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Understanding Agency Relationships and Their Impact on Business Decisions

This analysis explores agency relationships, highlighting how principals assign decision-making authority to agents. It addresses discrepancies between the interests of stockholders, managers, and creditors, outlining the challenges of agency problems. Using a case study on production methods, the discussion highlights the differing preferences of stakeholders: the societal and creditor perspectives favor safe operations to maximize value, whereas owners prefer riskier strategies expecting higher returns. Ultimately, it emphasizes the real-world implications of these choices on firm management.

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Understanding Agency Relationships and Their Impact on Business Decisions

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  1. Agency Relationships • An agency relationship arises whenever one or more individuals, called principals, hire(s) another individual or organization, called an agent, to perform some service and then delegates decision-making authority to that agent. • Agency Relationships versus Agency Problems: • Primarily: • Stockholders versus Managers • Stockholders versus Creditors

  2. Mitigating Agency Problems • Threat of Firing • Threat of Takeover • Managerial Labor Markets • Proper Structuring of Managerial Incentives

  3. An Example Agency Problem • Suppose you start a firm and finance the production of ________ with $25 (face value) of debt. Two methods exist for producing and distributing our __________. First, a safe method is available which produces profits (EBIT) of $40 if the economy is slack and $60 if the economy is robust. Alternatively, a risky process is available which produces profits (EBIT) of $0 if the economy is slack and $80 if the economy is robust. Assuming both states of the economy are equally likely to occur, which production and distribution process should the firm choose? • Societal Perspective » • Creditors Perspective » • Owners Perspective » • Conclusion:

  4. Societal Perspective • Maximize the Value of the Firm VFIRM|SAFE = 0.5*(40) + 0.5*(60) = 20 + 30 = 50 VFIRM|RISKY = 0.5*(0) + 0.5*(80) = 0 + 40 = 40 • Conclusion: Societally Efficient to Choose SAFE Operations Note: Debt = $25 and EBIT|SAFE=$40 or $60, EBIT|RISKY=$0 or $80

  5. Debt/Creditors Perspective • Maximize, or ensure, the Value of the Debt VDEBT|SAFE = 0.5*(25) + 0.5*(25) = 12.5 + 12.5 = 25 VDEBT|RISKY = 0.5*(0) + 0.5*(25) = 0 + 12.5 = 12.5 • Conclusion: Debtholders/Creditors Prefer SAFE Operations Note: Debt = $25 and EBIT|SAFE=$40 or $60, EBIT|RISKY=$0 or $80

  6. Equity/Owner’s Perspective • Maximize Shareholder Wealth (Equity Value) VEQUITY|SAFE = 0.5*(15) + 0.5*(35) = 7.5 + 17.5 = 25 VEQUITY|RISKY = 0.5*(0) + 0.5*(55) = 0 + 27.5 = 27.5 • Conclusion: Equityholders/Owners want managers to Select RISKY Operations Note: Debt = $25 and EBIT|SAFE=$40 or $60, EBIT|RISKY=$0 or $80

  7. An Example Agency Problem • Suppose you start a firm and finance the production of ________ with $25 (face value) of debt. Two methods exist for producing and distributing our __________. First, a safe method is available which produces profits (EBIT) of $40 if the economy is slack and $60 if the economy is robust. Alternatively, a risky process is available which produces profits (EBIT) of $0 if the economy is slack and $80 if the economy is robust. Assuming both states of the economy are equally likely to occur, which production and distribution process should the firm choose? • Societal Perspective » CHOOSE SAFE • Creditors Perspective » CHOOSE SAFE • Owners Perspective » CHOOSE RISKY • Conclusion: WHAT IS LIKELY TO REALLY HAPPEN???

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