Agent Problem

The relationship between stockholders and management is called an agent relationship. Such a relationship exists the whenever someone (principle) hires another (agent) represent his or her interest. In the agent relationship, management and stockholder might have different interests; therefore, a possibility of conflict of interest might exist. Such a conflict is called agency problem.

Hires

Self-

interest Self-

interest

Performs

For Example, a new investment plan is considered which expect to favourably impact stock price, however, It also have a relatively risk. Because the stock price will rise, the stockholder will wish to take the investment, but management might not because the investment may fail that the management jobs will be lost. But if management does not take the investment, then the stockholders lose a chance to make money. This example is called agency cost. However, if left to themselves, managers would focus on the business power or wealth. This goal could case to an overemphasis on business size or growth. Therefore, management keep organizational survival to security.

As the graph shown, there is information asymmetric between stockholder and management. Management to a transaction has more or better information than the stockholders. This creates an imbalance in power in transactions. Asymmetric information can be financial information and business information. Also a self-interested manager could divert company funds for consumption of value-reducing private benefits. Increasing the debt level (and reducing outside equity) aligned the manager with the investors by increasing the manager’s personal equity stake in the firm, hence reducing his incentives to take private benefits and considered self-interested managers’ incentives to waste free cash flow on empire-building, value-reducing, projects. Increasing debt commits managers to paying out to debt holders, hence reducing the free cash flow problem. There are always empire building appear in the management as the manager allowed to hire staff based on the relationship rather than employ based on ability. Therefore, the manager can build up his or her kingdom in the company. Moreover, managers tend to evaluate projects based on the short-term profits that typically determine their own remuneration (Sternberg 2004). The issue is that managers may make decisions, not for long-term financial growth, but to increase their own wealth. While it seems that this might benefit shareholders, these short-term decisions can often have negative affects in the future and are not necessarily good for shareholders. In addition, since managers have more information about company performance than do shareholders, there is a fear that management will abuse their power to make themselves wealthier at the cost of long-term financial stability. Different view for evaluation of risk, Different people is willing to take different level of risk, manager might take too much risk as the shareholder doesn’t want to or manager take too few risk that does not appreciate the shareholders.

In additional, the single owner-manager (which called “insider” blew) 100% owns and runs the firm, and firm value is influenced by the quantity of perks consumed (perk). The value of the firm will be V* and the perks consumed, F*. The maximum a potential buyer (outsider) of equity in the business will be willing to pay, provided the perk consumption is guaranteed to remain the same, will be V*. after a fraction of the firm has been sold be a, then the outsider now owns (1-a), (0<a<1). As a result the insider no long bears the full cost of the perks taken.

As the diagrams shown below, the insider will move to point A to achieve the highest available indifference curve, with perks F0 and wealth V0. After the sale, the constraint is given by V2P2, this represents the new trade-off between perk and wealth. this represents the new trade-off between perks and wealth. B is the only point that will be acceptable to both parties. . V*-V’ is the reduction in market value by introducing the agency relationship. This is the agency cost of the sale of outside equity in the absence of monitoring and bonding activities. The cost is entirely borne by the insider, whose total wealth after the sale is V’.

Without monitoring, and with outside equity of (1-a), the value of the firm is V’ and the consumption