Principal Agent Problem Solution

How do we give the agent, the managers, the right incentives to do exactly what the principles, the shareholders want them to do? 

And that implies that we need two things.

First, we need to be able to obtain periodic feedback. And the reason we want to obtain periodic feedback is very clear. Remember that when we run an NPV calculation, we say, we are considering investing in this project, we have tried to foresee. That is the keyword; we try to foresee, to forecast what the cash flows are going to be. We run our net present value, if it is positive, then we go ahead and invest in this project. But remember, we decide to go into this project based on what I expect to happen in the future because of an expectation. Then I need to evaluate, because what I expected, I may be very optimistic, and I may have put a lot of capital in a project in which the expectations are great, but then it turns out actually to be a flop.

I’m sure you can think of many companies that have gone through blunders like that. You know, we invest a lot in this project and then we realize nobody wanted to buy this product, or nobody wanted to buy this service. Therefore, we need to evaluate over and repeatedly, how we are doing. Are the expectations that we have, are they being met or not. Maybe we are doing better, maybe we are doing worse, but we need to be able to evaluate how the corporation is doing over time.

Remember the NPV is like taking a picture at one moment in time. You make a decision based on what you know you have to put in today in terms of capital, and what you expect to get in the future. And based on that you say I go ahead or I do not go ahead for this project. Well, our problem now is a little different. Our problem now is actually monitoring whether over time the corporation is creating value or not.

So,

  • First, we need to be able to obtain periodic feedback, annual, quarterly feedback on how the corporation is doing.
  • Secondly, how we actually create the appropriating incentives. How we actually motivate the managers to do exactly what shareholders would like them to do. And that goes to the heart of what you might have heard about us, at VBM (Value-based management).

AdminCorporate FinancePrincipal Agent Problem Solution How do we give the agent, the managers, the right incentives to do exactly what the principles, the shareholders want them to do?  And that implies that we need two things. First, we need to be able to obtain periodic feedback. And the reason we want to obtain periodic feedback...Investment analysis basics