Principal-Agent Theory And Issue OF Incentive System Design In The Firm Essay Sample
Incentives, Investment Decisions & Firm Performance
In financial management, the agency dilemma or principal–agent problem occurs in an event when one entity or person (the agent) makes decisions on behalf of another entity or person (the principal). This dilemma exists because the manager (agent), sometimes, is motivated to make decisions in his own best interests instead of those in favor of his principal authority . Common examples of Principal-Agent relationship include corporate management of any organization (agent) and all of its shareholders (principal). This relationship is also found when politicians (agent) are obliged, as representatives, to work for the benefit and welfare of their voters (principal).
Moral hazard issues and Conflicts of interest arise when an agent is hired by a principal to perform certain duties in the best interest of the principal which may prove to be very costly if not in the agent’s best interests. In other words, the agency problem comes to the front when an environment is created by a principal where an agent receives numerous incentives to align his self-interests with those pursued by the principal through an increase in incentives.
On the basis of the “utility theory” and depending upon the important concept that reflects the value of monetary incentives, it is easy to understand that financial benefits are more likely to positively affect individual behavior. When managers (agents) are awarded a fixed pay, the financial benefit is less likely to motivate them because they become entitled to a certain fixed payment regardless of the effort they put in and the decisions they make in favor of principals .
In other words, fixed payments will not encourage agents (managers) to align their self-interests to those of their principals (shareholders). Therefore, the thorough understanding of principal-agent theory is of prime importance to design the incentive system so that the agent’s behavior is modified and matched to interests of principals.
General Solutions to the Principal-Agent Theory and Requirements That an Optimal Incentive System Should Possibly Meet
Under this section, various solutions to the principal-agent theory are presented so that the interests of both the parties are aligned to each other. This section reflects minimum (optimal) requirements which every incentive system should contain (meet) so that managers, as agents, could act and make decisions in the best interests of the shareholders (principals).
The literature review related to the principal-agency theory helps the shareholders (as principals) to understand that the reasons for which certain employment and compensation contracts are best suited to particular business transactions in different organizational settings. Fundamentally, it is of critical importance to realize that principal-agent theory or agency dilemma is about the nature of trade-offs which change subtly as organizational conditions shifts for which different types of solutions are offered in a completely different corporate setting.
Furthermore, different firms follow different types of solutions and approaches when it comes to solve the principal-agent dilemma. Firms, like Pepsico, rely heavily on monetary incentive mechanisms displaying a preference for risk-taking, free-wheeling and an entrepreneurial form of decision- making process. Others successful organizations that follow the monitoring approach more in an attempt to deal with agency problem, like General Motors, often display a preference for “bureaucratic” form of decision making.
Because of the bureaucratic and continuous monitoring approach followed in General Motors to regulate behavior of agents (managers and employees), agents tend to prefer low-risks by depending more on standard operating procedures and hierarchical superiors for justification of their decision making and managerial actions. In other firms, like Southwest Airlines, the principal authorities have stressed upon higher levels of teamwork and cooperation within the firm to align manager’s interests to those of the principals (shareholders).
These behavioral characteristics, which are discussed above in this section, are thought to be as derivatives of different transactions and employment as well as compensation contracts that emerge in response to offering solutions to different principal-agent relationships.
While there are different solutions to agency problems, not one of them is completely perfect. Even though ideal solutions and conditions are followed to deal with information asymmetry and risk-aversion, yet, agency costs or problems continue to persistently happen. However, there are certain performance management indicators best suited for those situations where one solution may prove to be systematically feasible, better and fruitful than others. One of these solutions is the implementation of good governance systems to regulate managerial actions which is, still, sensitive to tradeoffs among different types of costs associated with different arrangements and organizational settings, between as well as within corporate firms.
Over the decades, a number of attempts have been made to solve the principal-agent problem. Again, it is necessary to mention the nature of agency problem so that a feasible incentive system could be presented under this section. The basic and major problem facing publicly traded organizations is that they hire people (as their agents) to do certain jobs/work on behalf of all stakeholders (including shareholders).
Because organizations and shareholders (principals) d not possess all skills needed to keep the business running smoothly and capture more market share by serving more customers, principals wish to retain their key and high performing managers (agents). This reflects the specialization and division of labor all over again. Conflicts arise when agents pursue self-interests and do not work in favor, for benefit and on behalf of their principals.
However, there are problems when incentives paid to agents do not necessarily lead to their behavior which suits best for benefiting the principal. For instance, a lawyer paid fees by the hour has an advantage to perform his duties slowly rather than more quickly. This problem also exists in large organizations and businesses. What is in the management’s (agents) best interest may not necessarily be in the best interests of their principal authorities (shareholders).
Successful global businesses, Apple Inc., have stressed heavily on the implementation of corporate governance systems concerning executive compensation. This organization has implemented a new rule where executive officers are obliged to hold three times more in company stock than their base salary. This initiative is introduced to make managers (agents) the principal to the organization so that they become motivated to align their self-interests to those of all the principal authorities (shareholders).
