In the case of a small business or partnership, that might be true, such as sole proprietor owner who is also the manager. In a larger business, there may be many levels of management and staff, and they do not necessarily own the firm. Aside from their salaries and benefits, they only profit from the business if they own shares of stock in the company. When employees are also shareholders, they tend to have a greater sense of responsibility to the firm.
Consequently, many companies encourage employees to become shareholders. Because the managers of a firm are directed and guided by a Board of Directors , and because they do not profit directly from the firm's goal to maximize shareholder wealth, unless they are also shareholders, conflict can sometimes arise between stockholders and managers. This conflict is called the agency problem. Managers serve as agents of the shareholders. If there is an agency problem, it is imperative to find a resolution as soon as possible to prevent problems within the business that can impede performance.
There is an idea that businesses focused on money are greedy and don't care about social issues or that socially responsible businesses can't increase stock values. The truth is that a company can be both profitable and socially responsible.
Consider the Great Recession and one of its main causes; the subprime mortgage crisis. Theses banks were more concerned about their investment portfolios instead of properly loaning money to customers, which is their charge. Those investment portfolios were filled with toxic assets, which eventually compromised the operations of many financial institutions and caused the failure of several big banks.
As a result, their share prices fell right along with them. In this case, greed and a lack of social concern led to their downfall. On the other hand, after almost failing during the Great Recession, GM turned itself around, repaid its debt, and developed "greener" vehicles. As a result, it realized an increase in its share price. GM took on the mantle of social responsibility rather than exploiting consumers for financial gain.
In addition to these constraints, bondholders may also demand a higher fixed return to compensate for risks not adequately covered by bond indenture restrictions. Inefficiencies that arise because of agency relationships have been called agency problems.
These problems occur because each party to a transaction is assumed to act in a manner consistent with maximizing his or her own utility welfare.
The example cited earlier the concern by management for long-run survival job security rather than shareholder wealth maximization is an agency problem. Another example is the consumption of on -the -job perquisites such as the use of company airplanes, limousines, and luxurious offices by managers who have no or only a partial ownership interest in the firm.
Shirking by managers is also an agency-related problem. In , the board of Enron permitted its CFO, Andrew Fastow, to set up and run partnerships that purchased assets from and helped to manage the risk of Enron. Fastow stood to make millions personally. These agency problems give rise to a number of agency costs , which are incurred by shareholders to minimize agency problems.
Examples of agency costs include. A number of different mechanisms are available to reduce the agency conflicts between shareholders and managers. These include corporate governance, managerial compensation, and the threat of take overs.
First, the board of directors of a corporation should have a majority of independent directors. Independent directors are individuals who are not current or former employees of the company and who have no significant business ties to the company. Additionally, the committee responsible for nominating members of the board of directors must be composed only of independent directors.
Further more, the post of chairman of the board of directors should be split from the CEO position or, alternatively, an independent lead, or presiding, director should chair board meetings. Also, all members of the audit and compensation committees, must be independent directors.
Finally, the company must disclose whether it has adopted a code of ethics for the CEO and senior financial officers and, if not, explain why it has not done so. Many of these proposals have been or are in the process of being implemented by public companies.
In addition to these proposed changes in how corporations govern themselves, the Sarbanes Oxley Act, passed by Congress in , mandated various changes in the processes used by corporations to report their financial results. Properly designed compensation contracts can help to align shareholder management conflicts. For example, providing part of the compensation in the form of stock or options to purchase stock can reduce agency conflicts.
Stock options granted to managers entitle them to buy shares of the company at a particular price exercise price. Typically, the options are set at an exercise price greater than the price of the stock at the time options are granted and can be exercised only after a certain period of time has elapsed. More important to stock value, this is an attempt to align their interests more closely with those of the shareholders.
As a result, some firms have adopted alternative incentive compensation policies. Such stock cannot be sold unless the manager remains with the company for a stated period of time. Microsoft, for example, stopped issuing stock options in and instead began offering restricted stock to its executives and all other employees.
For Microsoft managers, the restricted shares vest, or can be sold, over a 5 -year period. For example, in General Electric GE stopped issuing stock options to its CEO and instead offered , performance share units. Each performance share unit was equal to one share of common stock. Takeovers also can serve as an important deterrent to shareholdermanagement conflicts. The argument goes as follows: If managers act in their self -interest then share values will be depressed, providing an incentive for someone to take over the company at a depressed level.
The acquirer can then benefit from instituting policies that are consistent with shareholder wealth maximization, such as eliminating underperforming units and cutting overhead. In addition to these mechanisms, we will learn in later chapters that certain corporate financial policies, such as dividends and capital structure, can also serve to control agency conflicts.
Financial Management Interview Questions. Financial Management Practice Tests. IT Skills. Management Skills. Communication Skills. Business Skills. The most defensible form of SWM looks to long-term rather than short-term maximization. Have you created a personal profile? Login or create a profile so that you can save clips, playlists and searches. Navigating away from this page will delete your results. Please save your results to "My Self-Assessments" in your profile before navigating away from this page.
Entry Shareholders Entry Side-Constraints. Department of Justice U. Bureau of the Census Workplace Privacy.
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