Principal Agent Problem 1 Result of separation of ownership by stockholders

Principal agent problem 1 result of separation of

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Principal-Agent Problem 1.Result of separation of ownership by stockholders (principals) from control by managers (agents)2.Problem: agents act in ownrather than principals’ interestIf you pay the manager a fixed salary and give her no/little equity stake in the company, no incen-tive to do a good job (moral hazard)-Problem arises because the agents know more about the company than principals-Principals could monitor agents’ activities but that’s costlysur 45
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Solutions to Moral Hazard with Equity 1.Monitoring: ex-post screening Shareholders can observe the level of effort of the manager Problem with monitoring is that it is costly (both time and money)FIs are good at this: for example venture capitalists do constant, active monitoring and receive equity share in start-up that is not tradable2.Government InterventionEnforce the laws on fraudulent behavior (hiding & stealing profits)3.Debt Contracts The principal-agent problem arises with equity because equity is a claim on all profits of the firm. Thus, the principal needs to make sure no profit is diverted away by the agent. It requires monitoring (costly).A debt contract can reduce monitoring costs: only need to monitor in some states of the world (default). If the firm has high profits, the lender receives the fixed payment, as agreed, and does not monitor.Important result in theoretical finance: debt is the optimal security if moral hazard is present.+ (having some equity and debt is a way not to monitor the CEO, because the bank will take care of that)« Fact 2 » Explained: moral hazard can explain why debt (bonds+loans) is much more prevalent than equity.But debt itself is not immune from moral hazard. I.e: the entrepreneur, once the funds are obtai-ned, has the incentive to take on riskier projects.Why? Only pays fixed interest, keep the rest.Solutions to Moral Hazard with Debt To overcome moral hazard, debt contracts often have:1.Collateral(house for mortgage, car for car loan)The greater the collateral, the greater the incentives of the borrower not to default by engaging in risky behavior: it aligns the lender’s and the borrower’s incentives (incentive compatible contract)2.Covenants(to prevent undesirable behavior)Require a minimum of certain assets: (cash)/total assets, or low total debt/total assets (low leverage)FIs require and enforce both. These rules are meaningless if not enforced! The key is having a good, ecient legal systemsur 55
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