Business Finance – Agency Problem
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Earning retention conflicts
The first point of the agencies problems are “earning retention conflict”. As a manager, their aim is to rise the retain earning of the company to enable them to finance more business project so for them, it is not compulsory to increase the wealth of the shareholder every time. (Christie R.H, 1998) Especially for that high level of managerial investment policies, manager is not necessarily to provide a clear and apparent report to the shareholder but to the company. (Christie R.H, 1998) The responsibility of the manager is to grant management larger power base, job security, greater prestige, and an ability to dominate the board and award them higher level of remuneration. (Christie R.H, 1998)
Shareholders aim is to have a higher level of cash distributions, especially for that company who have lesser internal positive Net Present Value (NPV). (Christie R.H, 1998) Managers and shareholder have a conflict between their own interests.
Limits on power of directors
As a method to avoid corporate scandals where directors would end up to prohibit the shareholders, the director are prohibit from disposing undertaking of the whole part of company asset without the approval of the company which is under Section 183 (1)(b). (Bonazzi L., Islam S.M.N, 2007) Limits the power of directors is to do as they wish to the company assets, hence to avoid the possibility of ripping off by the shareholder. (Bonazzi L., Islam S.M.N, 2007) This way is to protect the shareholder from overzealous.
Performance Shares
The use of share options in executive compensation plans is generally regarded as the one of the most effective means of tying the interests of between the relationship of managers and shareholders. (Denis, D.J. and D.K. Denis, 1995) Under this scheme, shares are given to managers as a return for their good performance which increases shareholder wealth. (Denis, D.J. and D.K. Denis, 1995) Such options give management the right to buy company stock at a fixed price at given times in the future. As the ownership of the company by inside managers increases, it use to does their incentive to invest in positive NPV project and reduce private perquisite consumption. (Denis, D.J. and D.K. Denis, 1995) The higher the value of the firm, the higher the value of the option and the profit managers can make upon exercising them. Agrawal and Mandeker (1987) report that stock options encourage management to make investment and financing decision which increase the variance of the firms assets.Additional, Demos et al. (1997) find that executive ownership is related with greater corporate focus, it shown that the severity of the managerial risk-aversion problem may be reduced through higher equity stakes. Closely linked to performance shares is the economic value added [EVA] mechanism which can be used to tie managerial compensation to shareholder wealth maximization. (Demos et al., 1997) EVA is the performance measure most directly linked to the creation of shareholder wealth over time. A positive EVA indicates that management is creating wealth for the shareholders. It denotes an estimate of true “economic” profit, or the amount by which earnings exceed the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk. (Demos et al., 1997) On 7 February 2011 the Board of Directors of Pöyry PLC approved a performance share plan to succeed the plan ending in 2010. The plan was as part of the incentive and commitment programme for employees of the company and its subsidiaries. The performance share plan offered the opportunity to receive the Pöyry share to 300 annually nominated employee as a reward for attaining goals.
Time Horizon Agency Conflicts
McColgan (1991) observer that conflict of interest between shareholder and manager may arise with respect to the timing of cash flows. (Dechow, P.M. and R.G. Sloan., 1991) Manager only concerned the company cash flow for their term of employment, lead to a bias in favour of short term high accounting return project at the expenses of long term project with positive NPV. (Dechow, P.M. and R.G. Sloan., 1991) However, shareholder concerned with all the cash flow of the company in future. For example, the research and development reduce executive compensation in short term cause the research and development expenditure tend to decrease as top executive approach retirement, yet the retiring executive wont be around to reap the advantages of the investment. Time horizon agency conflict may lead to management to manipulate earnings prior to leaving their office in an attempt to increase performance-based bonus by using subjective accounting practices. (Dechow, P.M. and R.G. Sloan., 1991)
Cost of Shareholder-Management Conflict
Agency cost are defined as cost borne by the shareholder to encourage manager to help them maximizetheir wealth rather than only concern in their own interest. Corporate debt level and management equity level are influenced by a wish to contain then cost. (eNotes, 2000) There are 3 major type of agency costs:
Expenses for monitor manager activities, one of the cost is audit cost. (eNotes, 2000)
Expenses