Managers have always been known to lead and direct an organisation, since the firm is owned by the shareholders but run by the management. Managers should run the business with the shareholder’s interest, thus the main objective of managers should be to maximise owner’s wealth by maximise amount of dividends paid out to shareholders. Since the amount of dividend can be represented by the current stock market’s values of the firm ordinary share capital. As a result, the main interest of management is to take decision to maximise the stock value of company share.
Furthermore, managers might interest others area rather than pure financial gain. Management would interest on company’s responsibility to the environment and society, in turn to minimise the pollution to the environment. Secondly, managers interest on following the government’s legislation, for example, not to produce any harmful product that break the law. Finally, management are also highly concerned on the term and condition of their staffs, and make sure they are fairly paid.
However, there is no reason to assume that manager will always follow the interest of shareholder. Since salary of manager usually not based on the share price of firm’s value, therefore, manager might concentrate more on their own interest such as personal jet and commission paid of sales.
In a corporation, the legal entity is separate and distinct from its owner, the shareholders and owners are separate from the management. Therefore, management is given responsibility for running the corporation’s affairs in shareholder’s interest. Conflict of interest happens when both parties want to maximise their benefit. The shareholders want to have a higher share price as more dividends can be paid; however, the managers are more interested on revenue because it means more expense can be made that are beneficial to them. By applying the fisher separation theory, it stated that if the manager and shareholder have the same perfect information with the same rational approach to decision making, they should have identical expectations, therefore, no conflict of interest is create. On the other hand, if the management and shareholder have delegated decision making with asymmetric information, it will generate an agent problem.
Generally, there are number of ways where the interest of shareholders and managers may conflict, firstly, managers may wish to hold more cash and received perks like having a personal company car that would be the expenses on company, this will affect the firm’s profit and wealth, since managers have to face a trade-off from perks and firm’s wealth. In an example of a single owner-manager case, we assume the owner is also the manager, so, firm is owns and run by the owner. Illustrated with the graph below, with an x-axis of perk consume, Y-axis of Value of firm. The slope on the graph is -1; represent the owner has 100% of ownership.
As the graph shown, if the perk consumption rises by 1 unit units, the values of firm will drop by 1 unit, so, there is an inverse relationship between perk consumption and firm’s wealth. For every one pound in perks consumed from owner, there will be a reduction of 1 pound in the values of firm. As a result, there is a trade off between firms’s value and perks, the more the manager increase on perks, the more it reduces on the firm’s values.
We can understand more about the conflict between shareholder and manager by studying the principal-agent relationship, where the agent (managers) act on the behalf of principal (shareholder), but the principal cannot monitor the actions of the agent( hidden action) or the principle does not have full set of information known to agent( hidden information). Those hidden action and information from principal create agent cost.
In a multiple owner’s case, the original point at D. If a fraction of firm is sold, the insider (owner-manager)’s holding will reduce to AZA±, and the outsider (potential buyer) now owns (1- AZA±). Now, the insiders will share the cost of perks taken with the others shareholders, for example, the cost to the owner-manager of consuming £1 of perk in the firm will no long be £1, instead, it will be (AZA± X £1).
According to the graph above, when the new budget constraint with (V1,P1), the insider will achieve a higher level of utility at U1, as a result, original point D will move to point A with perks F0 and wealth reduced to V0. After the sale, the new constraint is (V2, P2), and point B is the trading point accepts by both parties with perks F” and wealth V”. As the graph shown, the value of firm is reducing from V* to V” is giving by a movement from point D to B. The reduction of wealth is the agency cost by introducing the agency relationship with outsider in the absence of monitoring and bonding.
Secondly, the insufficient effort by managers, they may not grow the firm at an optimal rate, since the value of firm does not directly influence on manager’s salary and individual have different preferences, so, managers may pursue a sub-optimal expansion path for the firm at a different level of investment. The best ways to illustrate this concept is to plot a graph with production opportunity set, indifferent curve and financial market line.
According to the graph, the optimal production rate is where the MRS = MRT= -(1-r), but the manager might make the investment decision above the production rate at point A or below it at point B according to their own preference. Therefore, managers investing decision might not be the optimal level for the firm. Without a single market rate, shareholder will not able to delegate their investment decision to managers.
Thirdly, both managers and shareholders have different attitude toward risk, the shareholders are more risk loving because they may invest in many companies, so that they are holding less risk if one company go into bankruptcy. Whilst managers tend to be more risk averse when they facing an investment decision, since manager’s financial security relies on what happen to the firm, if the value of firm falls below what it should be, the risk of takeover or change in management is likely to increased. Conflict also arise when these is a takeover bid to the company, therefore managers will lose their job whilst shareholders usually gain from this takeover as they will receive above the normal share price. Therefore, the investment decision make by managers might not favour the shareholders of investing risky project. By applying a diagram of efficient frontier of an asset portfolio, with x-axis (Risk) and y-axis (expected return).
It shows each indifference curve represent a different equilibrium position which depends on varying risk attitude, shareholders will make their investment decision on IC1, but mangers often set their indifferent curve on IC2 where closer to the minimum variance portfolio at point D. Consequently, firm couldn’t achieve high return by investing on those less risk assets, which reducing the return on firm’s revenue.
The potential conflicts between managers and shareholders could be mitigated by arranging contractual financial remuneration to the managers. But, the shareholders have to be careful to choose an award that link to their performance and own interest.
Furthermore, the agency cost induced by conflict between managers and shareholders can be mitigated by contractual arrangement. It is possible for shareholders (outsider) to monitoring the expenditure of non-pecuniary from managers. Owner-manager can enter a contract with the shareholders (outsider) to restrict their spending on non-pecuniary consumption.
According to the graph, without monitoring from outsiders, firm’s value is V’ and perks is F at point B. By given the contract, the consumption of perk will restrict to F” and value of firm rise to V” .The optimal monitoring expenditure on the outsiders, M, is the amount between D-C.
If the equality market is competitive, the potential buyers will be indifferent between two contracts: Firstly, potential buyers can purchase of a share of (1- AZA±) of the firm total price of (1- AZA±) v’, but giving no right to monitor on managers consumption. Secondly, potential buyers can purchase share of (1- AZA±) of firm total price of (1- AZA±) V” and D-C is the net cost of monitoring and bonding, which could limit the owner-manger’s consumption on perks.
The expenditure on bonding is a form of contractual guarantees to have financial accounts audited by an external auditor, which contractual limited manager’s decision making power because it restrict his ability to take advantage on his own profitable opportunities. If the bonding costs were under the control of the owner-mangers and yielded the opportunity set at BCE, it would limit the perk consumption to F”.
Finally, the optimum occurs at point C, where bonding cost yielded the same opportunity set as the monitoring cost. The solution to reduce agency conflict I is when the shareholders (outsider) perform monitoring to owner-manager (insider).
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