CH10Q

What are some possible agency conflicts between borrowers and lenders?

After the loan is originated, borrowers might make decisions that are harmful to the lender. For example, borrowers might invest in risky projects. From the borrower's point of view, risky project are like options. If the project pays off big, most of the benefits accrue to the borrowers (the creditors just get the principal back). If the project fails by a little or by a lot, the borrower doesn't get anything. So borrowers have an incentive to take on riskier projects. Borrowers also might take on additional debt. Lenders anticipate this, and charge a higher interest rate.

What are some actions an entrenched management might take that would harm shareholders?

Entrenched managers consume too many perquisites, such as lavish offices, excessive staffs, country club memberships, and corporate jets. They also invest in projects or acquisitions that make the firm larger, even if they don't make the firm more valuable.

How is it possible for an employee stock option to be valuable even if the firm's stock price fails to meet shareholders' expectations?

Stock options in compensation plans usually are issued with a strike price equal to the current stock price. As long as the stock price increases, the option will become valuable, even if the stock price doesn't increase as much as investors expect.

Agent; principal; agency relationship:

When any person or an entity acts on behalf of another, then such person is called an Agent and another is called Principal and the arrangement between principal and agent is known as agency. For example, shareholders are the owner of company but they elect Board of Directors to act on behalf of company for its management and other operational matters. In this case Board of Directors acts as an agent of Shareholders and so there exists Principal-agent-relationship. An agency relationship arises whenever one or more individuals, the principals, hire another individual, the agent, to perform some service and then delegate decision-making authority to that agent. Primary agency relationships exist between (1) stockholders and managers, and (2) between debtholders and stockholders.

A stock option

allows its owner to purchase a share of stock at a fixed price, called the strike price, no matter what the actual price of the stock is. Stock options always have an expiration date, after which they cannot be exercised. A restricted stock grant allows an employee to buy shares of stock at a large discount from the current stock price, but the employee is restricted from selling the stock for a specified number of years. An Employee Stock Ownership Plan, often called an ESOP, is a type of retirement plan in which employees own stock in the company.

What is the possible agency conflict between inside owner/managers and outside shareholders?

This agency problem causes outsiders to pay less for a share of the company and require a higher rate of return. This is exactly why dual class stock that doesn't have voting rights has a lower price per share than voting stock. Again this is an agency cost for the minority shareholders Owner/managers benefit from higher wealth due to ownership, but they also benefit from the perks they consume, such as lavish offices, vacations, golf club memberships, etc. If the owner/manager is the only manager, then the owner/manager bears full cost of the perks. But if the owner/manager only owns part of the company, the owner/manager reaps all the benefits of the perks but the cost is shared by the outside shareholders. Potential investors know this might happen, so they pay less for a minority interest in a company.

Agency Cost

a. Agency cost is an inherent cost which arises in every Principal-agent-relationship. It arises when principal and agent does not get agreed upon the same terms of actions as required. In other words, where there occurs any conflict of interest between the principal and agent then it will be called agency cost of disagreement and it results in agency problems. As for example in case of company, shareholders aim to run company in a manner to maximize their wealth, whereas board of directors may wish to run company in a manner to attain personal benefits. This situation will result in loss to company and called as agency cost. Agency costs include all costs borne by shareholders to encourage managers to maximize a firm's stock price rather than act in their own self-interests. The three major categories of agency costs are (1) expenditures to monitor managerial actions, such as audit costs; (2) expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside investors to the board of directors; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for stockholder votes on certain issues, limit the ability of managers to take timely actions that would enhance shareholder wealth.

Basic Types of Agency Conflicts Conflict of Interest-

a. when agent starts working on their personal interest rather than following the principal's goal then there exist the conflict of interest. This situation may arise due to many reasons like uncertainty, improper flow of information etc . An agency problem arises whenever a manager of a firm owns less than 100 percent of the firm's common stock, creating a potential conflict of interest called an agency conflict. The fact that the manager will neither gain all the benefits of the wealth created by his or her efforts nor bear all of the costs of perquisite consumption will increase the incentive to take actions that are not in the best interests of the nonmanager shareholders. In addition to conflicts between stockholders and managers, there can also be conflicts between stockholders (through managers) and creditors. Creditors have a claim on part of the firm's earnings stream for payment of interest and principal on debt, and they have a claim on the firm's assets in the event of bankruptcy. However, stockholders have control (through managers) of decisions that affect the riskiness of the firm.

Targeted share repurchases, also known as greenmail,

occur when a company buys back stock from a potential acquiror at a higher than fair-market price. In return, the potential acquiror agrees not to attempt to take over the company. Shareholder rights provisions, also known as poison pills, allow existing shareholders in a company to purchase additional shares of stock at a lower than market value if a potential acquiror purchases a controlling stake in the company. A restricted voting rights provision automatically deprives a shareholder of voting rights if the shareholder owns more than a specified amount of stock.

Managerial entrenchment

occurs when a company has such a weak board of directors and has such strong anti-takeover provisions in its corporate charter that senior managers feel there is very little chance that they will be removed. Non-pecuniary benefits are perks that are not actual cash payments, such as lavish offices, memberships at country clubs, corporate jets, and excessively large staffs.