Corporate Finance TMA1 -Result.docx - Question 1 The agency theory explains the relationship between principal(shareholders owners and the

Corporate Finance TMA1 -Result.docx - Question 1 The agency...

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Question 1 The agency theory explains the relationship between principal (shareholders / owners) and the agent ( Management who represent the principals to execute all business transactions). Such relationship is more pronounced in large corporations as compared to private firms because large corporations, the shareholders normally would hire the agents to run the business operations on their behalf. Thus, result in separation between ownership and management. Agency Problem, such as conflict between principle and agents. Problem arises when the principal and agent have different and conflicting interests and asymmetric information. The manager may prioritise their own personal interest which result in conflict with shareholders’ interest. For example, Managers may wish to have a luxury car with higher costs as his Company car, bigger office and etc. This will not benefit the stockholders, instead it will reduce the profit of the company due to higher costs. Agency costs the internal costs as a result of the agency problems . These agency costs are directly affecting the shareholder value. Below are 2 ways out of many to resolve Agency Problems: - i. Designing compensation plans The principles invested their money in the Company, they hire the agents (managers) to execute all business transactions so that their wealth can be maximised. At the same time, the agents (managers) are investing their human capital in the company, and they want to maximize their investments as well. 1
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Thus, higher incentive given to managers who are able to maximise profit is able to help to better align the manager interests with the shareholder interests. The incentive payments shall be tied to their company's performance in order to encourage managers to pay more attention to long-term performances. ii. Employee Share Option Scheme (ESOS) ESOS is a way to make the managers become the shareholder of the Company so that the managers are take care of shareholders’ interest as good performance leads to increase in share price, managers can sell the share in higher price.
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