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. FAgency Relationships versus Agency Problems: FPrimarily:  Stockholders versus Managers  Stockholders versus Creditors

Mitigating Agency Problems  Threat of Firing  Threat of Takeover  Managerial Labor Markets  Proper Structuring of Managerial Incentives

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:

Societal Perspective  Maximize the Value of the Firm V FIRM|SAFE = 0.5*(40) + 0.5*(60) = = 50 V FIRM|RISKY = 0.5*(0) + 0.5*(80) = = 40  Conclusion: Societally Efficient to Choose SAFE Operations Note: Debt = $25 and EBIT|SAFE=$40 or $60, EBIT|RISKY=$0 or $80

Debt/Creditors Perspective  Maximize, or ensure, the Value of the Debt V DEBT|SAFE = 0.5*(25) + 0.5*(25) = = 25 V DEBT|RISKY = 0.5*(0) + 0.5*(25) = = 12.5  Conclusion: Debtholders/Creditors Prefer SAFE Operations Note: Debt = $25 and EBIT|SAFE=$40 or $60, EBIT|RISKY=$0 or $80

Equity/Owner’s Perspective  Maximize Shareholder Wealth (Equity Value) V EQUITY|SAFE = 0.5*(15) + 0.5*(35) = = 25 V EQUITY|RISKY = 0.5*(0) + 0.5*(55) = = 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

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???