.
This presently situation is quite narrow to the relationship which exists between shareholders
and managers. The managers have experience and expertise, which the shareholders don¶t
have in reality, that¶s why they are called as managers. Shareholders can view profits, but
they cannot examine the efforts of managers which they put in to enhance the profit. To
confuse the matter further, even if the behaviour of managers can be observed, the
shareholders don¶t have expertise to appraise it. Everyone can see company¶s revenue, but to
estimate how large these revenues could have been if the managers had act differently, it
takes very detailed knowledge.
Board of directors, who signify the shareholders of a firm, hire some expertises that have
relevant knowledge to monitor managerial behaviour, but again it is costly.
These examples represent the principal agent problem. This is a problem of crafting
mechanism that will persuade agents to perform in their principal¶s interest. Generally, unless
there is costly examining the agent¶s performance, the problem cannot be completely solved.
Managers (gardeners) in general want to chase their own goals. They cannot disregard profit,
because if their performance is not good enough then they might lose their job. Just how
much opportunity they have to trail their own goals through the expense of profits relied on
many things, includes the scale of competition in the firm and the possibility of capture
through more profit oriented management.



4.0 Example of Principal Agent
problem and principle of self-
interested behaviour:
The example given below illustrates the conflict between principal and agent relationship.
Assume that a company enjoy a record sales and huge profitable quarter from their normal
operations. This boon is a direct result of the employees, the owner¶s agents, who put their
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efforts in to maximize the corporate and consequently shareholders wealth. The manager of
firm decides that what would be the best use of the extra cash lying around as a liquid asset.
The managers have decided that the money will be use for one of two purposes: the
employees would be rewarded by increasing their wages in respond to their efforts or the
extra income for the shareholders who put their capital in, which was required to make extra
income.
The principle of self interested behaviour would propose that the stockholders wish for
dividend option since it meant to be more money for them. Employees, on the other hand
would wish for increase in wages since it means more money in their pocket. The self interest
behaviour principle would suggest about the managers, that making the decision they would
also wish for increase in wages because it means more wealth for them.

5.0 ISSUES:
Agency theory elevates primary problems in organisation---self-interested behaviour. A
manager of a company has its own goals that contend with the owner¶s goals of maximizing
shareholder wealth. As the shareholders of the organisation give the authority to the manager
to manage the company¶s assets, a potential conflict of concern is present between the two
groups.
5.1 Self-interested behaviour:
The theory about agency illustrates that in those markets where there is no perfection in
capital and labour, managers will be looking for exploiting the benefits for themselves
through shareholders expense. Agents comprise the aptitude to work in for their self interest
rather than performing best in the best concern of company due to the fact that managers
know better than the shareholders that either they have the capability to meet the
shareholder¶s objective. This is known as asymmetric information. And managers also know
the numerous factors to final result, and it may not be obvious that either the agent is going to
cause the negative outcome or positive outcome. This is known as uncertainty.
A possible conflict of agency arises when a manager of the corporation possesses less than
the 100% of company¶s stock. Assuming that the firm is a sole proprietor, and the
management is in the hand of owner, the manager will obviously take action in the way to
increase their own utility. The manager (agent) will most likely evaluate benefit by own
means, but could exchange other reflection, such as leisure and privilege. If the owner give
up a section of his stock and sell it to external investor, a possible conflict of agency will
occur, known as agency conflict arises. For example manager who is owner as well might
give the priority to more relax way of life and not work alike to exploit the wealth of
shareholders, because the owner manager doesn¶t have the 100% money in and manager now
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ensue less of t e wealt Also t e owner manager might settle on to get more pri ilege
because the outsi er sharehol er will now going to get some cost of benefits.
In large public firms the principal there is possibilit of agency conflict because the
managers of the firm not own a high percentage of the stock. Hence the sharehol ers wealth
maximi ation coul be subordinated to an assortment of other managerial goals. For example,
the manager of the firm may have an elemental objective to expand the firm¶s si e. By
crafting a large growing firm the management enhance personal position, generating more
opportunity for middle and the low level managers and enhancing their salary and their job
safety because an inhospitable takeover is less alike. Thus the present administration may
track diversity through shareholders expense, who can simplybrand out their individual
assortment by buying share in the other firms.
6.0 Control echanis and its
i act on shareholders wealth
axi ization
Managers can be persuaded to perform similar to the shareholders interest by the means of
incentive, constraints and punishment. These methods can be of well use when shareholders
can monitor each and every action taken by the managers. The moral hazard can be occur if
managers take actions for their own interest, and it is not practically possible for the
shareholders to examine all those actions taken by managers. In order to minimize this
problem the stockholders must incur agency cost.
Agency cost is defined as the cost which the shareholders incur in order to encourage
managers to exploit shareholders wealth rather than acting for their personal interest.


