Executive Compensation as an Agency Problem Finance Essay

All modern organizations have one common feature that forms the major distinguishing factor between the management and the shareholders. In the developed countries, large corporations are actually composed of a distinct structure made up of the shareholders and management. In fact, the separation of management and ownership seems to have gained immense popularity during the start of twentieth century. As a result of the separation of corporate ownership and management, the corporate world has experienced unprecedented growth. On the other hand, separation of ownership and management has created an increase in conflict between the shareholders and the management. As a matter of fact, many academics and players in the world of business have been attracted to the conflict and even made attempts to propose diverse mechanisms of resolving them. The conflicting interest between the shareholders and the management has been commonly referred to as the agency problem.

Motivation

The motivation to research on executive compensation is brought about by the desire to maintain high levels of integrity and patriotism in the management while at the same time ensuring the maximization of stockholders' value. Executive compensation is among the multivariate propositions made by different academics and people in the business world as a possible solution to the agency problem (Bebchuk & Fried, 2003). As a tool for the resolution of agency problems, executive compensation embraces the creation of incentives to the management. The incentives are seen as a move towards motivating the management to act in favor of the shareholders. Research into executive compensation as a solution to the agency problems is crucial as it elaborates on the relevance of executive compensation as well as how it can be applied in solving the agency problems. The fact that management has the mandate to undertake diverse decisions that greatly affect the financial position of the organization means that their role is very critical in the firm. As such, motivating the management is viewed as a way of ensuring that the interests of the shareholders are considered supreme by the management whenever decisions are being evaluated. Additionally, the selection of executive compensation as the research topic is due to the controversy that is often associated with compensation in organizations.

Problem description

In the modern world of business, there is always a separation of the ownership of the business and the management. In fact, the owners of the business- shareholders are no longer involved in the day to day management of the business. The main roles of the shareholders are to provide capital and elect the board during the AGM. Thereafter, the board appoints the management team to carry out the daily operations of the business. In such companies where the shareholders are not involved in management, managers possess substantial power and determine the course that the companies take. Means and Berle (1933) observed that when directors are in the office, they possess a free discretion in their management. In modern finance, discretion and the power of management has been defined to as agency problem (Balsam, 2002).

The fear that the management may opt to use their managerial discretion to pursue selfish gains is the major reason for engaging in executive compensation. There are a number of activities into which the management may get involved into whose end results do not benefit the shareholders. For instance, empire building is an activity that has an impact of benefiting the managers' pursuit of fame. Similarly, it is possible for some managers to hold excess cash instead of distributing it during the times when profitable investments are lacking. Moreover, some managers ensure that they strongly entrench their positions such that ousting them out of their offices is almost impossible. This is particularly when the performance of such managers is extremely poor (Bebchuk & Fried, 2003).

In consideration of executive compensation, fundamental conflicts of interest between the shareholders and the management are considered inexistent. Therefore, two major views have been considered in the process of resolving agency problems through executive compensation: approach on optimal power and approach on managerial power (Balsam, 2002). Most of the financial economists believe that executive compensation should be viewed through the approach on optimal contracts. According to the financial economists who subscribe to this approach, the arrangements yield partial solution to the inherent agency problem. In the approach, the board sets schemes through which the executive is compensated with the main goal of availing executive incentive towards maximization of shareholders wealth. Nevertheless, a number of flaws have been identified with the approach. In fact, the major problem has been identified as that there are inherent political limitations on the extent to which executives can be treated generously. Therefore, such schemes on compensation do not seem high powered in an adequate manner (Jensen & Murphy, 1990).

The approach on managerial power is another way towards executive compensation. The approach focuses on how the agency problem and executive compensation can be linked together to yield better results in the maximization of shareholders' wealth. The proponents of this approach are of the view that executive compensation does not only solve the agency problem but also that it is itself an agency problem. Through various research works, it has been realized that sometimes executive compensation does not result to the intended goal of providing incentives to the management. On the contrary, the compensational attempts have been seen to promote rent seeking by the management. In consideration of the pros and cons associated executive compensation, there is intense influence from managers on executive compensation.

