Agency problem is the likelihood that managers may place personal goals ahead of corporate goals. A characteristic feature of corporate enterprises is the separation between ownership and management. Thus, with the objective of survival, management would aim at satisfying instead of maximizing shareholder’s wealth.
The agency problem can be prevented by: Market Forces Agency Costs Market Forces: It is of two types: Behaviour of security market participants Hostile Takeovers
• Behaviour of security market participants: The participants include institutional investors(mutual funds, insurance etc.) actively participate in management. They use their voting rights to replace more competent management.• Hostile takeovers: It is the acquisition of the firm by another firm that is not supported by management. The constant threat of takeover motivate management to work for maximising owner’s wealth.
These are the costs borne by shareholders to prevent agency problem as to maximise owners wealth. They have to incur 4 types of costs: Monitoring Bonding Opportunity Structuring
Monitoring the activities of the management to prevent satisfying and maximising owner’ wealth. It relates to the payment for audit and control procedures to ensure that management is working for maximising owner’s wealth. Bonding protects the owners from the consequences of dishonest acts by management/managers. They firm pays to obtain a fidelity bond from a third party bonding company to compensate for financials loses due to dishonest acts.
Opportunity costs are those which results from the inability of the firm to respond to new opportunities. Due to organisational structure, hierarchy etc. the management faces difficulties in seizing profitable investment opportunities. Structuring expenditure relates to structuring managerial compensation to maximise owner’s wealth.
It is of two types:1. Incentive Plans2. Performance Plans Incentive Plans: They tie management compensation to sare price. The most widely used plan is stock options which allows management to acquire shares at special prices. Higher price will result in larger management compensation.
Performance Plans: These plans compensate management on the basis of its proven performances. Performance shares are given to management for meeting the stated goals Another type, cash bonuses – cash payments are given for achievement of the stated performance goals.