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Check Your Understanding Essay 2. A principal-agent relationships involves the owners (principals) delegating decision-making authority to managers (agents). A conflict occurs when the agents pursue acceptable levels of shareholder wealth and profit rather than a maximization of profit. They are pursuing their own self-interests. One way that the agents act in their own self-interests would be by focusing on long-term job security. This could cause the agents to limit the amount of risk taken by the firm. The firm may have an opportunity that is considered a riskier venture that could produce high profits if successful. If the venture proves to be unsuccessful, then the agent is at risk of dismissal. Therefore, the agent may avoid taking advantage of that opportunity. This may also impact decisions concerning diversification and the nature of the cash flow. The actions of the agents are impacted by their compensation package, threat of dismissal, and the threat of a takeover by new owners. In order to mitigate agency problems, agents can receive either cash compensation or long-term incentives. The issue with immediate cash compensation is that it can further promote an agent to act in his or her own self-interest. For example, agents may choose a path of diversification that will result in immediate earnings. This could inflate the quarterly earnings that are directly tied to the agents’ executive bonuses that quarter, but hurt the profitability of the company and the value of the stock in the long-run. In addition, the cash compensation could work to take away from resources that could be used in the advancement of other areas of the company in order to promote growth in the company. Long-term incentives would be a better way to reward agents in order to align their interests with the interests of the principals. These incentives include restricted or deferred stock, as well as long-term performance based payments. If an agent owned stock in the company, then maximizing shareholder wealth would be the same as maximizing his own wealth. The agent would want the company to succeed so that he or she could benefit from its success. In addition, long-term performance based rewards could motivate the agent to make decisions that will pay off in the future instead of trying to produce instant results. The decisions made would promote the growth of the company rather than the growth of short-term bonuses (McGuigan, Moyer, Harris, 2011, pp.10-11). 3. Executive bonuses are often directly linked to corporate profitability. If there is a decline in profitability in the overall marketplace, then the performance percentage used to trigger executive bonuses would be affected. Therefore, if corporate profitability declined by 20 percent, then the percentage used to trigger executive bonuses should also decline by 20 percent. However, this may not be the best option if profitability is declining because it would allow the manager a greater ability to receive a bonus even in tough economic times. This could take away from resources that the company needs in order to try to remain profitable or competitive during these times. Therefore, the owners should keep the performance trigger the same or decrease it by half of the percentage that the corporate profitability declined. This may help the managers to try to find inventive ways to still reach that percentage so that they can still receive a bonus. This could be seen as a motivator. On the other hand, this would also mean that that managers’ total performance based compensation could decrease or be eliminated altogether. This could create issues with hiring and retaining the best managers. Many companies attract and retain exceptional executives based on the benefits package that includes bonuses and other perks. A company that is unwilling to adjust the performance trigger associated with executive bonuses may have difficulty attracting managers with the desired qualifications and experience. In addition, the managers hired may choose to only stay long enough to gain work experience and improve their resume before leaving to join a company with a more desirable bonus structure. A company has to find a way to achieve a balance between rewarding managers to the point that it is detrimental to the company and finding a way to maximize the wealth of the shareholders. 6. The goal of shareholder wealth maximization model is to maximize the return to shareholders, and it is measured by the value of the firm’s common stock. It is also concerned with minimizing the risk to the shareholders’ bonuses. The model looks at the present value of all expected future cash flows (McGuigan, Moyer, Harris, 2011, p.8). a) New foreign competitors: This has the potential to decrease the value of the firm and could impact the future cash flows of a company. The introduction of competition in the marketplace can affect the profitability of a company. The level of the decrease in value would depend on the involvement of the firm in global markets and the level of competition. b) Strict pollution control: This has the potential to decrease the value of the firm if the firm cannot adapt to the changes in requirements. If the firm allows the stricter requirements to hamper production, then the value of the firm would decrease. However, if the firm has planned for this threat by having flexibility when making business plans or creating new technology to take advantage of the Go Green movement, then there is an opportunity to increase the value of the firm. c) Unionization: This would decrease the value of the firm. Unionization would create an increase in risk that involves the ability to achieve operational efficiency. There would be a threat of union strikes that could delay or stop the production of products. This would create uncertainty and could affect future cash flows. d) Increase in inflation rate: In the shareholder wealth maximization model, an increase in inflation rates would be a factor that is out of the manager’s control and influences the price of a stock. Inflation would increase the cost of goods and services, while decreasing the purchasing power of money. An increase in inflation would decrease the value of a firm. If a company has the inability to purchase the same amount of goods with its money, then there is an increase in money spent in order to get the same amount of goods. Increased spending affects cash flows and would decrease the value of the firm. e) Reduced production costs through technology: This would increase the value of the firm. The reduction in the production costs would increase the overall profit. In addition, it has the potential to create more resources within the firm. The extra money from reduced costs could be used to improve other areas of the business in order to grow the business. This has the potential to increase future cash flows, which adds value to the company.