Agency Relationship

Agency relationship:

Managers have personal goals that personal interest competes with the wealthy maximization of goal of the shareholders, managers were empowered by the owners through their voting rights, and this brings about the conflict of interest known as agency theory,

An agency relationship arises out of the when one or more individuals known as principals hire another individual known as agent, that person is delegated the authority of decision making. There are two type of agency problems:

1. Stockholders and managers
2. Stockholders and bondholders

Conflicts between managers and stockholders and bondholders

Manager’s personal goals may conflict the shareholders’ wealth maximization goal. Many managers pay excessive salaries bonuses or participate their own birthdays which is very costly to the company.

The following are useful motivational tools:

1. Reasonable compensation

Compensation should be sufficient enough to make sure the manager is retained while he performs well. The package should not go beyond what is necessary to motivate.  Compensation should be structured so that the manager is adequately rewarded, depending stocks’ performance on the long run the firm’s business. The price of the stock should be based on the market price, but it must reflect the average over certain time.

1. Direct intervention

Shareholders can intervene with the managers.  Unlike the past individual stock owners now, institutional investors replaced individuals they intervene if they suspect under performance from time to time, they don’t only oversee but also have to do with the running the company. They talk to the manager and give suggestion on how well the firm should be run.

1. Threat of firing

Until recently, firing managers was almost impossible however it become increasingly important having retaining the management depended on the performance. If their performance remains poor the company immediately fires the managers on the ground their poor performance.

1. Hostile takeovers

If the company’s value is undervalued corporate raiders will see as advantage to capture the corporation through hostile takeovers, hostile takeover is referred as:  the acquisition of a company over the opposition of the management.

Stockholders versus Bondholders

1. Fixed payment regardless if the company’s project is successful or not
2. Over the use of additional debt which risks the payment of the current debts. The more the debt the higher the risk
3. Bondholder protects themselves by limiting firms’ access to additional debts through agreement before they accept the bonds; this prevents the company from acquiring additional debts which is in the interest of the bondholder rather than the firm.
4. Sometimes the bond value reduces due to the fact that the company can make the deal now as time passes the value of the bond declines through inflation, etc which is not in the interest of the bondholders

Chapter 6

Time value of money

Time lines

One of the most important tools used by the analyst to find out what is going to happen in particular problem; the tool also helps the experts to find solution for the problem.

Example

Time zero is today, time 1 is one period from today. The time can be either be at the beginning or at the end of a period.  Time 2 is two periods from today and so on and so forth.