May 2017 Q6 b.
Agency problems are inherent in static corporate structures. This conflict arises when separate parties in a business relationship, such as a corporation’s managers and shareholders, have disparate interests. Corporations employ several dynamic techniques to circumvent static issues resulting from agency problems.
Required:
Identify FOUR measures which shareholders may seek to resolve any agency problems that arise. (4 marks)
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- One of the measures that can be taken to overcome this problem is the way of financial rewarding of the managers. The best way is to calculate their bonuses as a percentage of the realized profit of the company.
- To resolve any agency problem and the development of the company, the external and internal audit is of the great importance to be made. It helps to evaluate the efficiency of the company, to detect and stop the eventually inefficient operations as well as to protect the assets and the capital. The most effective way in this situation is to engage external audits who would periodically value the reality and objectivity of the company’s financial reports. Precise financial reporting is critical to ascertaining that the results are stated fairly and the management has not manipulated results for personal gain.
- Share options. This gives directors and possibly other managers and staff the right to purchase shares at a specified exercise price after a specified time period in the future. The options will normally have an exercise price that is equal to, or slightly higher than, the market price on the date that the options are granted. Options can be used to encourage cautious directors to take positive action to increase the value of the company – for the benefit of shareholders.
- Performance-related bonuses. The performance-related elements of executive directors’ remuneration need to be carefully designed in order to ensure that the behaviours and actions that are promoted as a result of the targets are aligned with the long term success of the company and the interests of shareholders and at the same time are stretching. Remuneration incentives should be compatible with risk policies and systems and criteria for paying bonuses should be risk-adjusted. However, non-executive directors should not be remunerated by shares or other performance-related elements, since this will compromise their independence.
- The threat of take over. Another market force is the threat of takeover by another firm that believes it can enhance the target firm’s value to restructuring its controlling, processes, and funding. The constant threat of takeover tends to motivate management to act in the best interest of the firm’s owner.
- Annual General Meetings. AGMs are a means to engage shareholders and allow them to participate actively in the running of their companies. This way, agency problems would be reduced since shareholders are involved in the decision making regarding their companies.