Question

1) Describe why publicly-held firms have an "agency problem."

Agency problems exists when the interest of the individuals that act as agents to manage the company, that may not align with the interest of the firms stockholders. Publicly held firms typically have agency problems due to conflicts on interest with people on the board including the companies stockholders and management..... Not quite sure what to add here...

2) Identify the main mechanism used to deal with the ageny problem.

3) How are boards of directors composed? What (allegedly) makes boards more independent? What makes boards less independent?

4) How are CEOs compensated in order to reduce the agency problem?

Answer 1

1) Agency problems arise when the management acts in their own self-interest using their authority instead of acting in the interest of the shareholders. Publicly-held firms have agency problem and could lead to the bankruptcy of the entire organization as witnessed in the Enron bankruptcy due to the agency problem. In this Enron case, the senior management of the public company acts to maximize their wealth instead of maximizing the wealth of the shareholders resulting in a conflict of interest between parties referred to as the agency problem. In the case of Enron, the senior management had issues with incentives and pressurized sales targets that were transferred to the managers and executives resulting in bankruptcy. Hence issues in incentives, task completion pressure, acting in self-interest and misuse of authority are the main reasons for agency problems in publicly-held companies.

2) The main mechanism to reduce or deal with the agency problem is the fiduciary rule of establishing good relationships between management (Principal) and managers (agents). The fiduciary rule recommends the motivation of managers through incentives based on their performance to avoid acting on self-interest or misusing their authority. Managers are held accountable and responsible for their work tasks and provided incentives accordingly. This fiduciary rule enhances the principal-agent relationships and helps to deal with the agency problem in an effective manner.

3) The board of directors is mainly composed of founders of the company, senior employees of the company, maximum shareholders of the company etc. Boards become independent when the maximum share equity of the company is held by a single investor. Boards become less independent when there is a proportionate share of equity held by every member in the board of directors representing the equal proportion.

4) Altering the compensation structure of the agents reduces the agency problem. The CEO’s are held accountable for their decisions through independent evaluations and performance feedback. The CEO’s are provided incentives and bonus based on the positive impact of their decisions on the organization performance. The compensation structure of CEO’s also gets changed based on their effective business decision making bringing benefits to the organization. This approach reduces the agency problem to a great extent.