Corporate Finance (12th Edition) Edit edition

This problem has been solved:

…

In Corporations, the shareholders select board of directors to work in favor of enterprise and take decisions in the best interest of the shareholders. The ownership and management are separate.

Hence, the corporation is basically owned by shareholders. The shareholders are investors of the Company, they are interested in earning higher returns in form of increased share price or profits.

The management takes all important decisions for success of the company. Therefore, the agency relationship exists. The management acts in favor of shareholders and management.

Hence, there exists an agency relationship between management and shareholders.

Shareholders select persons who can manage and steer the company in right direction. The board is updated regularly in shareholders general meeting.

Public companies also have the policy of self-evaluation of the top management and they report the same to the shareholders.

If the shareholders feel that the board of directors is not working or not taking decisions in favor of company, they have the right to remove the director.

The above points ensure that owners have proper control over the management.

The problems that may arise due to agency relationship is as follows:

Board may act in its own best interest rather than in the interest of the enterprise and the shareholders. The decisions taken may lead to prejudice to shareholders wealth and effect the company.

The board or management is in full control of the operations, there could be dilution of interest, that is, remuneration of management, adjusting financial statements, etc.