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Agency Relationships

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:

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Agency Relationships

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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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