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Agency Problems (exam 3)

Agency Problems (exam 3) - Agency Problems Part 1 including...

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Agency Problems Part 1 including Chapter 12
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Topics Covered The Separation of Ownership and Control Jensen and Meckling 1976 “Solutions” to the Agency Problem Incentives/Compensation Monitoring/Governance The Market for Corporate Control Imperfections of Each “Solution”
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The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers
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The Principal Agent Problem Managers prefer to shirk duties (minimize effort) or take on projects that are negative NPV for the firm but benefit the manager (perks, empire building, entrenchment) Owners (shareholders) prefer that the manager take positive NPV projects that maximize the value of equity
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The Principal Agent Problem Managers receive the entire benefit of shirking/perks, but only pay part of the cost Owners (shareholders) get none of the benefits, but pay most of the cost Without other mechanisms in place to prevent manager from shirking, why would shareholders ever invest in firm?
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The Principal Agent Problem Shareholders would know that managers will shirk, and would lower their expected value of the firm’s stock This means that it would be more difficult to raise equity financing (or even impossible), and the equity market would be quite different that what we observe
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The Principal Agent Problem How do we solve this problem? We need mechanisms that will either encourage or force managers to make the right choices Carrot & Stick
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The Principal Agent Problem Carrot: Incentive Compensation Pay managers in a way that gives them the incentives do maximize shareholder value First, equity compensation. Pay the manager with stock so they have incentive to maximize the value of the stock Next, add option compensation to encourage an underdiversified manager to take necessary risks (because we know option values increase with risk)
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