How Managerial Incentives Affect Investment Decision?

How managerial incentives affect investment decision?

The Separation of Ownership and Control

Most large companies are effectively controlled by managers with relatively small stakes. There is a separation between ownership and control in large corporations. Manager who has complete control of the firm and who may, for personal reasons want less risk and more growth than shareholders. Large shareholders who may influence a firm’s capital structure decision, but cannot control the day-to-day decisions made by the managers. This separation causes problems because the interests of managers are not generally aligned with those of shareholders.

Agency problem

In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth. Managers take advantage of their positions and engage in actions that allow them to benefit personally at the expense of shareholders which can lead to management decisions might deviate from those that maximize firm values.

There are two Components of an Agency Problem: uncertainty that the agent cannot control and a lack of information on the part of the principal. If the principal were able to observe the actions of the agent and if there were no free-rider problem, there would be no incentive problems. The principal could simply force the agent to work in his or her interests. The agent who refused could be fired.

Investors will have positive stock price reactions to CEO retirements and deaths

One interpretation of the positive stock price reactions to CEO retirements and deaths is that investors believe that a new CEO, with fewer ties to the firm’s other managers, may be more willing to make the kind of tough decisions that might be required to improve share values.

The Investment Choices Managers Prefer

Making Investments That Fit the Manager’s Expertise. If benefits from controlling a corporation are sufficiently large, a CEO’s desire to remain on the job will also be very large, providing the CEO with an incentive to bias financing and investment decisions in a manner that makes it more difficult to replace him in the future.

Managers also may wish to rely on implicit contracts and personal relationships in their business dealings to make it more difficult for potential replacements to complete the deals.

Making Investments in Visible/Fun Industries. Most of us would probably prefer managing a media company to a chemical company. There are clearly more opportunities for doing interesting things and meeting interesting people at a movie studio than at a refinery.

Making Investments That Pay Off Early. An additional consideration is that managers may want to make investments that help the current stock price of the firm even when they hurt it in the long run. Having favorable financial results in the short run may allow a manager to raise capital at more favorable rates and, perhaps, both increase his compensation and reduce the chance that he will lose his job.

Making Investments That Minimize the Manager’s Risk and Increase the Scope of the Firm. The high personal cost of a firm’s bankruptcy provides an additional bias to the investment and financing choices of managers.

Shareholders’ choice

Large outside shareholders, knowing that managers have a tendency to skew decisions in directions that benefit them personally, have an incentive to reduce management’s discretion. These outside shareholders may favor investments in fixed assets and other technologies that limit the manager’s future discretion.

Diversified Portfolio

Investors have an incentive to hold diversified portfolios. Indeed, the Capital Asset Pricing Model suggests that all investors hold the same market portfolio, implying that an investor’s shareholdings in any individual firm must be extremely small.

An individual investor who wishes to obtain enough shares to control management would generally have to hold an undiversified portfolio. Although the investor would benefit by getting management to make value-maximizing decisions, he or she would bear significant costs by holding an undiversified portfolio. Hence, investors face a trade-off between diversification and control.

How to solve incentive problems?

Changes in corporate governance

A number of changes in corporate governance will make managers more responsive to the interests of shareholders. These include a more active takeover market, an increased usage of executive incentive plans (e. g., stock options) that increase the link between management compensation and corporate performance. Also, corporate boards of directors should become more effective monitors of management.

As a result of these changes, CEOs are much more likely to be terminated for poor performance.

Capital structure and managerial control

the shareholders of a firm that is run by “self-interested” management may prefer a higher leverage ratio than one would find in firms that are managed in the shareholders’ interest, because if the shareholders try to make the leverage ratio high, it will have some limitations on the manager’s discretion.  

A large debt obligation limits management’s ability to use corporate resources in ways that do not benefit investors. A manager may prefer less than the optimal level of debt because additional debt increases the risk of bankruptcy and limits a manager’s discretion. The added debt may prevent a manager from expanding the firm more rapidly than would be optimal.