Chapter 13, Problem 1Q

a)

Summary Introduction

To determine: The definition of agent, principal and agency relationship.

Explanation of Solution

If one or more people, the managers, employ another person, the agent, conduct some service and then assign decision-making authority to that agent, an agency relationship occurs. Relationships between primary agencies exist among

• Stockholders and managers
• Debt holders and stockholders.

b)

Summary Introduction

To determine: The definition of agency cost.

Explanation of Solution

The expenses of the corporation include all costs incurred by investors to enable management to increase the stock value of a company rather than operating in their interests. The three key types of company costs are"

• Administrative activities controlling expenditure, such as audit costs.
• Expenditure on structuring an organization in such a way as to reduce undesirable managerial behavior, such as nominating outside investors to the board of directors.
• Expenditure on incentives incurred when restrictions imposed by shareholders, such as criteria for voting by shareholders on certain topics, hinder managers ' ability to take appropriate action to improve shareholder wealth.

c)

Summary Introduction

To determine: The definition of basic types of agency conflicts.

Explanation of Solution

An agency issue arises when a company manager owns less than 100% of the common stock of the company, creating a potential conflict of interest called an agency conflict. The fact that the director will not receive all the wealth benefits generated by his or her efforts or bear all the expense of perquisite consumption would increase the incentive to take actions that are not in the best interests of non-manager investors.

There may also be conflicts between stockholders (through managers) and creditors in addition to conflicts between stockholders and managers. Creditors have a claim for payment of interest and principal on debt on part of the company's earnings stream, and in the event of bankruptcy, they have a claim on the company's assets. Nevertheless, stockholders monitor decisions (through managers) that affect the company's riskiness.

d)

Summary Introduction

To determine: The definition of managerial entrenchment; nonpecuniary benefits.

Explanation of Solution

Managerial entrenchment occurs when a company has such a weak board of directors and in its corporate charter has such strong anti-takeover provisions that senior managers feel there is very little chance of being removed. Non-specific benefits are non-real cash rewards, such as luxury workplaces, country club memberships, corporate jets, and an excessively large staff.

e)

Summary Introduction

To determine: The greenmail; poison pills; restricted voting rights.

Explanation of Solution

Targeted share repurchases, also termed as greenmail, occur when a firm buys back stock at a higher than fair market price from a potential acquirer. The potential acquirer agrees, in return, not to try to take over the business. Provisions on investor rights, also known as poison pills, enable existing shareholders in a company to purchase additional stock shares below market value if a prospective acquirer buys a majority stake in the company.

A limited clause of voting rights deprives a shareholder of voting rights automatically if the shareholder owns more than a defined amount of stock.

f)

Summary Introduction

To determine: The definition of stock options; ESOP.

Explanation of Solution

A stock option permits its owner to buy a stock share at a fixed price, termed the strike price, regardless of what the stock's actual price is. Stock options always have an expiry date after which they cannot be exercised.

A limited stock grant allows an employee to buy stock shares at a large discount from the current stock price, but for a specified number of years, the employee is restricted from selling the stock. An Employee Stock Ownership Plan often referred to as an ESOP, is a type of retirement plan where employees own the company's stock.