The Role of Agency (1.3.1)

• What does agency theory in finance primarily deal with?

  The relationship between principals (owners, shareholders) and agents (managers or executives).
• What is the main focus of agency theory?

  The conflicts that arise when the goals of the agent diverge from the goals of the principal.
• Who are principals?


  Owners and Shareholders
• Who are agents?


  Managers and Executives
• What is adverse selection in the context of hiring an agent?

  When the principal may lack complete information about the agent's capabilities or motivations, potentially leading to a poor selection.
• What is moral hazard in agency theory?

  When agents engage in riskier behavior because they do not bear the full consequences, with risks often shared by the principal.
• What is information asymmetry in the principal-agent relationship?


  When agents have more information about day-to-day operations than the principals, making it harder for principals to monitor agents.
• What is the agency problem?

  When the interests of the agent do not align with those of the principal, such as a manager prioritizing personal goals over maximizing shareholder value.
• What is the principal-agent relationship?

  The principal delegates tasks or authority to the agent, such as shareholders (principals) hiring managers (agents) to run the business.
• What challenge does a principal face due to information asymmetry?

  Effectively monitoring the agent’s actions and ensuring alignment with the principal’s goals.
• What risk does adverse selection pose to a principal before hiring an agent?

  The principal may not fully know the agent's skills or motivations, leading to the selection of an unsuitable agent.
• Why might agents take more risks than principals would prefer?

  Because agents often do not bear the full consequences of their actions, leading to moral hazard.
• Give an example of an agency problem in a corporation.

  A manager might pursue personal goals like job security, larger bonuses, or perks instead of focusing on maximizing shareholder value.
• How does agency theory influence corporate governance structures?

  It underpins mechanisms like performance-based compensation, stock options, and boards of directors to align managers' interests with those of shareholders.
• What is the purpose of performance-based compensation in corporate governance?

  To align the financial incentives of managers with the goal of maximizing shareholder value.
• How does agency theory affect capital structure decisions?

  It influences decisions on debt and equity financing to control agency problems.
• How can taking on debt reduce agency problems in a company?

  Debt creates discipline by obligating managers to make fixed payments, limiting their ability to use excess cash for personal goals.
• How do stock options help align the interests of managers with shareholders?

  By providing managers with a direct financial incentive to increase the company's stock value, aligning their goals with those of shareholders.
• What role do contracts play in addressing agency issues?

  Contracts set expectations and accountability, helping to align the agent’s actions with the principal’s goals.
• How can contracts reduce moral hazard and adverse selection risks?

  Well-designed contracts that clearly outline roles, responsibilities, and compensation help prevent agents from acting against the principal's interest.
• How can monitoring and auditing mitigate information asymmetry?

  Regular audits, reporting requirements, and oversight by boards of directors reduce the information imbalance between principals and agents.
• How does incentive alignment reduce agency problems?

  Structures like stock ownership or performance-based bonuses incentivize agents to act in the principal's interest.
• What are the solutions to agency problems?

  • Incentive Alignment
  • Monitoring and Auditing
  • Contracts