Principles of Managerial Finance

CHAPTER 1 The Role and Environment of Managerial Finance 19

agency problem
The likelihood that managers
may place personal goals ahead
of corporate goals.

5. For an excellent discussion of this and related issues by a number of finance academics and practitioners who have
   given a lot of thought to financial ethics, see James S. Ang, “On Financial Ethics,” Financial Management(Autumn
   1993), pp. 32–59.


6. The agency problem and related issues were first addressed by Michael C. Jensen and William H. Meckling, “The-
   ory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3
   (October 1976), pp. 305–306. For an excellent discussion of Jensen and Meckling and subsequent research on the
   agency problem, see William L. Megginson, Corporate Finance Theory(Boston, MA: Addison Wesley, 1997),
   Chapter 2.

Hint A stockbroker
confronts the same issue. If she
gets you to buy and sell more
stock, it’s good for her,but it
may notbe good for you.

financial manager, a number of the In Practiceboxes appearing throughout this

book are labeled to note their focus on ethics.

Ethics and Share Price

An effective ethics program is believed to enhance corporate value. An ethics pro-

gram can produce a number of positive benefits. It can reduce potential litigation

and judgment costs; maintain a positive corporate image; build shareholder confi-

dence; and gain the loyalty, commitment, and respect of the firm’s stakeholders.

Such actions, by maintaining and enhancing cash flow and reducing perceived

risk, can positively affect the firm’s share price.Ethical behavior is therefore

viewed as necessary for achieving the firm’s goal of owner wealth maximization.^5

The Agency Issue

We have seen that the goal of the financial manager should be to maximize the

wealth of the firm’s owners. Thus managers can be viewed as agentsof the own-

ers who have hired them and given them decision-making authority to manage

the firm. Technically, any manager who owns less than 100 percent of the firm is

to some degree an agent of the other owners. This separation of owners and man-

agers is shown by the dashed horizontal line in Figure 1.1 on page 7.

In theory, most financial managers would agree with the goal of owner

wealth maximization. In practice, however, managers are also concerned with

their personal wealth, job security, and fringe benefits. Such concerns may make

managers reluctant or unwilling to take more than moderate risk if they perceive

that taking too much risk might jeopardize their jobs or reduce their personal

wealth. The result is a less-than-maximum return and a potential loss of wealth

for the owners.

The Agency Problem

From this conflict of owner and personal goals arises what has been called the

agency problem,the likelihood that managers may place personal goals ahead of

corporate goals.^6 Two factors—market forces and agency costs—serve to prevent

or minimize agency problems.

Market Forces One market force is major shareholders,particularly large

institutional investors such as mutual funds, life insurance companies, and

pension funds. These holders of large blocks of a firm’s stock exert pressure on

management to perform. When necessary, they exercise their voting rights as

stockholders to replace underperforming management.