Conflict of goal between management and owners: Agency problem
A characteristic feature of corporate enterprise is the separation between ownership and management as a corollary of which the latter enjoys substantial autonomy in regard to the affairs of the firm. With widely diffused ownership, scattered and ill-organised shareholders hardly exercise any control/influence on management, which may be inclined to act in its own interests rather than those of the owners. However shareholders as owners of the enterprise have the right to change the management. Due to the threat of being dislodged for poor performance, the management would have a natural inclination to achieve a minimum acceptable level of performance to satisfy the shareholders requirements/ goals, while focussing primarily on their own personal goals. Thus in furtherance of their objective of survival, management would aim at satisfying instead of maximising shareholders’ wealth.
However, the conflicting goals of management objective of survival and maximising owners value/wealth can be harmonised. The shareholders delegate the decision-making authority to professional management on the premise that the latter will work in the best interest of the former, that is, management is an agent of the owners. In order to ensure that management would take optimal decisions compatible with the shareholders’ interest of value maximisation and minimise agency problems in terms of conflicts of interest, two remedial measures commend themselves:
- Provision of appropriate incentives and
- Monitoring of agents/managers
- Incentives to management: the incentive given to management is of various types. Some of them are as follows
i) Stock options: confer on management the right to acquire shares of the enterprise at a special/concessional price
ii) Performance shares are given based on the performance of the management as reflected in rates of return.
iii) Cash bonus- linked to specified performance targets
iv) Perquisites- such as company car, expensive offices and fringe benefits
These incentives are closely related to the stake of management in the ownership of the company. They promote congruence between the personal goals of management and the interests of the owners.
- Monitoring of managers:
Since management accounts for a small portion of the ownership of the enterprise, they would not be oriented to the maximisation of the value of the shareholders. Monitoring of the activities of management can be done by:
i) Bonding the agent
ii) Auditing financial statements and limiting decision making by the management
In case of bonding, the enterprise obtains a fidelity bond from a bonding company to the effect that the latter will compensate the former up to a certain specified amount of losses caused by dishonest acts of managers. The audit and control procedures and limiting managerial decisions are intended to ensure that the actions of management sub serve the interests of shareholders.