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Agency cost has three major types:
1. Expenses incurred to monitor the managers activities are known as audit costs.
2. Costs incurred to the formation the organisation in a way that will bound the adverse
managerial actions, for example restructuring the business units of the company or
hierarchy of the company.
3. Expenses which are incurred when the shareholders imposed limits, for example
voting of shareholders on specific problem, restrict the capability of managers to take
actions that maximize shareholders wealth.
By lack of efforts by shareholders to amend managerial actions, there will be usually some
loss of shareholders wealth because of inappropriate managerial behaviour. Alternatively
agency cost would be unnecessary if the shareholders tried to make sure that every action
taken by managers are be conventional with the interest of shareholders. Thus the agency cost
bear by the shareholders can take into the account of cost benefit context. Agency cost must
be increased as like each pound spends by shareholders results the increase of one pound in
shareholders wealth.
The solution to these problems is splitting in two ways, reward and punishment. Punishment
means sacking the employee and takeover of the company. On the other hand reward can be
in different forms.
FIRING:
If the managers doesn¶t perform well the company will do a bad job, there is a threat for the
mangers that if the company is not performing well than might be manager will lose this job.
Because of that threat they will put their effort in for the sack of job safety. But this all
happens in theory.
TAKEOVER:
If a company¶s management is not performing well, it means that the company is not
performing well. And if company is not doing good job, then this is a sign that they are not
achieving its maximum market value. Due to this, the big can will get the chance to take over
the company, change the management which was already working and will bring some new
management, by doing that they will maximize the market value of stock, which definitely
bring them huge profit. Because of that reason the management (agency) will perform in the
company/shareholders (principal) best interest.
REWARDING:
There are many approaches of rewarding the management. The better of them is rewarding
the management (agent) through stocks option. When the shareholders (principal) give the
management (agent) stock, it means that principals are giving them a part of the ownership,
which will increase their interest to maximize the market value of the stock. In this solution
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the problem is not been eliminated, agents are getting part of owner ship which results in
avoiding different conflicts of interest by shareholders (principal) and the managers (agent).
The second approach is performance related pay includes bonuses, commissions and etc. In
this case shareholders needs to put a certain target which if the management will succeed to
achieve they will get bonuses and commissions. Increase in the rewards in regarding to the
targets is important. In respect of that managers will try to work hard in order to maximize
their own utility. On the other side it will proportionally increase the shareholders wealth.
7.0 A SECONDARY AGENCY
CONFLICT
STOCK HOLDERS VS CREDITORS:
This conflict arises between stockholders and creditors. Creditors are interested on part of
firm income in the shape of interest and principal payment on debt and also they have a key
argument on firm¶s assets in case of bankruptcy. Creditor¶s loan the money to the company at
the rates based on the risk integrated to firm¶s assets, and on the basis of present capital
format of equity and debt, and also opportunities attached with the risky projects of these
variables. While stockholders uphold the control of operating decision those affects the firm¶s
cash flow and their resultant risks. Stockholders maintain the control through firm¶s
managers.
Major issue among stock holders and creditors is that the creditors/bondholders/lenders get
paid a fix amount and they will get paid before the stockholders will get. For example the
stockholders are lending £20 from creditors. There is a choice a investing in safe project and
risky one. The scenario for these two projects is like:
In project safe the return in bad time is £20 and in good time it is £30. There is a possibility
of 50% of good and bad time occurring. Payout to stockholders and creditors will be in the
manner as follows:
State Good Bad
Probability 0.50 0.50
Earnings £30 £20
Creditors payout 20 20
Stockholders payout 20 0

