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In agency relationship occurs when a principal hires an agent to perform

some duty. A conflict, known as an "agency problem," arises when there is a


conflict of interest between the needs of the principal and the needs of the
agent.

In finance, there are two primary agency relationships:
Managers and stockholders
Managers and creditors
1. Stockholders versus Managers
If the manager owns less than 100% of the firm's common stock, a
potential agency problem between mangers and stockholders exists.
Managers may make decisions that conflict with the best interests of
the shareholders. For example, managers may grow their firms to
escape a takeover attempt to increase their own job security.
However, a takeover may be in the shareholders' best interest.
2. Stockholders versus Creditors
Creditors decide to loan money to a corporation based on the riskiness
of the company, its capital structure and its potential capital structure.
All of these factors will affect the company's potential cash flow, which
is a creditors' main concern.
Stockholders, however, have control of such decisions through the
managers.
Since stockholders will make decisions based on their best interests, a
potential agency problem exists between the stockholders and
creditors. For example, managers could borrow money to repurchase
shares to lower the corporation's share base and increase shareholder
return. Stockholders will benefit; however, creditors will be concerned
given the increase in debt that would affect future cash flows.
Motivating Managers to Act in Shareholders' Best Interests
There are four primary mechanisms for motivating managers to act in
stockholders' best interests:
Managerial compensation
Direct intervention by stockholders
Threat of firing
Threat of takeovers
1. Managerial Compensation
Managerial compensation should be constructed not only to retain competent
managers, but to align managers' interests with those of stockholders as
much as possible.
This is typically done with an annual salary plus performance bonuses
and company shares.
Company shares are typically distributed to managers either as:
o Performance shares, where managers will receive a certain
number shares based on the company's performance
o Executive stock options, which allow the manager to purchase
shares at a future date and price. With the use of stock options,
managers are aligned closer to the interest of the stockholders
as they themselves will be stockholders.
2. Direct Intervention by Stockholders
Today, the majority of a company's stock is owned by large institutional
investors, such as mutual funds and pensions. As such, these large
institutional stockholders can exert influence on mangers and, as a result,
the firm's operations.


3. Threat of Firing
If stockholders are unhappy with current management, they can encourage
the existing board of directors to change the existing management, or
stockholders may re-elect a new board of directors that will accomplish the
task.

4. Threat of Takeovers
If a stock price deteriorates because of management's inability to run the
company effectively, competitors or stockholders may take a controlling
interest in the company and bring in their own managers.

In the next section, we'll examine the financial institutions and financial
markets that help companies finance their operations.