Agency Problems in Finance

Contracting & Corporate Governance

Agency Problems  Incentives and information – No problems if either is perfect  Two possibilities – Owner is sole employee – Principal/Owner hires agent .

Owner-managed  Maximize Individual Utility – Tradeoff profits against own interests – Discount cash flows at “personal” rates Firm risk = Personal risk  Capital constrained manager might sacrifice long term cash flow for short term cash flow  .

Firm with Outside Investors  Shareholders own the company. by law – Managers have a fiduciary duty to maximize wealth of shareholders . so prioritize their interests – All shareholders like Money so.

Goal of Maximizing Shareholder Wealth    What about other stakeholders? Often (not always) goals overlap „Nexus of Contracts‟ – Labor – Customers – Creditors  Legal and regulatory constraints .

Moral Hazard   Hidden Action Solutions: – – – – Write contracts to mitigate problem Monitor Align incentives Don‟t delegate .

Adverse Selection   Hidden Information Solutions: (signaling and screening) – Guarantees/warranties – Reputation/brand names – Lemon laws .

Agency Problems in Corporate Finance  Capital providers – What firm will do with capital – Quality of firms seeking capital  Capital seekers need to consider these concerns .

Types of Conflicts     Intra-firm conflicts Reorganization conflicts Stockholder/Bondholder conflicts Stockholder/Manager conflicts .

Intra-firm Conflicts   Firms aren‟t monolithic Divisions raise capital from HQ – analogous to problem of firms raising capital from external markets  Corporate socialism .

Restructuring – Creditors – Managers – Stockholders .Reorganization Conflicts   Going Public Liquidation vs.

Stockholder/Bondholder Conflicts    Increase dividends Subordination of claims Asset substitution .

Solutions     Direct monitoring Bond covenants Reputations Contract design .

Stockholder/Manager Conflicts     Shirking Perquisites Entrenchment Outright theft .

Solutions  Carrots – Compensation contracts – Larger ownership stakes  Sticks – Pressure from inside the firm – Pressure from outside the firm .

Role of Governance  Capitalism requires reliable information Good governance – Oversight   Formal & informal Firms that minimize costs survive – Competition  .

Corporate Governance  Cash rich firms with excess capacity – No pressure to use equity capital efficiently Takeovers Changes in Compensation –1980: <20% of total CEO comp. was equity based –1994: ~50% of total CEO comp. was equity based  Accounting Scandals – 2002: Sarbanes Oxley No loans to management Required auditor independence Penalties for incorrect financial statements .

Concluding Thoughts    Agency problems arise frequently Contracts and markets evolve to mitigate problems Legal system and political/regulatory system have an important role .

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