Expected value of project = (0.5 * 30) + (0.5*20) = £25
Expected value of debt = (0.5 * 20) + (0.5 *20) = £20
Expected value of stock = (0.5*20) + (0.5*0) = £10
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If the risky project will succeed stockholders will get the benefit because the lenders only
receive the fixed amount. Project risky return will be £35 in good times and in bad times it
going to be £10 (possibility of occurring is 50%).
Payout to creditors and stock holders will be in the manner as follows:
State Good Bad
Probability 0.50 0.50
Earnings £35 £10
Creditors payout 20 10
Stockholders payout 25 0


Expected value of project = (0.5 * 35) + (0.5*10) = £22.5
Expected value of debt = (0.5 * 20) + (0.5 *10) = £15
Expected value of stock = (0.5*30) + (0.5*0) = £15
From the above calculation it shows that stockholders will prefer the risky project as it makes
them extra £5 from creditors expense. This is the agency conflict between creditors and stock
holders. Creditors seek to protect them by restricted agreement that which project can be
taken and later on who get to loan the company. Also in the course of threat of no future
lending.


8.0 MAXIMIZING SHAREHOLDERS
WEALTH:
Maximization of shareholder¶s wealth involves the flow of dividend to shareholders for long
term. This is the primary objective of the business. While shareholders are the one who owns
the business and bears the enduring risk. In good times shareholders get benefit but in the
hard times they should bear losses. If the business fails shareholders can claim the assets of
the business will go to the bottom of the quantity. The situation of shareholders distinct with
the other stakeholders, such as employees, customers, creditors and suppliers, who claims are
the first legal priority in excess of shareholders. In addition to this the stakeholders can
protect themselves from losses through contractual agreement. For example creditors want
security for the loan and in that sense they can compel limit on loan agreement. Thus the
situation of the shareholders gives them authority to control the business to make sure that
their interest remains happen.
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Another risk in shareholders wealth maximization is that the directors might misuse the
resources to get extreme rewards for them. Since in these circumstances shareholder is the
one who must bear this cost and the directors have to be accountable for that. According to
Milton Friedman ³ In a free enterprise, the executives are the employees, so they have direct
responsibility to the employers/owners. It is the responsibility of the employees to conduct
the business in according to the interest of their employees, and generates as much money as
possible in the presence of basic rules of the society. Milton also quoted that the directors
who do not look for shareholders wealth maximization are in fact stealing from them.
The objective of maximizing shareholders wealth is that it persuade industrial activity, which
will have vital benefits of all those associated with the business. Shareholders have enduring
claim on the business benefits, as compared to other stakeholders, such as employees, lenders
etc. Because they usually obtain fixed claim. By having the enduring claim on the benefits
shareholders have a reason to increase the size by undertaking new and risky projects. On the
other hand the stakeholders will prefer to avoid new ventures to minimize the risks. The
executives may also prefer to avoid the new projects if they suffer with their job security.
Even so they will be required to please the shareholders needs, for that they will have to
increase the profit and business size to the benefit of all.
The shareholders wealth maximization will only be beneficial for the stakeholders if there is
strong market competition. If the competition is not strong it means that the company is
intense in the hands of monopolists. Monopolists maximize the profit through reducing
output and by increasing prices. This is beneficial for shareholders but the stakeholders like
employees, suppliers will not get advantage.
In a competitive market, it¶s difficult for the executives to stay away from shareholders
wealth maximization. Job competition for executives and also shareholders rivalry, connive
that shareholder needs are success. Directors are aware from the fact that if the shareholders
will not consider of being satisfied, then they might get replaced from other executives. Even
if they neglect it, might be they find the deprived profit record, due to risk involved. This will
authorise shareholders to sell their shares, thus lowering the share price. This will give an
opportunity to business seekers to take over the company; they are likely to change the
management to enhance their profitability.

9.0 CONCLUSION:
The report concludes the conflict between principal (shareholders) and agent (managers),
involves the relationship between the managers and shareholders, what are the issues which
gives rise to these conflicts, what impacts these issues are putting on a firm, and also on the
relationship between principal and agents. The report also concludes the self interest
behaviour of individual, and also how to overcome these issues and its impact to shareholders
wealth maximization. There is also a secondary agency conflicts which usually lies between
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stockholders and creditors. The report also comprises the discussion on shareholders wealth
maximization and other objectives related to it.


