Answer to Question #244573 in Economics for sammy

Question

Examine how the concepts of agency theory can be used to explain the relationship that exists between the managers of a listed company and its shareholders. Your answer should include an explanation of the following : i. asymmetry of information; [5 marks] ii. agency costs; [5 marks] b) The primary financial objective of a business is stated by corporate finance theory to be maximising shareholder wealth as against profit maximisation, sales maximisation, and maximisation of benefit to employees and the local community. Provide a reasoned argument in support that wealth maximisation should be the main goal of the financial manager. [15 marks

Answer 1

a)

i) Information asymmetry is a condition wherein one party in a relationship has more or better information than another. Two broad categories of contractual agency are likely to reduce information asymmetry: (1) self-selection, in particular through information disclosure and signalling, and screening, and (2) designing of incentive structures and monitoring.

ii) Agency costs include any fees associated with managing the needs of conflicting parties, in the process of evaluating and resolving disputes. This cost is also known as agency risk. Agency costs are necessary expenses within any organization where the principals do not yield complete autonomous power.

b) Wealth maximization is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders. The most direct evidence of wealth maximization is changes in the price of a company's shares. The goal of shareholder wealth maximization is a long term goal achieved by many short-term decisions to maintain or exceed the expected value of shareholders.