Tam Lai Ying Law Tsz Yeung Au Man Hung

An agency relationship exists when: Shareholders(Principals) Firm Owners Managers(Agents) DecisionMakers which creates Agency Relationship Risk Bearing Specialist (Principal) Managerial Decision- Making Specialist (Agent) HireHire Agency 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 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

4 Agency Problem of Outside Equity Managers expropriate wealth from shareholders Moral hazard problems Excessive perquisite consumption Underinvestment due to risk aversion/short horizon Accept poor investment projects (NPV<0)

5 Examples of Agency Problems/Costs Direct expropriation Take cash out Looting assets, low transfer pricing Indirect expropriation by non-optimal investing Empire building: excess firm expansion Underinvestment/Overinvestment Not maximizing shareholder wealth Making poor capital budgeting decisions (incorrect method, execution, etc.) Decision making based on managers wealth maximization not shareholders Inefficient actions Shirking (too little effort) Excess consumption of perks Illegal actions Misleading statements Insider Trading

6 Encourage excess risky investments Realized Profit = $100 –Debt: $50 –Management: $30 –Employees: $20 –Shareholders: $ =0 Realized Profit = $0 –Debt: $0 –Management: $0 –Employees: $0 –Shareholders: $ =-100 –BANKRUPT! Realized Profit = $400 –Debt: $50 –Management: $30 –Employees: $20 –Shareholders: $ = 300 Realized Profit = $300 –Debt: $50 –Management: $30 –Employees: $20 –Shareholders: $ = 200 Expected Profit=$200 with two possible outcomes Possible Outcomes: $100 or $300 Possible Outcomes: $0 or $400

7 Earnings Game CFO’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 spending 55% would sacrifice small value projects

8 Agency Problem of Overvalued Equity “Overvalued”: When management knows they can not sustain value Managers more likely to behave sub-optimally Target based corporate budgeting systems Manipulation of both target and realized result Skew preference for short term cash flows (earnings) Excessive risk taking: Place high risk bets Earnings management: More likely and higher error Jensen (2005)

9 Agency Problem of Debt Equityholders expropriate wealth from debtholders Moral hazard problems Overinvestment, risk shifting, asset substitution Debt overhang, underinvestment Claim dilution Take 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 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 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

13 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 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