Question

Suppose you decide (as did Steve Jobs and Mark Zuckerberg) to start a company. Your product is a software platform that integrates a wide range of media devices, including laptop computers, desktop computers, digital video recorders, and cell phones. Your initial market is the student body at your university. Once you have established your company and set up procedures for operating it, you plan to expand to other colleges in the area, and eventually to go nationwide. At some point, hopefully sooner rather than later, you plan to go public with an IPO, and then to buy a yacht and take off for the South Pacific to indulge in your passion for underwater photography. With these issues in mind, you need to answer for yourself, and potential investors, the following questions.
a. What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.

b. If you expanded and hired additional people to help you, might that give rise to agency problems?

c. Suppose you need additional capital to expand and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur?

d. Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs?

Answer 1

Answer:

a1) Agency problem refers to conflict of interest between a company's management and its company's stakeholders.

a2) No

b) YES

c) Creditor Agency Problem

d) Agency Cost of Debt

Explanation:

a. What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.  

Answer

a1) Agency problem refers to conflict of interest between a company's management and its company's stakeholders.

a2) When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? NO, because based on the definition above, there will be no stakeholders, hence no possibility of conflict of interest if there is just one person.

b. If you expanded and hired additional people to help you, might that give rise to agency problems?

ANSWER

YES, because based on the definition, conflict of interest will become possible when agents are recruited and expected to act on behalf of the owner of the company; they might just start doing their own thing by pursuing their own interest against that of the owner.

c. Suppose you need additional capital to expand and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur?  

ANSWER

This will give rise to a Creditor Agency Problem which is different from Management Agency problem. In the Creditor Agency Problem, Creditors are the principal and the shareholders are the agent because they get the money from outside investors on a promise that they will use it in projects that are low in risk and sure in returns BUT after getting the funds, shareholders might approve that the money be used in High Risk High Return projects which is not in the best interest of the outside investors who do have a controlling interest.

d. Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs?

ANSWER

Agency cost of debt will occur, this refers to an increase in the cost of debt in the event that the interests of shareholders differs from that of management.

How might lenders mitigate the agency costs?

Lenders are aware that management is in full control of their money and they can mitigate the agency costs by imposing certain restrictions on the companies called bond indentures, to reduce the agency-cost issue.  Indentures are legally binding agreements surrounding the use of the money and what happens in the case of bankruptcy.