 Hello and welcome to the session. This is Professor Farhad and this session we would look at the agency problem and the control of the corporation. This topic is covered in a typical introduction to corporate finance or introduction to finance course. It's covered also on the CPA BEC exam. As always, I would like to remind you my viewers to connect with me on LinkedIn. YouTube is where you would need to subscribe. I have 1,500 plus accounting, finance, auditing and tax lectures. This is my website or my website. You could access additional information and additional resources. Make sure to check it out. Also, if you're studying for your CPA or CFA, I suggest you check out studypal.co, which they will match you with another study body. It's an artificial intelligence driven study body system. They are located in 85 countries and 2,800 cities from LA to New York. So let's go ahead and look at this agency problem. So first of all, do we know what is an agency problem? So what is an agent? So when we say you are an agent, what does it mean? It means you have the right to represent someone else, you represent someone else. The relationship between stockholders and management is called agency relationship. So the stockholders hire you, the manager, the CEO, the CFO to act on their behalf. Such a relationship exists whenever the principal hires the agent to represent his or her interests. For example, you might hire someone to sell your car. That's while you're at school. Now, in such a relationship, there's a possibility of conflict, of interest between the principal, between you who owns the car and the agent who's trying to sell your car. Such a conflict is called agency conflict. Now, what is the conflict here? Well, it could be that you ask this individual to sell the car for 10,000 and you'll give them 10% interest. Well, guess what? This individual is waiting to sell the car at 11,000 to get more, more commission. But that's not in your best interest. You wanna sell it at 10,000. There could be other conflict of interest as well. I'm just telling you that your interests and their interests may not be the same. Suppose you hire someone and agree to pay that person a flat fee when they sell your car. Well, if that's the case, they're gonna sell it with the first person. The agent incentive in this case is to make the sale. Not necessarily to get you the best price, but if you offer commission 10%, then that individual will increase your sales price. But if you wanna sell it quickly, they might ask for more to get more commission or they, if they accept the commission, they may sell it and get the 10%. There's always the possibility of conflict. So this is what's called agency relationship, a relationship between an agent and the principal. The principal is the person with the money. Think of the person with the money here is the stockholders and the agents are the employees of the company. So let's talk about management goals because management goals and stockholders goal may not be always the same. To see how management and stockholder interests might differ, imagine that a firm is considering a new investment. So the new investment is expected to favorably impact the share value, but it's also relatively risky. The owners of the firm will wish to make the investment because they're better off, they might have more return. But management say, well, let's not look bad. What if the venture did not succeed, then we look bad. So if management does not take the investment, then the shareholders would lose a valuable opportunity. So this is basically an agency problem where the managers, I'm not gonna take this project because I might look bad if the project failed, but the shareholders are willing to take the risk. So management will not do it, management will not do it. So more generally the term agency cost, what's agency cost refer to the cost of the conflict of interest between the stockholders and management, these costs can be indirect or direct. An indirect cost is a lost opportunity. Lost opportunity means we did not took the investments and as a result, we missed out. This is what the most opportunity is. We also have direct cost, they can come in two forms. The first is corporate expenditure, that benefit management that caused the shareholders. For example, the purchase of luxurious fleet of cars, of planes and unneeded corporate jet that would fall under this heading. So management will buy goodies for themselves with the corporate money. The second type of direct cost is an expense that arises from the need to monitor management. Well, to monitor management, you need to have auditors, you need to have managers, you need to have internal auditors, you need to have additional cost. You need to add more and more layers of internal control, which will cost you money. So paying outside auditor to assess the accuracy could be an example or having an internal audit department, that's basically in a sense an agency cost, okay? It's sometimes argued that left to themselves managers would tend to maximize the amount of resources over which they control. So manager, what they like to do, the more they can control of resources, the more power they feel they have. This call can lead to over emphasis on corporate size and growth. For example, we're the largest company. Well, it may not be in the best interest of the owners to expand and be the largest company, but the managers, they have more resources under their control and they can claim they're on the largest company in the industry, okay? And this often happened when management overpay to buy another company. Why? Because when they buy that other company, they're bigger. So they feel they're more powerful, although it may not be in their best interest to buy the company in the first place, or of course not to overpay for it, but they will do it anyway, okay? So this is what we mean by management call. Management call might be different. So let's take a look at the second subtopic in this chapter and talk about do managers act in the best interest of the shareholders? And if not, what can we do to align to make sure they are aligned? So do managers act in the shareholders' best interest? So do managers do what the shareholders want them to do? And again, we already talked