Study of Agency Theory. This essay is having research on agency theory and the study of which in current economic environment and a literature review will be done on the conflicts between executive compensation and the goal of maximizing the shareholders

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Corporate Finance Course Work                                                Study of Agent Theory

STUDY OF AGENCY THEORY

Dilemma of CEO & SHAREHOLDERS

Module title:         Corporate Finance

Examiners:                Mohamed Kamara & Moshfique Uddin

Student Name:        123

Student #:                123

Total Words:                1,978

Dec 15th, 2009


Introduction

Agency theory has been bothered with all the companies whose owners hire a CEO in their business operations. Under current global financial crisis, the problem of whether CEO should be given such attractive compensation has aroused heated debate over the whole economic world. Dunlop and Andelman (1997) mentioned the fact in their book Mean Business: How I Save Bad Companies and Make Good Companies Great that CEO is always having unbelievably high compensation, as this can motivate him for better performance, but the shareholders should also pay attention that, compensation should be tied to shareholders’ returns or it would be meaningless.

This essay is having research on agency theory and the study of which in current economic environment and a literature review will be done on the conflicts between executive compensation and the goal of maximizing the shareholders’ equity. This will be followed with analysis and discussion on how the conflict could be minimized with the methods of management, finance, and etc.

About Agency Theory

Generally, the agency theory is a theory that explaining the relationships between principals, who is the economic resources owners such as shareholders, and agents, the one that uses and controls the resources offered by principles such as the companies’ executives. In such relationship, the principals are hiring the agents to work as business operators in their capitals, and the agents are usually constrained by contracts (Eisenhardt, 1989). Under this theory, there are usually two problems:

  • The goals of the principal and agent are usually in conflict (also viewed as agency problem), and also it is difficult and expensive for the principal to verify what the agent is actually doing.
  • The principals and agents are holding different tolerances for risks, principle and the agent may prefer different actions because of the different risk preferences (Eisenhardt, 1989).

However, when principals themselves are agents, there would no longer be problems of agent problem. However, when the managers of enterprises are absorbing new economic resources from issuing its company stocks in stock market, they will have a potential to raise the companies’ expenses in the aim to be more relaxed and reduce the intensity of work. In a nutshell, if the managers of enterprises are rational agents, the behavior of whom will be very different from the previous condition that when they are also the only owners of the enterprises. The relationships between principal and agent can be clearly presented as the following graph.

Literature Review and Relative Analysis

Jensen and Meckling (1976) mentioned in their article “Theory of the firm: Managerial behavior, agency costs, and ownership structure” that the principal-agent problem will emerge when the situations happen in which 1) the agent acquires compensation from principle and act very useful performance for the principle, but costly to the agent (or the expectation for performance is too high to be achieved); 2) the performances are costly to be observed.

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In order to fix that, Choudhury and Sampler (1997) offered their idea in the article “Information specificity and environmental scanning: An economic perspective” that as there are always information lacking for principals, and thus they do not know clearly about whether the contracts between them and the agents have been constraining or carried out by the agents, thus under such problem, principals could only offer a high enough compensations to be the appropriate incentives in order to make agents act in the way that principals wish them to.

Austin (2001) takes contracts between agents and principals as ...

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