Apple’s new corporate governance measure obligates executive officers to hold three times in stock more than their annual base salary. These executives, however, must be employed in Apple Inc. for at least five years to satisfy the stock option requirement. The new policy measure requires the company’s chief executive officer (CEO) to hold ten times more in stock more than his annual base salary where non-employee directors are required to hold five times their annual to become eligible for stock option plan.
This seems to be one of the most decent plans to align the self-interests of managers (agents) to make decisions and act in favor of as well as benefit the shareholders (principals) .
Level and Structure of the Compensation Pay and CEO’s Performance
Family and Non-Family Owned Businesses
The CEO compensation is largely affected by the ownership structure because the share ownership by family members, banks, state authorities and investors is more common outside the United States. In marketplaces where such practice is prevalent, the CEO compensation tends to be less with a minimum focus on equity-based compensation. This is a standard practice outside the U.S. because CEOs, owning direct share ownership in the family owned businesses; need less monetary incentives because many other block-holders have their equal participation in the management affairs . Vice versa will be the situation where businesses are owned by the public being listed on the stock market.
Stock Options, an Integral Part of Incentive Program Design
However, there are many companies in the world which design their CEO incentive programs differently, depending on their corporate success. High-performing businesses emphasize greatly on the stock options plans. In those high-performing companies, stock option plans account for about fifty percent more of the long-term incentive program where less focus is placed on those performance plans that contain explicit performance measures like comparative total investment return made available to a shareholder.
Compensation Program Designs Evolve as Business Becomes more Successful
In the same manner, those firms which are innovative and risk takers, they tend to pay higher compensation structures to their CEOs who prefer risk-taking over risk-averse attitude. The said organizations pay less compensation levels to their risk-averse CEOs and employees regardless of their hard work and performance. Additionally, firms running a highly risky and innovative business reward their risk-taking CEOs with greater option-based compensation structures than those who display risk-aversion while managing operations. Such a difference in level and structure of compensation exists as risk-taking CEOs have the ability to maximize corporate value and are highly motivated by incentive-intensive pay structures.
Though most successful companies with global operations appear to be an equal opportunity employer, even then, they still remain vulnerable to gender discrimination. It is said that female CEOs are paid with less compensation structure than their male counterparts. Such an enormous difference not exists within an organization but across businesses as well .
Common Pay Structures and CEO’s Performance (Investment Behavior)
These days, the board of directors of every business makes tremendous efforts to link CEO compensation to the financial and non-financial performance of the company. This idea is implemented to increase the corporate and shareholder value. If common compensation is paid to every CEO regardless of the firm’s size, its corporate success (development), nature of the business and other influencing factors, it would become difficult to screen out the performing as well as non-performing CEOs.
When common pay level and structure is rewarded to every CEO, those with high risk taking attitude, working in innovation (risky) firms and managing a highly a developed corporation etc will have less motivation to work harder and display a distinctive performance. Additionally, those CEOs who take less risk, are more motivated by interests (instead of creating shareholder value) and are not growth oriented, they will have an added advantage to receive the standard pay regardless of their performance and corporate success.
If different structures are paid to different CEOs, high performing ones will be more motivated to increase their value by display progressive performance for creating corporate and shareholder value. Similarly, those CEOs who perform below standards will also feel motivated to take risks for corporate success. To sum up, it is necessary that common pay packages should never be rewarded depending on how much stake CEOs are willing to assume to deliver value to investors and work on their behalf for corporate success.
Incentive Mechanism That Encourage CEOs to Make Investment Decisions for Calculated Risk
The major solution to the principal-agent problem implies that the self-interests of managers (as agents) should be aligned to those of their principal authorities (shareholders). For this, it is important that managerial activities must be molded in a way that he makes only those decisions and take actions which benefit not only the organization but also create value for shareholders. It is critically important that to solve the agency problem, managerial compensation must be made dependent upon the performance level.
It is recommended that the CEO compensation should be linked to his risk taking attitude and his performance. This will cause CEOs to take-on risky investment decisions but it will also expose their compensation to a greater risk. CEOs receiving risk based incentives may even ignore high risky investments (to save their career in the company they work for) even though the Net Present Value of accepting that investment decision may be positively very high.
As a general, but simply effective, recommendation in this section, the awarding of equity-based incentives is critically important in this regard. If the stock options are provided, this will only cause CEOs to accept risky investments which create corporate value but will be driven by taking only calculated risks thereby avoiding imprudent (unwise) risk taking attitude. As CEOs become owners of the public business themselves, they will be encouraged to work on behalf of other principals instead of being driven by self-interests to take imprudent investment decisions. Stock option plan, as implemented by Apple Inc., will cause CEOs to align their interests to those of other principals by taking only calculated risks (not imprudent ones) while considering risky investment decisions.
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