The problem in the preamble is known as the Agency problem, where Management pursues their personal interest, which conflicts with shareholder interest.

• Conflict of goals between Management and shareholders. The goals of Management and Shareholders might differ. Management might be pursuing goals and making decisions that will be maximising their personal interest instead of that of the shareholders. Goal congruence
• Divergence/Separation of ownership and control. This is where those who own the business or company do not run the day to day operations of the company but hands over that function to Management (Agents) appointed.
• Asymmetry of information that exists between Management (agents) and shareholders (principals). Management, by their role, have access to real-time and up-to-date day-to-day information on both financial and non-financial data for decisions, whereas shareholders only get historical and annual reports which are open to or subject to miss reporting and manipulations

(1.33 marks per point = 4 marks)

The strategies that can be used to manage or mitigate this problem to protect shareholders are:

• Internal Firings or dismissals. Management can be fired or dismissed or warned and threaten with firings or layoffs for non-performance. This will help put Management on their toes to improve performance for shareholder value maximisation
• Use of external analysts and experts to monitor and assess the performance and quality of information by Management
• Performance-related incentives such as executive share option and compensation linked to the performance of the share price. This will push Management and help in influencing goal congruence and enable both Management and shareholders to be joint beneficiaries of the company’s excellent performance.
• Performance-related pay. Management pay and bonus and other rewards linked to how well the company is performing
• Use of market forces. Threats by shareholders, especially institutional investors and pension houses, can exercise their strong voting powers to replace non-performing Management to protect their interest.
• Monitoring. Performance of Management can be monitored through monitoring schemes by shareholders. External consultants and auditors can be hired to perform this role on behalf of shareholders.

(Any four points @ 1 mark each = 4 marks)

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. Within the context of limited liability company, the agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.

• Managers prefer greater levels of consumption and less intensive work, as these factors do not decrease their remuneration and the value of the company’s shares that they own;
• Managers prefer less risky investments and lower financial leverage, because in this way they may decrease the danger of bankruptcy, and avoid losses on their managerial capital and portfolios;
• Managers prefer short-term investment horizon;
• Managers avoid problems stemming from reductions in employment levels, which increase with the changes in control of a company.
• Managers also fear rocking the boat to deliver shareholder value and will rather choose operating in their comfort zones.

• Managerial Compensation:
  Managerial compensation refers to the incentive mechanism for the good performance of the management. Their objectives are to attract and retain able managers and to harmonize managerial actions with the interest of shareholders. Several measures are used to evaluate managers’ performance. Some of the most common are sales, profit, current value of expected cash flows and value added.
• Shareholder control and interference:
  Shareholders can influence the company’s management in two ways. Firstly, they can influence management directly as to how the company should be managed. Secondly, any shareholder can make a proposal which is voted on at the annual general meeting (AGM).
• Threat of dismissal:
  In the past it seldom happened that a senior manager or chief executive officer was dismissed by shareholders. The reason for this was possibly that the ownership of a great number of companies was dispersed, as well as the fact that the agency problem was only brought to the attention of shareholders (and management) over the past two decades.
• Threat of take-overs:
  The threat of a take-over serves to monitor the actions of management. If the actions or decisions of management decrease the future earnings or value of shareholders, the share price usually decreases as well. In some instances, the company can become a take-over target. If the management of such a company is replaced, the move can benefit the shareholders. The threat of take-overs can thus serves as an external control mechanism which ensures that the decisions and actions of management maximize shareholders’ wealth.

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.

• 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)