10.0 REFERENCING:
10.1. WEB REFERENCES:

1. Web
(www.advn.com/money-words_term_151_agency.html)
2. Web
(www.investorwords.com/.../principal_agent_relationship.html)
3. Web
(www.ruf.rice.edu/~schuler/principal-agent.html -)
4. Web
(http://www.referenceforbusiness.com/encyclopedia/A-Ar/Agency-Theory.html)
5. Web
(www.sayeconomy.com/how-to-solve-principal-agent-problem/)
6. Web
(www.definitions.net/definition/principa)
7. Web
(forumserver.twoplustwo.com > ... > Business, Finance, and Investing)
8. Web
(business.kent.edu/courses/spring02/Fin/36054/ .../chapter1.doc -)
9. Web
(http://www.enotes.com/biz-encyclopedia/agency-theory#conflicts-between-
managers-shareholders)
10. Web
(www2.accaglobal.com/student/dipfm/module_b/tech.../3445864)
10.2. JOURNALS:

1. Fama, Eugene, and Michael Jensen. "Agency Problems and Residual Claims." Journal of Law
and Economics 26 (1983), 327-349.

2. Hayne, Leland E. "Agency Costs, Risk Management, and Capital Structure."Journal of
Finance, August 1998.

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3. Jensen, Michael C., and William H. Meckling. "Theory of the Firm, Managerial Behaviour,
Agency Costs, and Ownership Structure." Journal of Financial Economics 3 (October 1976),
305-360
10.3. Bibliography:
1. Bamberg, Giinter, and Klaus Spremann, eds. Agency Theory, Information, and
Incentives. Berlin: Springer-Verlag, 1987.

2. Bowie, Norman E., and R. Edward Freeman. Ethics and Agency Theory: An
Introduction. New York: Oxford University Press, 1992.

3. The social responsibility of business is to increase its profits, Frieman M. New York Times,
13 September 1970
10.4. BOOKS:
1. Tackling the issue of the corporate objective: an analysis of the United
Kingdom's 'Enlightened Shareholder Value Approach' , Keay A, Volume 29 No. 4
Sydney Law Review December 2007 pp577-612.
10.5. OTHERS:
1. Lectures
2. Handout
3. Notes.

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CORPORATE FINANCE This report will examine the principal and agent relationship and its impact on shareholders wealth maximization. or in general that involves organising transaction between two parties. Principal is one who employs any individual to act for him. Business of one which is initiated with apprehension of other is known as agency. The performance of the agent is expensive to monitor and the incentive of agent differ from those of the principal. Even as renowned from an agent.0 INTRODUCTION: 1. 2. 1. How do owners of the business know about their manager day to day decision making. An agency is something which acts as an intermediary between the seller and buyer without taking any financial risk as a firm and charging commission for providing services. 1. Further how the conflicts between them arise and what will be the solution of these conflicts. a person.0 R lationship between principal and agent: of busi ss and law Pag 3 Sch . A principal may hire an agent to perform that act. or in certain cases a minor) is a principal.3 Principal-agent Problem: When a business set prices and outputs to increase the profit.1 Agency: The organisation or business. 1. the conflict arises when the decisions are about to be made between the ownership where the control could be difficult to monitor. employ an agent (e.g. the principal. In other words. established in a way to provide a particular service. Also discussion on the shareholders profit maximization and some other objectives. a finance or sale manager) to carry out the task on his behalf but the principal cannot certify that the agent is performing the act in the same way as the principal would like him to do. that these are operating well in order to maximize the shareholder values? This lack of information is known as the principal-agent problem.2 Principal: A person who has a legal capability to carry out an act (means that they are not insane.

