Agency Relationship and Corporate Governance
What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.
An agency relationship is a relationship between two parties, and it is created by law. An agency relationship comes into existence when there is a principal and an agent who works for his principal. The principal gives the authority to its agent, who acts on his behalf. The authority can vary according to the nature of work, and it can be to take decisions or to deal with third parties and so on.
If you have begun business operations and you are the only employee, it means that you are performing all the business activities and you have invested the entire capital. In this case, there is no delegation of authority, and there is no agent to work on behalf of the principal. So there will be no agency conflict. Generally, agency conflicts occur when there is more than one person that works to attain the same common objective.
If you expanded and hired additional people to help you, might that give rise to agency problems?
Yes, it will certainly give rise to agency problems. Hiring additional employees and expansion in the operations of the business will require the principal to assign work and responsibilities to its agents. The agent will also be assigned a few powers to complete the work assigned. This will create a relationship between the principal and the agent. Now everything will depend on the performance of the agent. If the agent will not be able to perform according to the expectations of the principal, it will give rise to the agency problem.
Suppose you need additional capital to expand, and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur?
Sourcing additional capital to expand the business operations by way of issuing stock to outside investors will give rise to agency problems. The selling of stocks means that you are transferring a certain percentage of ownership to some other person. The agency conflict that will arise in such a case will be the conflict among managers and stockholders, and the entire cost of such conflicts is borne by the shareholders. Such kind of conflicts occurs due to the difference in the interest of managers and shareholders. The managers are more ambitious and are ready to take more risks to maximize the revenue and profits, whereas the managers and the shareholders have different perspectives, and they are in favour of taking less risk in business operations.
Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate agency costs?
Borrowing money from outside lenders not only gives rise to interest costs, it also increases the number of agency costs. If everything goes well in the course of business, then there is no problem. The borrowing of money leads to more business activities that add to the profitability of the business, and shareholders are directly benefitted from it whereas the interest rate of the lender does not change and is fixed. Contrary to, the shareholder also stands with the risk of losing his investments if the business ceases due to high losses. In such cases, the agency problem arises, and it gives rise to agency costs. These are the costs that are mainly opportunity costs. It is an opportunity cost for the lender as he could have earned a return on his money by lending to the second-best alternative.
Suppose your company is very successful, and you cash out most of your stock and turn the company over to an elected board of directors. Neither you nor any other stockholders own a controlling interest (this is the situation at most public companies). List six potential managerial behaviours that can harm a firm’s value.
A number of publically traded companies are controlled by the managers. The shareholders appoint managers to run the business operations of the company, and there is no owner of the company. It gives birth to a high level of leverage for the managers. They start behaving in an arrogant manner and do not pay full emphasis on the smooth working of the business. As a result of it, the companies sustain significant losses and the performance of the business of the company is hampered. Some of the managerial behaviours that can harm the firm’s value are discussed hereunder:
- The managers can reduce the dividend payout to keep more money with them for business expansion and acquisitions.
- They do not work wholeheartedly for the welfare of the company, and the growth of the business of the company is
- The managers also tend to make financial benefits from the company, which significantly dents the image of
- They could also take biased decisions to pass on the maximum benefit to their relatives and friends.
- They may protect the company from undergoing projects with positive NPV and more risk as they do not want to get blamed if the project does not.
- They can also undergo projects with negative NPV so as to hit home.
What is corporate governance? List five corporate governance provisions that are internal to a firm and are under its control.
All companies and businesses are governed by some of the rules to run the business. Corporate governance refers to the procedures and rules used to control and direct the business operations of the company. It attempts to make a balance between the various stakeholders. These different stakeholders are creditors, employees, vendors, suppliers, management, lenders, etc. The five corporate governance provisions internal to a firm are discussed hereunder:
- Proposing and adopting an optimum capital
- Creating bye-laws and provisions to prevent any hostile
- Reviewing and checking the performance of the
- Monitoring the accounting system of the business and making changes, if
What characteristics of the board of directors usually lead to effective corporate governance?
The following are the characteristics that the board of directors leads for effective corporate governance:
- The Chairman of the board and the Chief Executive Officer are not the same
- The majority of the board members are
- The number of members on the board is not too high.
- The board members are paid suitable.
List three provisions in the corporate charter that affect takeovers.
- The three provisions are discussed hereunder:
- Repurchase of targeted shares as treasury
- Controlling the voting rights of the members.
- Rights and provisions of the shareholders.
Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as a form of compensation?
Stock options are one of the methods adopted by companies to compensate their employees. In this system, the employees are offered the stocks of the company. These stocks are issued at a predetermined price, and this price is called the strike price. There is also a timeframe attached to the stock options. The stock options are also helpful in promoting the long-term relationship of the employees with the company and also facilitate a high level of commitment among the employees. Following are a few potential problems with stock options:
- It can lead the managers to do manipulations or window dressing in preparation for financial statements so that the price of the stock may
- The managers to whom stock options are issued will be facilitated with high compensation irrespective of poor performance of the business of the company
What is block ownership? How does it affect corporate governance?
Block ownership is ownership which is created when an outsider owns a large share of the total shares of the company. In such cases, the block owner assumes control over the working of the company. The impact of block ownership on corporate governance is that it leads the block owner to influence the decisions according to his wish by using the voting right. The positive impact of block ownership is that the block owners monitor the working of managers on a regular basis and also take active participation in a number of matters of the company to facilitate a high level of governance.
Briefly explain how regulatory agencies and legal systems affect corporate governance.
Corporate governance is affected by a number of factors, and compliances with regulatory agencies and legal systems are major among them. These compliances are important from the investor’s point of view as they protect the investors from being exploited by the majority shareholders or block owners. They also facilitate the companies to have fast access to the financial markets and to raise equity easily, as and when required.
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The main goal of financial management is to maximize intrinsic stock value for the benefit of society. In this sphere, special companies minimize costs through innovation in the production process, create value for the customer by providing quality services and products, and creating value for employees through training and development and foster an environment that allows employees to utilize their skills and talents.
Suppose you decide to start a company. Your product is a software platform that integrates a wide range of media devices, including laptop computers, desktop computers, digital video recorders, and cell phones. Your initial market is the student body at your university. Once you have established your company and set up procedures for operating it, you plan to expand to other colleges in the area and eventually go nationwide. At some point, hopefully sooner rather than later, you plan to go public with an IPO, then buy a yacht and take off for the South Pacific to indulge in your passion for underwater photography. With these issues in mind, you need to answer for yourself and potential investors the following questions.
Assignment: Write a short answer to these questions using the above case.
- What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.
- If you expanded and hired additional people to help you, might that give rise to agency problems?
- Explain why “maximation of shareholders’ wealth” is the appropriate goal of the firm.
- What items of good corporate governance serve to mitigate the tension between owners and managers?
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