Question

Discuss a recent case of agency problem and how it affected the shareholders. Discuss how this issue could have been mitigated.

Answer 1

In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.Agency problem arises when incentives or motivations present themselves to an agent to not act in the full best interest of a principal.Example is as follows:

Executive Compensation and WorldCom

When an executive uses company assets to underwrite personal loans, the agency problem occurs as the company takes on debts to provide its executives with higher incomes. In 2001, WorldCom CEO Bernard Ebbers took out over $400 million in loans from the company at the favorable interest rate of 2.15 percent. WorldCom did not report the amount on its executive compensation tables in its annual report. Details of the loans did not come out until the company's accounting scandal

This issue can be mitigated by:

1.Managerial Compensation:Managerial compensation refers to the incentive mechanism for the good performance of the management. Their objectives are to attract and retain able managers and to harmonize managerial actions with the interest of shareholders. Several measures are used to evaluate managers' performance. Some of the most common are sales, profit, current value of expected cash flows and value added.

2. Shareholder control and interference:Shareholders can influence the company's management in two ways. Firstly, they can influence management directly as to how the company should be managed. Secondly, any shareholder can make a proposal which is voted on at the annual general meeting (AGM).

3. Threat of dismissal:in the past it seldom happened that a senior manager or chief executive officer was dismissed by shareholders. The reason for this was possibly that the ownership of a great number of companies was dispersed, as well as the fact that the agency problem was only brought to the attention of shareholders (and management) over the past two decades.

4. Threat of take-overs:the threat of a take-over serves to monitor the actions of management. If the actions or decisions of management decrease the future earnings or value of shareholders, the share price usually decreases as well. In some instances, the company can become a take-over target. If the management of such a company is replaced, the move can benefit the shareholders. The threat of take-overs can thus serves as an external control mechanism which ensures that the decisions and actions of management maximize shareholders' wealth.