If on the other side the owner (principal) put forward a commission offer like 20% on price of sale. The agency relationship generally entered into by informal agreement.e. the relationship must be précised in writing). This relationship is defined as the arrangement that exists when one person or an entity (called as a agent) acts on the behalf of another (called a principal). These phrases illustrate the relationship between a principal and agent. For example a company choose accountants to do the company¶s audit.CORPORATE FINANCE A principal is one who hires another (agent). In general a contract is used to specify the principal-agent relationship.0 Principal-agent theory: If an individual (as a principal) employ a Gardner (agent) to clean up your lawn while the individual (principal) is going away. repose the trust and confidence on agent. or it can be enter through formal agreement as well (i. either for general purposes (i. Any individual or firm which has the capability to comprehend that work is qualified to serve an agent/agency. principal cannot hire an agent to kill the CEO of Competitor Company. Principal in response.e.e. for conducting many transactions) or for specific purpose (i. which has the capability to act for the principal¶s interest. An agent cannot take personal advantage through business occasions that the agency situation not covers. then the owner (principal) will give him a house free. 3. These commitments will bring a fiduciary relationship between principal and agent. The agent presumes a commitment of loyalty that they will obey the principal¶s order and will neither intentionally nor neglectfully act through improper way while performing the act. so that the agent can get more benefit. In this case the agent¶s interest is to just sell the car and not to get best price of it. all individual can examine that how the lawn looks like when you return home. the shareholders (principal) choose a manager (agent) to act on their behalf. then this problem might not exists. However the act must be legal i. This example points up that the way the agents are remunerated is one factor that affects agency problems. 2.2 Basis of agency relationship: The main element in the relationship of principal and agent is a consideration that agent will perform on in accordance with principal interest. selling or purchasing the house). For example if a car owner (principal) employ a person to his car. As individual agreed that Gardner could clean it up every 15 days or School of business and law Page 4 . which is of trust and confidence. a security company (principal) hires a security guard (agent) to provide services on their behalf. because the agent will put his whole effort to sell the car on best price. instead of alternative offer of a house. It let the principal to empower somebody to perform on his/her behalf.1 Purpose of the relationship: The contract to be made by the agent on behalf of principal is measured to be the contract of the principal not that of an agent.e. 2.

They cannot disregard profit. The managers have experience and expertise. the owner¶s agents. who signify the shareholders of a firm. includes the scale of competition in the firm and the possibility of capture through more profit oriented management. To confuse the matter further. Because of the fact that you have not study the law and much of what he does will be mystery to you. Generally.0 Example of Principal Agent problem and principle of selfinterested behaviour: The example given below illustrates the conflict between principal and agent relationship. but they cannot examine the efforts of managers which they put in to enhance the profit. By prevailing on a neighbour to monitor the employee¶s performance. Further it is easy in that way that if you hire a lawyer. Board of directors. Everyone can see company¶s revenue. 4. but again it is costly. This is a problem of crafting mechanism that will persuade agents to perform in their principal¶s interest. This presently situation is quite narrow to the relationship which exists between shareholders and managers.CORPORATE FINANCE he can mowed it in two days before when you were due for only once. but to estimate how large these revenues could have been if the managers had act differently. Shareholders can view profits. Just how much opportunity they have to trail their own goals through the expense of profits relied on many things. who put their School of business and law Page 5 . the shareholders don¶t have expertise to appraise it. unless there is costly examining the agent¶s performance. principal can identify what employee actually did. hire some expertises that have relevant knowledge to monitor managerial behaviour. it takes very detailed knowledge. because if their performance is not good enough then they might lose their job. although at the same cost. Assume that a company enjoy a record sales and huge profitable quarter from their normal operations. it is not easy for you to judge that how much effort the lawyer put in the case. which the shareholders don¶t have in reality. Managers (gardeners) in general want to chase their own goals. the problem cannot be completely solved. that¶s why they are called as managers. These examples represent the principal agent problem. even if the behaviour of managers can be observed. This boon is a direct result of the employees.

