THE EFFECT OF AGENCY PROBLEMS IN VALUE MAXIMIZATION Siti Balkish Roslan ZP01796 Financial Management 2/2013
According to HBS Professor Michal C. Jensen, many managers are caught in between the desire to maximize the value of their companies and the demands of “stakeholder theory” to take into account the interests of all the stakeholders in a firm.
It is already agency problems arise within a firm whenever managers incentives to pursue own interests at the shareholder expense. This is common knowledge in the business world. There have also been devises and mechanisms that have been created to reduce these problems such as managerial shareholdings, concentrated shareholdings by institutions or by block holders, which can increase…show more content…
A firm cannot maximize value, Jensen writes, if it ignores the interests of its stakeholders. But a melding of new interpretations of both value maximization and stakeholder theory is necessary, he writes, to make possible the "long-run maximization of the value of the firm as the criterion for making the requisite tradeoffs among its stakeholders." He calls this the ENLIGHTENED VALUE MAXIMIZATION and the ENLIGHTENED STAKEHOLDER THEORY. Enlightened value maximization as understood in a new light and explained is that it recognizes communication with and motivation of an organization's managers, employees, and partners is extremely difficult. What this means in practice is that if we tell all participants in an organization that its sole purpose is to maximize value, we would not get maximum value for the organization. (Jensen, 2000)
Enlightened stakeholder theory is explained as follows. It can take advantage of most that stakeholder theorists offer in the way of processes and audits to measure and evaluate the firm's management of its relations with all important constituencies. Enlightened stakeholder theory adds the simple specification that the objective function of the firm is to maximize total long-term firm market value. In short, changes in total long term market value of the firm are the scorecard by which success is measured. (Jensen, 2000)
In conclusion, none of the above arguments depend on value being easily observable. Nor do they depend
Why conflict of interest between owners and management?
The control of the modern corporation is frequently placed in the hands of professional non-owner managers. We have seen that the goal of the financial manager should be to maximize the wealth of the owners of the firm and given them decision-making authority to manage the firm. Technically, any manager who owns less than 100 percent of the firm is to some degree an agent of the other owners. In theory, most financial managers would agree with the goal of owner wealth maximization. In practice, however, managers are also concerned with their personal wealth, job security, and fringe benefits, such as country club memberships, limousines, and posh offices, all provided at company expense. Such concerns may make managers reluctant or unwilling to take more that, moderate risk if they perceive that too much risk might result in a loss of job and damage to personal wealth. The result is a less-than-maximum return and a potential loss of wealth for the owners.
Why conflict of interest between shareholders and management?
To address the conflict of interest between shareholders and management, it is important to stress that even within the same class of shareholders, there may be conflicts, this conflict may relate to what proportion of the company’s profit should be paid in the form of dividend and what proportion should be retained for future investments and for capital investment purposes. Other potential conflicts may involve company’s ethical policies, its corporate and social responsibilities policies. The agency theory, considering the potential conflicts of interest between shareholders and management may arise as a result of several factors, some of such factors include:
- Reward to management
- Risk attitudes of management and shareholders
- Takeover decisions by management
- Time horizon of management
From this conflict of owners with management and shareholders with management arises what has been called the agency problem-the likelihood that managers may place personal goals ahead of corporate goals.
The agency problem generally refers to the conflict of interest between management and ownership in a business enterprise. Ownership is primarily focused on maximizing its wealth through the business, while management is primarily interested in maximizing and stabilizing its income without incurring significant risk.
Two factors-market forces and agency costs-act to prevent or minimize agency problems.
- Market Forces: One market force is major shareholders, particularly large institutional investors, such as mutual funds, life insurance companies, and pension funds. These holders of large block of a firm’s stock have begun in recent years to exert pressure on management to perform. When necessary they exercise their voting rights as stockholders to replace under performing management. Another market force is the threat of takeover by another firm that believes that it can enhance the firm’s value by restructuring its management, operations, and financing. The constant threat of takeover tends to motivate management to act in the best interest of the firm’s owners by attempting to maximize share price.
- Agency Costs: To minimize agency problems and contribute to the maximization of owners’ wealth, stockholders incur agency costs. These are the costs of monitoring management behavior, ensuring price. The most popular, powerful, and expensive approach is to structure management compensation to correspond with share price maximization. The objective is to compensate managers for acting in the best interests of the owners. This is frequently accomplished by granting stock options to management. These options allow managers to purchase stock at a set market price; if the market price rises, the higher future stock price would result in greater management compensation. In addition, well-structured compensation packages allow firms to hire the best managers available. Today more firms are tying management compensation to the firm’s performance. This incentive appears to motivate managers to operate in a manner reasonably consistent with stock price maximization against dishonest acts of management, and giving managers the financial incentive to maximize share.
