Agency Problems In Corporate Management

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Introduction Agency problems have gained more and more attention in corporate management nowadays. They are likely to arise when the ownership is separated from control in publicly listed companies. Agency costs of equity incur when managers have conflicts with shareholders whereas conflicts between shareholders and debt holders generate agency costs of debt. Normally, cost of monitoring, losses caused by the choice of objective function, and information asymmetry are considered to be the three types of agency costs (Copeland, Weston, and Shastri, 2005). In economics, the agency theory is associated with the structure of the optimal compensation contract between the principal and the agent. In finance, however, the agency theory mainly focuses…show more content…
Because the manager invests a significant portion of his or wealth into the human capital of the company, he or she is particularly concerned about the total risk of the firm. Reagan and Stulz (1986) proved in their paper that the manager will be less willing to bear all the risk in his or her compensation contract if the asset the manger invested in is positively correlated with the company, for instance, human capital. Therefore the manger may propose business diversification or mergers and acquisitions to diversify the risk while the shareholders may hold other thoughts. For shareholders, diversifying a financial portfolio is much cheaper than business diversification. Thus any costs of unwarranted business diversification by managers will become the agency cost for the…show more content…
Myers (1977) claims that a firm may reject projects with positive NPV because the returns of the project may directly go to bondholders. In another case, if the firm has an opportunity to invest in a profitable project, but the shareholder will have to give up dividends or issue new shares, the manager hesitate whether or not to approve the investment. Rational bondholders are able to identify the conflicts between them and shareholders and take action to reduce their loss. They may create bond covenant so as to protect their interests. A covenant generally requires the company to sustain certain financial conditions, such as working capital, interest cover, and minimal level of net worth (Ross, Westerfield, and Jaffe, 2005). However, it is argued that covenants are expensive to negotiate and enforce, and are likely to limit value-increasing investment opportunities of the company.

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