known as agency conflict arises. If the owner give up a section of his stock and sell it to external investor. Assuming that the firm is a sole proprietor. but could exchange other reflection. This is known as uncertainty. a potential conflict of concern is present between the two groups. 5. a possible conflict of agency will occur. that making the decision they would also wish for increase in wages because it means more wealth for them.CORPORATE FINANCE efforts in to maximize the corporate and consequently shareholders wealth. Employees. For example manager who is owner as well might give the priority to more relax way of life and not work alike to exploit the wealth of shareholders. A possible conflict of agency arises when a manager of the corporation possesses less than the 100% of company¶s stock. 5. This is known as asymmetric information. the manager will obviously take action in the way to increase their own utility. and the management is in the hand of owner. The principle of self interested behaviour would propose that the stockholders wish for dividend option since it meant to be more money for them. on the other hand would wish for increase in wages since it means more money in their pocket. And managers also know the numerous factors to final result. The manager of firm decides that what would be the best use of the extra cash lying around as a liquid asset. because the owner manager doesn¶t have the 100% money in and manager now School of business and law Page 6 . such as leisure and privilege. Agents comprise the aptitude to work in for their self interest rather than performing best in the best concern of company due to the fact that managers know better than the shareholders that either they have the capability to meet the shareholder¶s objective. which was required to make extra income.0 ISSUES: Agency theory elevates primary problems in organisation---self-interested behaviour. A manager of a company has its own goals that contend with the owner¶s goals of maximizing shareholder wealth.1 Self-interested behaviour: The theory about agency illustrates that in those markets where there is no perfection in capital and labour. The managers have decided that the money will be use for one of two purposes: the employees would be rewarded by increasing their wages in respond to their efforts or the extra income for the shareholders who put their capital in. The self interest behaviour principle would suggest about the managers. As the shareholders of the organisation give the authority to the manager to manage the company¶s assets. and it may not be obvious that either the agent is going to cause the negative outcome or positive outcome. The manager (agent) will most likely evaluate benefit by own means. managers will be looking for exploiting the benefits for themselves through shareholders expense.

constraints and punishment. For example. and it is not practically possible for the shareholders to examine all those actions taken by managers.CORPORATE FINANCE ensue less of t e wealt Also t e owner manager might settle on to get more pri ilege because the outsi er sharehol er will now going to get some cost of benefits. who can simply brand out their individual assortment by buying share in the other firms. generating more opportunity for middle and the low level managers and enhancing their salary and their job safety because an inhospitable takeover is less alike.0 Control echanis and its i act on shareholders wealth axi ization Managers can be persuaded to perform similar to the shareholders interest by the means of incentive. In order to minimize this problem the stockholders must incur agency cost. Thus the present administration may track diversity through shareholders expense. Agency cost is defined as the cost which the shareholders incur in order to encourage managers to exploit shareholders wealth rather than acting for their personal interest. maximi ation coul be subordinated to an asso the manager of the firm may have an elemental objective to expand the firm¶s si e. 6. Hence the sharehol ers wealth rtment of other managerial goals. These methods ca be of well use when shareholders n can monitor each and every action taken by the managers. By crafting a large growing firm the management enhance personal position. The moral hazard can be occur if managers take actions for their own interest. School of business and law Pa e 7 . In large public firms the principal there is possibilit of agency conflict because the managers of the firm not own a high percentage of the stock.

Punishment means sacking the employee and takeover of the company. By lack of efforts by shareholders to amend managerial actions. On the other hand reward can be in different forms.CORPORATE FINANCE Agency cost has three major types: 1. it means that the company is not performing well. there will be usually some loss of shareholders wealth because of inappropriate managerial behaviour. Due to this. When the shareholders (principal) give the management (agent) stock. it means that principals are giving them a part of the ownership. reward and punishment. The solution to these problems is splitting in two ways. FIRING: If the managers doesn¶t perform well the company will do a bad job. restrict the capability of managers to take actions that maximize shareholders wealth. Because of that threat they will put their effort in for the sack of job safety. the big can will get the chance to take over the company. 3. Costs incurred to the formation the organisation in a way that will bound the adverse managerial actions. The better of them is rewarding the management (agent) through stocks option. Expenses which are incurred when the shareholders imposed limits. Alternatively agency cost would be unnecessary if the shareholders tried to make sure that every action taken by managers are be conventional with the interest of shareholders. for example voting of shareholders on specific problem. But this all happens in theory. Expenses incurred to monitor the managers activities are known as audit costs. change the management which was already working and will bring some new management. 2. Thus the agency cost bear by the shareholders can take into the account of cost benefit context. Because of that reason the management (agency) will perform in the company/shareholders (principal) best interest. by doing that they will maximize the market value of stock. TAKEOVER: If a company¶s management is not performing well. In this solution School of business and law Page 8 . there is a threat for the mangers that if the company is not performing well than might be manager will lose this job. which will increase their interest to maximize the market value of the stock. then this is a sign that they are not achieving its maximum market value. for example restructuring the business units of the company or hierarchy of the company. And if company is not doing good job. which definitely bring them huge profit. Agency cost must be increased as like each pound spends by shareholders results the increase of one pound in shareholders wealth. REWARDING: There are many approaches of rewarding the management.