The agency problem can be defined as a conflict when the agents entrusted with the responsibility of looking after the interests of the principals choose to use the power or authority for their benefits and in corporate finance. It is a conflict of interest between its management and stockholders.
It is a common problem in almost every organization, whether a church, club, company or government institution. A conflict of interest occurs when responsible people misuse their authority and power for personal benefits. However, it can be resolved if only the organizations are willing to fix it.
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Types of Agency Problems
Every organization has its own set of long-term and short-term goals and objectives that it wishes to achieve in a predetermined period. In this context, one must also note that the management’s plans may not necessarily align with the stockholders.
The management of an organization may have goals that are most likely derived to maximize their benefits. On the other hand, an organization’s stockholders are most likely interested in their wealth maximizationWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits.read more. This contrast between the goals and objectives of the management and stockholders of an organization may often become a basis for agency problems. Precisely speaking, there are three types which are discussed below: –
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- Stockholders vs. Management – Large companies may have many equityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more holders. It is always crucial for an organization to separate management from ownership since there is no reason to form a management part. Segregating rights from management has endless advantages as it does not affect regular business operations. The company will hire professionals to manage the key functions of the same. But hiring outsiders may become troublesome for stakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes.read more. The managers hired may make unjust decisions and misuse the shareholders’ money, which can be a reason for the conflict of interests between the two and agency problems.
- Stockholders vs. Creditors – The stockholders might pick up risky projects to make more profits. This increased risk might elevate the required ROR on the company’s debtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more. Hence, the overall value of the pending debts might fall. If the project sinks, the bondholders will supposedly have to participate in losses, resulting in agency problems with the stockholders and the creditors.
- Stockholders vs. Other Stakeholders – The stakeholders of a company may have a conflict of interests with other stakeholders like customers, employees, society, and communities. For example, the employees might be asking for a hike in their salaries which, if rejected by the stakeholders, there is a probability of agency problems occurring.
Example
ABC Ltd. sells gel toothpaste for $20. The company’s stockholders raised the selling price of the toothpaste from $20 to $22 to maximize their wealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation.read more. This sudden unnecessary rise in the cost of toothpaste disappointed the customers and boycotted the product sold by the company. Few customers who bought the product realized a fall in the quality and were utterly disappointed. It resulted in agency problems between the stockholders and the loyal and regular customers of the company.
Causes
There can be various causes of agency problems. These causes differ from the position of an individual in the company. However, the root cause of these problems is the same in all mismatch or conflict of interests cases. When the agenda of the stockholderA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares.read more clashes with the other groups, the agency problem will occur. In the case of employees, the reason would be the failure of stockholders to meet employees’ expectations concerning salary, incentives, working hours, etc.
In the case of customers, the cause would be the failure of stockholders to meet customers’ expectations like the sale of poor-quality goods, poor supply, high pricing, etc. In the case of management, the causes of agency problems could be the misalignment of goals, separation of ownership and control, etc.
Solutions to Agency Problems
The companies can resolve the agency problems between the stockholders and the company’s management by offering stock packages or commissions for the decisions taken by the administration and their outcomes on the shareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more. In addition, the companies can try to resolve these problems that can exist between its stockholders and management/ creditors/ other stakeholders (employees, customers, society, community, etc.) through taking instituting measures like tough screening mechanisms, offering incentives for good performance, and behavior and likewise penalizing for poor performance and bad behavior, and so on. However, an organization cannot completely heal from agency problems since the associated costs outweigh the total outcomes sooner or later.
Conclusion
Agency problems are the mismatch of interests between the company’s management/ creditors/ other stakeholders (employees, customers, society, community, etc.) and its stockholders, which may sooner or later result in a conflict of interest. Therefore, companies must address the underlying problems to ensure that their regular profit Profit refers to the earnings that an individual or business takes home after all the costs are paid. In economics, the term is associated with monetary gains. read moregeneration.” url=”//www.wallstreetmojo.com/business-operations/”]business operations[/wsm-tooltip] are not impacted. This problem can exist anywhere: a company, club, church, or government institution.
The three types of agency problems: stockholders vs. management, stockholders vs. bondholdersA bondholder is an investor who buys or holds a government or corporate bond.read more/ creditors, and other stakeholders like employees, customers, community groups, etc. Companies can resolve it with the help of measures like offering incentives for good performance and behavior and penalizing for poor performance and bad behavior, tough screening mechanisms, etc. Of course, it is almost impossible for companies to eliminate agency problems, but it can still minimize the same implications.
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