about it. If they're left by themselves, they prefer to maximize their power within using the shareholders wealth, okay? So when managers will in fact act in the best interest of the stockholder, well it all depends on how are you paying them? How are you compensating them, okay? So one is how closely management calls are aligned with stockholder? This question related, at least in part, by the way, managers are compensated. How do you pay managers, okay? Two, how easily you can replace managers? Because if you don't feel managers are doing a good job, how hard or how easy it is to fire them or replace them, okay? So let's talk about management compensation or managerial compensation, basically how much do you pay them, okay? Management will frequently have a significant economic incentive to increase share value. Well, for two reasons. One, managerial compensation at the top is tied to financial performance. So simply put what you would say is, the more the company would make, the more top people would make, okay? For example, managers are frequently given the option to buy stocks at a bargain and you want the stock to go up, therefore you want the company to do well. The more the stock is worth, the more valuable is this option, okay? In fact, options are often used to motivate employees, not just on the top. In late 2014, Google, more than 46,000 employees owned enough options to buy 6.1 million shares and a lot of people became millionaires overnight when Google went public. The second incentive have related to job prospect. Better performers within the firms will tend to get promoted. So if you promote them, if you have a good structure, then they'll be more loyal and stay into the company longer. More generally, managers who are successful in pursuing stockholder gold will be in greater demand in the labor market. That's commanding higher salary, okay? So if we look at some news from the real world, in fact, managers who are successful in pursuing stockholders gold can reap enormous reward. According to the Wall Street Journal, the best paid executives in 2013 was the Lawrence Ellison, the CEO of Oracle, okay? He made out $76 million. By the way, Ellison made slightly a little bit more than LeBron James, okay? Just to give you an idea. Now, let's talk about who really control the firm, who really control the firm. Actually, we know who control the firm, or at least we should know who control the firm, who control the firm, the shareholders. The shareholders are in control of the firm, but really the shareholders are not there on a day-to-day basis to see what's going on. So the ultimate control rest with the shareholder. Again, the shareholder elects the board of directors who, in turn, hire managers, and managers who hire their employees, all of them to work on behalf of the shareholder, okay? So an important mechanism by which unhappy stockholder can act to replace existing management is called the proxy fight. So what is a proxy fight? A proxy fight is the authority to vote with someone else's stock. So what you do, if you're not happy, you'll ask someone else, can I have your right to vote? So as a shareholder, you may not own a lot, but if other people will give you the right to vote, then it's in a sense you own those stocks, although you'll actually own them, but you have the right to vote on their behalf and the more vote you have, the more power you have and what you can do. You can replace the board of directors, or even elect yourself on the board of directors if you are unhappy. Another way that managers can be replaced is by takeover, okay? Firms that are poorly managed are more attractive as acquisition because of the greater profit potential. So let's assume we have company A and company B. Company A, they're doing a lousy job. Company A are doing a lousy job. They're spending a lot of money and they're not making profit, spending money on themselves. So on themselves, it means to enrich themselves, they're not being effective. So company B would come in and say, well, here's an opportunity. If we buy their stock, fire management, and we can run the company, we could do a better job, okay? This is what we mean by a takeover, okay? Basically, in a conclusion, remember, shareholders are in charge, but the problem with shareholders, they cannot be there on a day-to-day basis to see what's going on. Now in a lot of companies, they do somehow stay involved in one way or another, but in multinational company, they can't do that. So the available evidence, the available theory and evidence are consistent with the view that stockholders control the firm and stockholders wealth maximization is the relevant goal of the corporation. So that's what all the literature will show, okay? Now our discussion so far implies that management and stockholders are the only parties with the interest in the firm. This is oversimplification. You have the employees, the customers, the supplier, even the governor. So you have more than just the shareholders. And those other people, other than the shareholders, we call them stakeholders. So taken together, taken together, anyone who has interest in the corporation they're called stakeholders, not shareholders. In general, the stakeholder is someone other than the stockholder or the creditor who has potentially a claim on the cash flow of the firm. Hopefully with this lecture, you get a better idea about the agency problem. And this topic is covered more and if you're a finance major, you're gonna see this problem, not this problem, this issue again and again, discussed in other courses. And in some places, this is a course in some schools, the agency problem is a course by itself because it's an interesting and an important phenomenon because there's a lot of money and there's a lot of shareholders and if we don't have good controls, there's a lot of waste and some people are being enriched on the expense of other. Anyhow, if you have any questions, any comments about this topic, please email me, don't forget to visit my website for additional lectures and additional resources. The website has a subscription, but once you subscribe, you have access to everything. It's like a buffet, finance, accounting, auditing tax, you have access to everything. Good luck and stay motivated.