Week 1, Check you Understanding
Chapter 1: Problems 2, 3, and 6

#2: Owners (the principals) frequently delegate decision-making authority to professional managers (the agents). Modern corporations allow firm managers to have no participation (or only limited ownership participation) in the profitability of the firm. Because the manager-agents usually have less to lose, they often seek acceptable levels of profits and shareholder wealth rather than maximizing profits unlike the owner-principals. Owner-principals tend to pursue their own self-interests. For example, agents may have less interest in maximizing profits in order to focus on their own interests like long-term job security. This is known principal-agent conflict. To mitigate agency problems, the compensation committee of the board should concentrate on more long-term incentives in order to avoid financially crippling a corporation by distributing large sums of cash at a single time. It also allows for more capital to be available to the company to make more profits. In general, managers will be more motivated when receiving extra income in the form of higher salaries, cash compensation and bonuses. I’m not sure of anyone that doesn’t like this type of reward. Also, this type of compensation is usually immediate. So, a manager can see an instant result. On the other hand, long-term incentives can be a little less motivating because of the time constraint, but can prove to be just as lucrative. If an executive’s pay is tied to their performance, they will be more motivated to do well rather than slack off. The point is for the managers to have the company’s best interest in mind in order to maximize profits, which will eventually flow down to them.

#3: Because corporate profitability isn’t dependent on performance alone, I would lower bonuses based on individual performance evaluations.