5 * 20) + (0. commissions and etc. and on the basis of present capital format of equity and debt.5*20) + (0. In respect of that managers will try to work hard in order to maximize their own utility. Creditors are interested on part of firm income in the shape of interest and principal payment on debt and also they have a key argument on firm¶s assets in case of bankruptcy. Increase in the rewards in regarding to the targets is important. The scenario for these two projects is like: In project safe the return in bad time is £20 and in good time it is £30. There is a possibility of 50% of good and bad time occurring.50 £20 20 0 Expected value of project = (0. For example the stockholders are lending £20 from creditors. Creditor¶s loan the money to the company at the rates based on the risk integrated to firm¶s assets. Major issue among stock holders and creditors is that the creditors/bondholders/lenders get paid a fix amount and they will get paid before the stockholders will get. 7. There is a choice a investing in safe project and risky one.5*0) = £10 School of business and law Page 9 .50 Earnings £30 Creditors payout 20 Stockholders payout 20 Bad 0. agents are getting part of owner ship which results in avoiding different conflicts of interest by shareholders (principal) and the managers (agent). In this case shareholders needs to put a certain target which if the management will succeed to achieve they will get bonuses and commissions. The second approach is performance related pay includes bonuses. On the other side it will proportionally increase the shareholders wealth.0 A SECONDARY CONFLICT AGENCY STOCK HOLDERS VS CREDITORS: This conflict arises between stockholders and creditors. While stockholders uphold the control of operating decision those affects the firm¶s cash flow and their resultant risks.5 * 30) + (0. and also opportunities attached with the risky projects of these variables. Stockholders maintain the control through firm¶s managers. Payout to stockholders and creditors will be in the manner as follows: State Good Probability 0.5*20) = £25 Expected value of debt = (0.CORPORATE FINANCE the problem is not been eliminated.5 *20) = £20 Expected value of stock = (0.

5 *10) = £15 Expected value of stock = (0. Also in the course of threat of no future lending. Creditors seek to protect them by restricted agreement that which project can be taken and later on who get to loan the company.5*30) + (0.5*10) = £22. For example creditors want security for the loan and in that sense they can compel limit on loan agreement. who claims are the first legal priority in excess of shareholders. such as employees. Project risky return will be £35 in good times and in bad times it going to be £10 (possibility of occurring is 50%). Thus the situation of the shareholders gives them authority to control the business to make sure that their interest remains happen.CORPORATE FINANCE If the risky project will succeed stockholders will get the benefit because the lenders only receive the fixed amount. 8. School of business and law Page 10 . This is the primary objective of the business.5 * 20) + (0.5 * 35) + (0. In addition to this the stakeholders can protect themselves from losses through contractual agreement. Payout to creditors and stock holders will be in the manner as follows: State Good Probability 0.5*0) = £15 From the above calculation it shows that stockholders will prefer the risky project as it makes them extra £5 from creditors expense. customers.0 MAXIMIZING WEALTH: SHAREHOLDERS Maximization of shareholder¶s wealth involves the flow of dividend to shareholders for long term. If the business fails shareholders can claim the assets of the business will go to the bottom of the quantity. In good times shareholders get benefit but in the hard times they should bear losses.50 Earnings £35 Creditors payout 20 Stockholders payout 25 Bad 0. The situation of shareholders distinct with the other stakeholders.50 £10 10 0 Expected value of project = (0.5 Expected value of debt = (0. creditors and suppliers. While shareholders are the one who owns the business and bears the enduring risk. This is the agency conflict between creditors and stock holders.

