Understanding Agency Conflicts in Corporate Governance: Causes, Effects, and Mitigation Strategies

The potential exists for agency conflicts between stockholders and managers

Which of the following statements is CORRECT?-A good goal for a firm’s management is maximization of expected EPS-Most businesses in the U.S. is conducted by corporations, and corporations’ popularity results primarily from their favorable tax treatment-Because most stock ownership is concentrated in the hands of a relatively small segment of society, firms’ actions to maximize their stock prices have little benefit to society-Corporations and partnerships have an advantage over proprietorships because a sole proprietor is exposed to unlimited liability, but the liability of all investors in the other types of businesses is more limited-The potential exists for agency conflicts between stockholders and managers

Agency conflicts occur when the interests of shareholders (stockholders) and managers diverge. Shareholders expect managers to act in the best interests of the company, which entails maximizing shareholder value. However, managers may be motivated by personal goals, such as job security, power, or prestige, which could conflict with the interests of shareholders. As a result, shareholders may experience a reduction in their wealth, while managers benefit from their actions.

There are several potential sources of agency conflicts between stockholders and managers. One source is the separation of ownership and control, which occurs when shareholders do not have direct control over the management of the company. Managers may have more information about the company’s operations and financial performance than shareholders, giving them an advantage in decision-making. Consequently, managers may act in their best interests rather than shareholders.

Another source of agency conflicts is the alignment of incentives. Managers may be compensated through a variety of mechanisms, such as stock options or bonuses, which may not align with the interests of shareholders. For example, managers may receive bonuses based on achieving revenue growth targets, even at the expense of profitability or long-term shareholder value.

Furthermore, managers may have different risk preferences than shareholders. Shareholders may be more risk-averse, while managers may be more willing to take risks to achieve their personal objectives. This can lead to managers making decisions that expose the company to excessive risk, potentially damaging shareholder value.

To mitigate agency conflicts, shareholders can use various mechanisms, such as monitoring, incentives, and corporate governance. Monitoring mechanisms involve monitoring the actions of managers, such as hiring independent auditors or board members to oversee management. Incentive mechanisms involve aligning the interests of managers and shareholders, such as tying executive compensation to stock performance. Corporate governance mechanisms, such as the separation of the roles of CEO and chairman, can also help reduce agency conflicts by ensuring a balance of power between stakeholders.

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