Executive Compensation and Agency Problem

 Executive Compensation and Agency Problem
Executive Compensation and Agency problems
Name of student:
Admission:
Course:
Institution:
Instructor:
Date of Submission:
Executive Compensation and Agency Problem
Executive Compensation and Agency Problems
In most of the publicly traded companies, shareholders do not engage in the day-to-day running
of the corporation. Instead, the executive managers and directors do the role of running the
corporation on a day-to-day basis. Nyberg et al., (2010) observe that shareholders of a
corporation delegate decision-making authority to the managers and directors, in what in finance
and economics literature is referred to agency relationship. This separation of powers seeks to
enhance corporate governance structures through separating ownership from management.
Shareholders delegate decision-making authority to management expecting the management to
act in shareholders’ interests of maximizing shareholders’ wealth.
However, this may not be the case as the management may pursue self-interest, which does not
maximize shareholders’ wealth, consequently giving rise to agency problems. Some of the ways
that management may abuse their power include empire building, awarding themselves longterm employment contracts, severance agreements and other personal enrichment plans that do
not add economic value to shareholders. When managers seek self-interest at the expense of
shareholders’ wealth, a corporation falls because of eroded value. Therefore, there is a need for
executive managers and directors to pursue shareholders' interests in order to maximize
shareholders’ wealth and build a strong corporation. Extensive research on ways to solve agency
problem proposes that executive compensation plans converge the interests of shareholders and
manager, and hence it is an effective way to mitigate the costly consequences of the separation of
ownership and control. This report seeks to discuss critically how managerial compensation can
be used to solve agency problems.
Executive Compensation and Agency Problem
Agency Powers and Agency Problem
Geiler and Renneboog (2011) explain that agency theory propose that agency is a relationship
between a principal and an agent; the agent represents the principal in transactions with a third
party, therefore any decision that an agent makes on behalf of the principal impacts on
principal’s welfare. Agency relationship, at the beginning of the twentieth century was
introduced in the running of large companies. Ross, Westerfield and Jaffe (2005) observe that the
corporate structure of separation of powers between the management and owners of a
corporation has resulted in the growth of corporations in the developed countries. However, the
success of agency relationship has been with problems due to conflict of interest between the
management and shareholders. For instance, managers may be willing to pursue short-term
interests while shareholders may be looking to pursue long-term interests to maximize the
shareholders’ wealth in the long-term. Thus, a need to resolve such kind of conflicting interests
between the parties. Bebchuk and Fried (2003) citing Jensen and Meckling (1976), who were the
first scholars to research on agency problems, asserts that conflicting of interest between
management and shareholders can be solved through managerial monitoring and incentivization.
Kim and Nofsinger (2004) term the cost that shareholders’ incur to resolve conflicting interests
between shareholders and management as agency costs. Agency costs include the sum of
expenditure that shareholders spend to monitor managers, cost of managerial incentives to
maximize shareholders’ wealth and residual loss to the firm’s value. Thus, agency costs can be
viewed, as real transaction costs determined by corporate structures of a firm and borne by
shareholders of a firm to ensure that managers engage in activities that maximize shareholders’
wealth. Early financial economists argued that managerial compensation is a tool that the owners
of a firm can use to ensure that managers pursue shareholders’ interests. However, Bebchuk and 
Executive Compensation and Agency Problem
Fried (2003) hold contrary views stating that executive compensation is an agency problem
because managers may use their powers to dictate their compensation, which may not be tied to
wealth maximization objectives of shareholders.
Ross et al., (2005) observe that prolonged agency problems that manifest as conflict of interest
between shareholders and management lead to a reduction in the value of a firm because of
ownership dilution. The scholars explain that conflict of interest between owners and managers
of a firm is because of four major reasons. The first reason is that managers prefer to invest in
projects with short-term horizons while shareholders prefer long-term investment horizon. The
second reason is that managers are risk averse and