Solutions to Tutorial Covering Week 1 - Agency Theory

1. Outline some of the factors that lead to an increase in agency costs within a firm.

Manager/Shareholder conflict

Direct Agency costs:

1. Managers act in their own self-interest, reducing the firm’s value to shareholders.

2. Managers need to be monitored to ensure their actions are in the owners’ best interests. This

generates monitoring costs.

3. Money is spent setting up contracts to control managers. This generates bonding costs.

Indirect agency costs:

1. The opportunity cost when value maximising investment opportunities are rejected.

Shareholder/Debtholder conflict

1. An agency problem arises if a firm elects a very risky project. This increases the required rate of

return on debt but decreases the value of the creditors existing debt. If the project is a success,

the shareholders will benefit. The creditors do not receive any extra return. If the project fails,

the firm may not be able to pay its creditors. If a firm continues to behave in this manner, then

the creditors may refuse to invest in the future or will demand higher rates of interest.

2. If a firm increases its borrowings based on the same assets

3. Increases dividends significantly or in the extreme, paying all its cash to shareholders as

dividends To protect themselves, creditors may demand that restrictive covenants be written

into the loan contract to restrict the firm’s behaviour.

2. Discuss some of the internal mechanisms available to help minimise or alleviate agency conflicts

in a large public corporation. How effective are these techniques?

1. The Board of Directors Employing executive and non-executive directors to join the Board

2. Major shareholders, such as institutions, can exert considerable influence on the company.

3. Managerial Compensation that gives managers incentives to act in the best interests of the

shareholders (e.g. using stock options)

3. Read Palepu and Healy (2003)

Discuss the following:

a. What are the main reasons that the authors give for the fall of Enron?

1. Enron used mark-to-market accounting and made some errors:

- Enron only considered the best possible outcome.

- Enron booked the entire profit on the day the contract was signed

- Enron ignored the time value of money and interest rate risk

- Enron never up-dated the numbers

- Enron used fake hedges to hide any losses and by creating Special Purpose Entities (SPEs).

2. Other people failed to pick up on the true financial situation in the firm.

- Auditors (Andersen)

- Investment banks

- Credit agencies

- Lawyers.

b. What solutions do they suggest?

1. Audit committees should provide more transparency and be refocused on ensuring that

investors have adequate information on the firms economic reality

2. Auditors focus on maximizing the value of audits. Includes separation of audit and consulting.

3. Rethink the way in which fund managers are compensated for relative performance.

c. Could the Enron situation have been prevented and how?

Better corporate governance for all capital market players.

Stricter legislation such as the Sarbanes- Oxley Act which specifies increased regulations in areas such as corporate responsibility, increased

disclosure, increased independence of audit committees.

The Act also increases criminal penalties

(fines and imprisonment) for companies that fail to meet the provisions of the Act.

4. Read Friedman and Friedman (2009) and discuss the impact (or lack)

of corporate governance

on the Global Financial Crisis.

Moral hazard arose due to :

− lack of adequate preventive controls of supervisor authorities

− potential conflict of interests of rating agencies

− unethical practice of banks’ risk management professionals

− unrealistic expectations of senior executives and global investors to maintain sustained double

digits profitability growth for a number of years.

Internal (board of directors, risk management) and external (rating agencies, regulation)

mechanisms seem to have failed to protect shareholders.