Agency Theory Is Used to Explain Executive Pay Essay

Agency theory has often been used by economists to explain executive pay. Both executives and shareholders may have divergent interests and risk profiles under agency theory. For instance, executives view their interest in profits as a bonus in contrast to shareholders that consider their interest to be dividends and capital gains. With divergent interests, executives may prefer to avoid risking company assets or resources to protect their jobs. That is, a risk that fails can put executives out of a job while shareholders only lose part of their portfolio. Risk-adverse executives may prefer to pay themselves excessive salaries rather than take on risks that could jeopardize the company or cause the loss of their livelihood. In contrast,†¦show more content†¦When equity-based incentives are combined with performance bonuses tied to accounting measures, the executives own wealth is implicitly tied to outcomes that produce shareholder value. Due to moral hazard, that is, the i nability of principals to observe the actions or behavior of an agent, incentives linked to outcomes can counter this issue. An emphasis on incentives in the principal-agent model reflects an important trade-off inherent in the principal-agent model. Executives that are comfortable taking risks will be motivated by incentives. However, the risks in the principal-agent model are not identical. While principals can diversify their investment risk through portfolio management, agents often have a large portion of their wealth and employment tied up in the company. Thus, the level of an executives wealth is likely to affect the appetite for risk. The wealthier an executive is, the more likely they are to take on greater risks. The principal-agent model recognizes that executives are motivated by financial and non-financial incentives that maximize their utility. Shortcoming of agent theory - According to agency theory, principals are assumed to know what actions should be taken to incre ase value. In practice, however, principals hire self-interested agent-executives because they possessShow MoreRelatedThe Finance Theory, Equity And Financial Crisis994 Words   |  4 Pages2007. It is said that one of the factors that contribute to the financial crisis and this is not the first time this point has been raised. General concern about the relationship between certain low corporate performance and high remuneration to executives in banks means there exists an imbalance between them (Andrew Clark, Tim Edmonds, 2015). With the Government investing public money in certain famous Banking Group, this problem has upgraded from a private sector concern to a significant politicalRead MoreAgency Theory : A Important Function Of Board1725 Words   |  7 Pages2.5 Agency theory: Another important function of board is to monitor the managers’ behaviour. 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