what are the issues which gives rise to these conflicts. There is also a secondary agency conflicts which usually lies between School of business and law Page 11 . for that they will have to increase the profit and business size to the benefit of all. due to risk involved. Even so they will be required to please the shareholders needs. The executives may also prefer to avoid the new projects if they suffer with their job security. and also how to overcome these issues and its impact to shareholders wealth maximization. which will have vital benefits of all those associated with the business. such as employees. Job competition for executives and also shareholders rivalry. suppliers will not get advantage. it¶s difficult for the executives to stay away from shareholders wealth maximization. This will give an opportunity to business seekers to take over the company. and also on the relationship between principal and agents.CORPORATE FINANCE Another risk in shareholders wealth maximization is that the directors might misuse the resources to get extreme rewards for them. Monopolists maximize the profit through reducing output and by increasing prices. Directors are aware from the fact that if the shareholders will not consider of being satisfied. lenders etc. and generates as much money as possible in the presence of basic rules of the society. as compared to other stakeholders. The shareholders wealth maximization will only be beneficial for the stakeholders if there is strong market competition. The objective of maximizing shareholders wealth is that it persuade industrial activity.0 CONCLUSION: The report concludes the conflict between principal (shareholders) and agent (managers). the executives are the employees. connive that shareholder needs are success. might be they find the deprived profit record. so they have direct responsibility to the employers/owners. It is the responsibility of the employees to conduct the business in according to the interest of their employees. The report also concludes the self interest behaviour of individual. Even if they neglect it. According to Milton Friedman ³ In a free enterprise. then they might get replaced from other executives. In a competitive market. thus lowering the share price. If the competition is not strong it means that the company is intense in the hands of monopolists. 9. involves the relationship between the managers and shareholders. they are likely to change the management to enhance their profitability. By having the enduring claim on the benefits shareholders have a reason to increase the size by undertaking new and risky projects. This is beneficial for shareholders but the stakeholders like employees. Shareholders have enduring claim on the business benefits. Since in these circumstances shareholder is the one who must bear this cost and the directors have to be accountable for that. Because they usually obtain fixed claim. On the other hand the stakeholders will prefer to avoid new ventures to minimize the risks. This will authorise shareholders to sell their shares. Milton also quoted that the directors who do not look for shareholders wealth maximization are in fact stealing from them. what impacts these issues are putting on a firm.

1.html) 5.doc -) 9. Web (forumserver. Web (www.com/student/dipfm/module_b/tech.com/how-to-solve-principal-agent-problem/) 6.investorwords./principal_agent_relationship./3445864) 10. August 1998.ruf. and Investing) 8. Web (www.com/money-words_term_151_agency.edu/courses/spring02/Fin/36054/ .advn." Journal of Law and Economics 26 (1983). Web (http://www. WEB REFERENCES: 1. Web (business. Finance. and Capital Structure.sayeconomy.com/encyclopedia/A-Ar/Agency-Theory. "Agency Costs./chapter1.0 REFERENCING: 10. The report also comprises the discussion on shareholders wealth maximization and other objectives related to it..definitions. "Agency Problems and Residual Claims... Fama. > Business. Web (www.. Leland E..kent. Web (www. 10. 2." Journal of Finance.. Web (http://www. Hayne.html) 3.referenceforbusiness. JOURNALS: 1.. Web (www.com/.com/biz-encyclopedia/agency-theory#conflicts-betweenmanagers-shareholders) 10.accaglobal. Web (www2.html) 2.rice.CORPORATE FINANCE stockholders and creditors. and Michael Jensen.com > .2. Eugene. School of business and law Page 12 .html -) 4.net/definition/principa) 7. 327-349.twoplustwo.. Risk Management.enotes.edu/~schuler/principal-agent.

4. New York: Oxford University Press. Handout 3. Giinter. and Klaus Spremann. 1992. "Theory of the Firm.. BOOKS: 1. Meckling." Journal of Financial Economics 3 (October 1976). Berlin: Springer-Verlag.5. 4 Sydney Law Review December 2007 pp577 -612. Agency Costs. School of business and law Page 13 . Frieman M. Managerial Behaviour. Bamberg. Tackling the issue of the corporate objective: an analysis of the United Kingdom's 'Enlightened Shareholder Value Approach'. 13 September 1970 10. and William H. Norman E. and Agency Theory: An 3. Keay A. Lectures 2. and R.3. 1987. OTHERS: 1. 10. and Ownership Structure. Agency Theory. The social responsibility of business is to increase its profits. Jensen. New York Times. Michael C. 2. Edward Freeman. and 1. 305-360 10. Incentives. Information. Volume 29 No. Bowie. Ethics Introduction..CORPORATE FINANCE 3. Notes. Bibliography: eds.