Tam Lai Ying 08028796 Law Tsz Yeung 08031916 Au Man Hung 08026130.

Tam Lai Ying 08028796Law Tsz Yeung 08031916Au Man Hung 08026130

An agency relationship exists when:An agency relationship exists when:

Shareholders Shareholders (Principals)(Principals)

Firm OwnersFirm Owners

Managers Managers (Agents)(Agents)

DecisionDecisionMakersMakers

which createswhich creates

Agency RelationshipAgency Relationship

Risk Bearing SpecialistRisk Bearing Specialist(Principal)(Principal)

Managerial Decision-Managerial Decision-Making SpecialistMaking Specialist

(Agent)(Agent)

HireHireHireHire

Agency TheoryAgency Theory

The Agency problem occurs when:

- - The desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved appropriately

Agency TheoryAgency Theory

•Equity: Potential conflict between shareholders and managers (principal-agent problem)

•Traditional: Outside (non-management) shareholders•Overvalued equity

•Debt: Potential conflict between shareholders and debt holders

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Agency Problem of Outside Equity

Managers expropriate wealth from shareholders

Moral hazard problemsExcessive perquisite consumptionUnderinvestment due to risk

aversion/short horizonAccept poor investment projects (NPV<0)

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Examples of Agency Problems/CostsDirect expropriation

Take cash outLooting assets, low transfer pricing

Indirect expropriation by non-optimal investingEmpire building: excess firm expansionUnderinvestment/OverinvestmentNot maximizing shareholder wealth

Making poor capital budgeting decisions (incorrect method, execution, etc.)

Decision making based on managers wealth maximization not shareholders

Inefficient actionsShirking (too little effort)Excess consumption of perks

Illegal actionsMisleading statementsInsider Trading

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Encourage excess risky investments

• Realized Profit = $100– Debt: $50

– Management: $30

– Employees: $20

– Shareholders: $0• 100-50-30-20 =0

• Realized Profit = $0– Debt: $0

– Management: $0

– Employees: $0

– Shareholders: $0• 0-50-30-20=-100

– BANKRUPT!

• Realized Profit = $400– Debt: $50

– Management: $30

– Employees: $20

– Shareholders: $300• 400-50-30-20 = 300

• Realized Profit = $300– Debt: $50

– Management: $30

– Employees: $20

– Shareholders: $200• 300-50-30-20 = 200

Expected Profit=$200 with two possible outcomes

Possible Outcomes: $100 or $300 Possible Outcomes: $0 or $400

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Earnings GameCFO’s were asked if they were not on

target for earnings which actions would they consider doing (Graham, Harvey & Rajgopal, 2004).

80% would delay discretionary spending55% would sacrifice small value projects

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Agency Problem of Overvalued Equity “Overvalued”: When management knows they

can not sustain value

Managers more likely to behave sub-optimallyTarget based corporate budgeting systems

Manipulation of both target and realized resultSkew preference for short term cash flows

(earnings)Excessive risk taking: Place high risk betsEarnings management: More likely and higher

errorJensen (2005)

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Agency Problem of DebtEquityholders expropriate wealth from

debtholders

Moral hazard problemsOverinvestment, risk shifting, asset

substitutionDebt overhang, underinvestmentClaim dilutionTake the money and run!

Used in corporations to establish order between the firm’s owners and its top-level managers

Corporate Governance is a relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations

Concerned with identifying ways to ensure that strategic decisions are made effectively

Corporate Governance

Recommendations for more effective Board Governance:

Governance Mechanisms

Board of DirectorsBoard of DirectorsBoard of DirectorsBoard of Directors

Strengthen internal management and accounting control systems

Establish formal processes for evaluation of the board’s performance

Increase diversity of board members backgrounds

Governance Mechanisms

Executive CompensationExecutive CompensationExecutive CompensationExecutive Compensation

Salary, Bonuses, Long term incentive compensation

Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes

In addition, stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their control

Incentive systems do not guarantee that managers make the “right” decisions, but they do increase the likelihood that managers will do the things for which they are rewarded

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Empirical Evidence: Effective Governance

Board Composition: Should have a majority of outside directors, i.e. independent board

CEO/Chairman should be separate role

Number of boards a director sits on

Corporate Governance and Ethical BehaviorCorporate Governance and Ethical Behavior

It is important to serve the interests of multiple stakeholder groups

Shareholders are one important stakeholder group, which are served by the Board of Directors