(13-1) Define each of the following terms:

a. Agent; principal; agency relationship: An agent is a person who acts on behalf of another person, called the

principal. An agency relationship is established when the principal grants authority to the agent to act on its behalf.

b. Agency cost: Agency cost refers to the cost incurred by a company as a result of the actions of its agents. This cost can

be in the form of lost opportunities, mismanagement, or reduced profits.

c. Basic types of agency conflicts the basic types of agency conflicts are: (1) Conflict of interest, where the

interests of the agent and principal are not aligned, (2) moral hazard, where the agent takes actions that increase the risk

of loss to the principal, and (3) adverse selection, where the principal is unable to assess the quality of the agent's

performance.

d. Managerial entrenchment; nonpecuniary benefits: Managerial entrenchment refers to the efforts of management to

maintain control of the company, even if it is not in the best interests of the shareholders. Nonpecuniary benefits refer to

benefits that a person receives in addition to compensation, such as power, prestige, or status.

e. Greenmail; poison pills; restricted voting rights: Greenmail is a situation where a corporation pays a premium price

to buy back its own stock from a hostile shareholder in order to prevent a takeover. Poison pills are actions taken by a

corporation to make its stock less attractive to potential acquirers. Restricted voting rights refer to limitations on the voting

rights of shareholders in order to protect the interests of the company.

f. Stock option; ESOP

Stock options are contracts that give employees the right to purchase company stock at a certain price. An ESOP, or

Employee Stock Ownership Plan, is a retirement plan in which employees own stock in the company for which they work.
13.2

What is the possible agency conflict between inside owner/managers and outside shareholders?

In "Financial Management: Theory and Practice" by Eugene F. Brigham and Michael C. Ehrhardt, agency conflict refers to

the conflict of interest that arises between two parties in an agency relationship: the principals (in this case, the outside

shareholders) and the agents (the inside owner/managers). The agency conflict between inside owner/managers and

outside shareholders can occur because the objectives and incentives of these two groups may not align.

For instance, inside owner/managers may prioritize their own interests, such as maximizing their own salaries or expanding

the size of the firm, at the expense of maximizing shareholder wealth. On the other hand, outside shareholders may be

primarily concerned with maximizing their own returns, which may not align with the goals of the inside owner/managers.

This conflict of interest can result in suboptimal decision-making and reduced shareholder value.
13.3 What are some possible agency conflicts between borrowers and lenders?

In "Financial Management: Theory and Practice" by Eugene F. Brigham and Michael C. Ehrhardt, agency conflict refers to

the conflict of interest that arises between two parties in an agency relationship: the principals (in this case, the lenders)

and the agents (the borrowers). The agency conflict between borrowers and lenders can arise due to the different

objectives and incentives aof these two groups.

For instance, borrowers may prioritize their own interests, such as maximizing their own consumption or investment in

high-risk projects, at the expense of timely repayment of the loan. On the other hand, lenders may be primarily concerned

with the repayment of the loan and the preservation of their capital. This conflict of interest can result in suboptimal

decision-making and reduced lender confidence in the credit market.

Additionally, borrowers may have asymmetric information compared to lenders, which can further exacerbate the agency

conflict. For example, borrowers may have better information about the risks and potential returns of a project, which can

lead to lenders making suboptimal lending decisions. To mitigate these conflicts, lenders often use various forms of

collateral and covenants to protect their interests and incentivize borrowers to act in their best interests.

13.4 What are some actions an entrenched management might take that would harm shareholders?

In "Financial Management" by Eugene F. Brigham and Michael C. Ehrhardt, the authors discuss that entrenched

management may prioritize their own interests over those of shareholders, leading to actions that harm shareholders.

Some examples of such actions include:

Overpaying for acquisitions that benefit management but do not create value for shareholders

Engaging in empire building by acquiring or retaining unprofitable divisions

Failing to invest in profitable opportunities or cutting back on investments that could improve future profits

Overcompensating management with excessive salaries, bonuses, and benefits

Underinvesting in research and development or delaying new product launches

Pursuing personal interests at the expense of the company

Ignoring shareholder concerns and failing to address their questions and criticisms.

These actions by entrenched management can lead to a decline in the company's stock price and harm shareholder value

over time.
13.5 How is it possible for an employee stock option to be valuable even if the firm’s stock price fails to

meet shareholders’ expectations?

In "Financial Management" by Eugene F. Brigham and Michael C. Ehrhardt, the authors discuss that employee stock options

can still be valuable to employees even if the firm's stock price fails to meet shareholders' expectations. This is because an

employee stock option gives the employee the right to purchase shares of the company's stock at a predetermined price

(strike price) in the future. If the market price of the stock is higher than the strike price, the employee can exercise the

option and purchase the stock at the lower strike price, then sell it in the market at a higher price and make a profit.

Therefore, even if the firm's stock price does not meet shareholders' expectations and falls below the strike price, the

employee can still benefit from the option if the market price is above the strike price. Additionally, the employee has the

advantage of being able to wait and see if the market price will rise before making a decision to exercise the option.