The design of an executive compensation package is highly influenced by the power possessed by the management (Balsam, 2002). Proponents of the contracting approach are particularly concerned with the extent to which the power of management determines executive compensation. Additionally, the power of management has been seen as likely to cause substantial pressure on the shareholders in terms of costs of executive compensation. The extra pay earned by the executives has an impact of distracting the intended incentive creation on the management and actually diluting it entirely. As such, the costs only affect the performance of the corporation without any positive change on the agency problem.

Executive compensational arrangements can be influenced by the prevailing forces in market directed towards maximization of value as well as power of management. As a result, the executive compensational arrangements depart from favoring the managers only. However, the power of management approach holds that the extent of deviation from the maximization of value is extensive making executive compensation inadequate means of incentive creation. The view in the approach towards optimal contract is that reasonable extent of suffering is experienced by managers in regard to agency problem. Consequently, managers do not always act in such a way as to maximize the value of the shareholders (Jensen & Murphy, 1990). This fact prompts the application diverse mechanism through which incentives can be created to the managers.

There are various limitations as to the application of executive compensation as a way of incentive creation to the management. Besides the influence that managers have on the implementation of executive compensation arrangements and the existent of agency problem caused by the directors, it has been realized that sometimes the market forces do not provide sufficient assurance that the outcome of embracing optimal contracts will lead to successful management motivation into observing shareholders' interests. Theoretically, it is hoped that different structures of the market have the ability to impose constraints between the decisions of the directors and the needs of the management (Jensen & Murphy, 1990). In fact, most of the markets impose less stringent measures such that substantial deviations are experienced. For instance, in the case of takeovers, many firms seem somewhat hostile towards the acquirer. As a result, the acquirer faces immense challenges from the incumbent management who often limits his full control of the firm. The hostility is to the detriment of the shareholders as the new acquirer provides better bids to the shareholder. As a result, shareholders lose substantial wealth.

Formulation of the hypothesis

The hypothesis for this research delves on the relationship between executive compensation and business performance towards the maximization of the shareholders' wealth. In view of the underlying agency problems between the management and the shareholders, it is imperative to analyze the extent to which executive compensation can help in the resolution of the problem.

Research methodology

Practical proofs on the effectiveness of executive compensation in the resolution of the agency problem need to be established. This can be done through various methods such as questionnaires, interviews and observations. Both quantitative and qualitative information need to be collected. For instance, quantitative data can be collected through questionnaires whereby closed headed questionnaires are used to know the number of executives in support of executive compensation. Similarly, the number of shareholders in support of executive compensation can be obtained through questionnaires during an AGM. It is also possible to ascertain the percentage of shareholder value growth in a scenario with proper executive compensation by relating between different periods when executive compensation had not been implemented. Qualitative data can also be obtained through interviews to shareholders on the benefits of executive compensation. In this case, ARR Corp. is the relevant example for the study.

Clarification of concepts

In this research paper, various terms and concepts have been used. Their meanings are as follows: Agency problem: refers to the conflicts that exist between shareholders and the management in balancing the interests of the stockholders and the selfish pursuits of the management (Balsam, 2002). The second concept is executive compensation which refers to the package of remuneration and benefits allowed to the managers in order to motivate them into undertaking decisions consistent with the interests of the shareholders. Shareholders are the owners of the business after having bought shares of the company through a stock exchange. The shares represent the unit of ownership in a public company.

Framework

The research is to be organized in form of chapters with elaborate sub-chapters. There will be a table of contents consisting of the various chapters to be covered in the full research. The list of items is as follows: Title page, Copyright, Approval Page, Dedication, Acknowledgements, Abstract, Table of contents, Tables list, Figures List, Body (Text), References, Appendices and Index.

Cite this page