Question

You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. Describe the relationship between shareholders and financial manager in a corporation and the nature of the agency conflict here.

Answer 1

This is a typical example of Principal - Agent problem. So shareholder are principal here and CEO is an agent.

Now there is always a problem between share holders and manager due to their different priorities. Principal main motivation towards investing in business is to generate more wealth to himself, that's why he always want more dividend income. At the same time manager want to make his firm big and think try to get more prestige and power. His performace depends on the authority and prestige in the industry which force him to take bigger decision related to company e.g., merger & aquisition or capital investment which required huge amount of investment.

These decision though generate revenue in forseen future but shareholders always try to minimize this kind of investment because it decrease their wealth and retained earning of company. That's why it create agency conflict.