This means that employee stock options can provide a source of value to employees that is separate from the performance

of the company and its stock price, which can help to attract and retain talented employees.
Mini Case

Suppose you decide (as did Steve Jobs and Mark Zuckerberg) to start a company. Your product is a software platform that

integrates a wide range of media devices, including laptop computers, desktop computers, digital video recorders, and cell

phones. Your initial market is the student body at your university. Once you have established your company and set up

procedures for operating it, you plan to expand to other colleges in the area, and eventually to go nationwide. At some

point, hopefully sooner rather than later, you plan to go public with an IPO, and then to buy a yacht and take off for the

South Pacific to indulge in your passion for underwater photography. With these issues in mind, you need to answer for

yourself, and potential investors, the following questions.

a. What is an agency relationship? When you first begin operations, assuming you are the only employee and only your

money is invested in the business, would any agency conflicts exist? Explain your answer.

b. If you expanded and hired additional people to help you, might that give rise to agency problems?

c. Suppose you need additional capital to expand and you sell some stock to outside investors. If you maintain enough

stock to control the company, what type of agency conflict might occur?

d. Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders

mitigate the agency costs?

e. Suppose your company is very successful and you cash out most of your stock and turn the company over to an elected

board of directors. Neither you nor any other stockholders own a controlling interest (this is the situation at most public

companies). List six potential managerial behaviors that can harm a firm’s value.

f. What is corporate governance? List five corporate governance provisions that are internal to a firm and are under its

control.

g. What characteristics of the board of directors usually lead to effective corporate governance?

h. List three provisions in the corporate charter that affect takeovers.

i. Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as

a form of compensation?

j. What is block ownership? How does it affect corporate governance?

k. Briefly explain how regulatory agencies and legal systems affect corporate governance
Solutions:

a. Agency relationship refers to a relationship in which one person (the principal) hires another person (the agent) to act on

their behalf. In this case, when you first begin operations as the only employee and the only one investing in the business,

no agency conflicts exist since you are both the principal and the agent.

b. Yes, hiring additional people to help you might give rise to agency problems as the new employees act as agents on

behalf of the company but may have different goals and incentives than the company's goals. This can create a conflict of

interest and result in decision-making that is not in the best interest of the company.

c. If you sell some stock to outside investors while still maintaining control of the company, an agency conflict of interest

might occur. The outside investors are the principals, while the management team is the agent. This can result in decision-

making that prioritizes the goals of management over the goals of the investors.

d. Agency costs might occur when the company raises funds from outside lenders. The lender is the principal while the

management team is the agent. The management team may engage in decision-making that is not in the best interest of

the lender and may result in additional costs for the company. Lenders can mitigate agency costs by monitoring the

company's operations and requiring regular reporting and accountability from management.

e. Six potential managerial behaviors that can harm a firm's value when the company is controlled by an elected board of

directors include:

Overinvesting in projects with low returns

Underinvesting in profitable projects

Underpriced sales of company assets

Overpriced purchases of assets

Failing to control costs

Engaging in unethical or illegal behavior.

f. Corporate governance refers to the system by which companies are directed and controlled. Five internal corporate

governance provisions that are under a company's control include:

Board structure and composition

Executive compensation
Audit and risk management processes

Disclosure and transparency

Shareholder rights and participation.

g. Characteristics of an effective board of directors include:

Independence from management

Diverse backgrounds and experiences

Strong understanding of the company and industry

Active engagement and involvement in company decisions

Willingness to challenge management and hold them accountable.

Three provisions in the corporate charter that affect takeovers are:

Voting rights and shareholder rights provisions

Anti-takeover provisions such as "golden parachutes" and "poison pills"

Ownership structure and control provisions such as dual-class stock and cumulative voting.

i. Stock options are a form of compensation where employees are given the right to purchase a specified number of shares

of the company's stock at a predetermined price. The use of stock options in a compensation plan is designed to align the

interests of employees with those of the company's shareholders, as employees will benefit if the stock price rises.

However, there are potential problems with stock options as a form of compensation. For example, there can be a

misalignment of incentives if employees are able to exercise their options before the stock price has risen significantly.

Additionally, stock options can result in dilution of ownership for existing shareholders.

j. Block ownership refers to the ownership of a substantial percentage of a company's stock by a single entity or a small

group of entities. Block ownership can affect corporate governance by potentially giving the block owner significant

influence over the company's management and decision-making. This can lead to a concentration of power and potentially

reduce the influence of minority shareholders.

k. Regulatory agencies and legal systems can affect corporate governance by setting rules and regulations that companies

must abide by. For example, securities and exchange commissions (SEC) regulate corporate disclosure and insider trading,
while laws such as the Sarbanes-Oxley Act of 2002 regulate accounting practices and financial reporting. These regulations

and laws help to ensure accountability and transparency in corporate governance, and can protect the interests of

shareholders and other stakeholders.