Nov 2016 Q1 a&b
a) Explain the term Agency problem in relation to a Public Limited Liability Company? (2 marks)
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Agency problem occurs when managers or management take decisions that are not consistent with the objectives of shareholder value maximization. Contributors to this agency problem are: divergence of ownership and control, goals of managers differing from those of share holders because of personal interest and asymmetry of information between managers and shareholders.
b) As a Finance expert, explain THREE practical steps to manage agency problem in public limited liability companies. (3 marks)
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- Use of performance related reward scheme: in the form of pay and bonuses based on satisfactory performance of managers in delivering shareholder value.
- Executive share option scheme: where managers or executives are allowed to buy the shares of the company at a fixed price within a particular period. The option will only have value if the market price is better than the price they will pay for exercising the option. This will encourage goal congruence between managers and shareholders.
- Threat of firing or dismissal: Managers or directors can be forced out by the shareholders if they are unhappy with their performance through shareholder meetings. This method can put pressure on managers or directors to perform.
- Key Market participants like institutional investors such as fund managers, pension houses, insurance companies who have larger shareholdings can exercise that to push managers to perform or be voted out.
- Monitoring and control of managers performance through the use of external and internal auditors, Board committees and review consultants. (Any 3 points)