The conflict of interest between the agent and the principal A principal-agent problem arises when there is a conflict of interest between the agent and the principal, which typically occurs when the agent acts solely in his/her own interests. In a principal-agent relationship, the principal is the party that legally appoints the agent to make decisions and take actions on its behalf. To learn more about similar topics, you can take CFI’s behavioral finance fundamentals course, which explores the fundamental issues of psychology on the behavior of financial agents.  The separation of the “ownership” (principal) and the “control” (agent) in principal-agent relationships creates the grounds for potential conflict of interests between the two parties. Reasons Behind Principal-Agent ProblemsThe main reasons for the principal-agent problem are conflicts of interests between two parties and the asymmetric information between them (agents tend to possess more information than principals). The principal-agent problem generally results in agency costs that the principal should bear. Because agents can act in their interests at the principals’ expense, the principal-agent problem is an example of a moral hazard. The principal-agent problem was conceptualized in 1976 by American economists, Michael Jensen and William Meckling. The problem has applications in political science and in economics. It is especially significant in the understanding of corporate governance. Examples of Principal-Agent ProblemThe following cases are among the most common examples of the principal-agent problem:
Solutions to the ProblemSolutions to the principal-agent problem aim to align the interest of both parties. There are two main areas of improvement to address the problem: 1. Contract designThe main purpose of contract design is the creation of a contract framework between the principal and the agent to address issues of information asymmetry, stimulate the agent’s incentives to act in the best interests of the principal, and to determine procedures for monitoring agents. 2. Performance evaluation and compensationThe agent’s compensation is the primary method of aligning the interests of both parties. In order to address the principal-agent problem, the compensation must be linked to the performance of the agent. The performance of the agent is usually measured by subjective evaluation because it is a more flexible and balanced assessment method for complex jobs. Common methods of agent compensation include stock options, profit-sharing, and deferred compensation. Tying the agent’s compensation closely to the benefits obtained for the principal helps to eliminate conflicts of interest. Related ReadingsThank you for reading CFI’s guide on Principal-Agent Problem. To keep learning and advancing your career, the additional CFI resources below will be useful:
We have textbook solutions for you!
The document you are viewing contains questions related to this textbook.
The document you are viewing contains questions related to this textbook.
Entrepreneurial Finance Leach/Melicher
What are the major duties of a financial manager?
I. To make investment decisionsII. To make financing decisions III. To manage cash flow from operating activities
Companies that attract the interest of just a few investors are said to be
What is the most important duty of a financial manager?
to make investment decisions
What is the most common way that principal-agent problems are addressed in most corporations?
by minimizing the number of decisions that a manager makes where there is a conflict between the managers interests and those of the shareholders
T/F: The firm's statement of cash flows uses the balance sheet and the income statement to determine the amount of cash a firm has generated and how it has used that cash during a given period.
Who is typically responsible for the day-to-day running of a corporation?
T/F: In most corporations the owners exercise direct control of the corporation.
T/F: The shares of private corporations are traded on a stock market.
T/F: In Canada, publicly traded companies can choose whether or not they wish to release periodic financial statements.
Which of the following is a way that the Operating Activity section of the statement of cash flows adjusts Net Income from the balance sheet?
It adds all non-cash entries related to the firm's operating activities.
Which of the following firms would be expected to have a high ROE based on that firm's high operating efficiency?
a grocery store chain that has very high turnover, selling many multiples of its assets per year |
What is the most common way that principal agent problems are addressed in most corporations?
Pos Terkait
Copyright © 2024 ketajaman Inc.
