Motivation of managers. Agency conflict

Motivation of managers.

Agency conflict.

Imagine yourself as the CEO of a corporation with outsider ownership. You are considering 2 investment projects. One should bring a profit of 1 million in case of successful implementation (60% probability), but in case of failure it will lead to a loss of 400 thousand to the company. The second project with a probability of 85% will bring a profit of 500 thousand, and in case of failure, the losses will amount to no more than 10 thousand.

Task 1. Which project will be more interesting for the manager if his reward depends on the company's profit? Do his interests coincide with the interests of shareholders?

Expected profit = (Profit * Probability of success) - (Loss * Probability of failure)

Project 1:

Expected profit = (1000000 * 0.6) - (400000 * 0.4) = 440000

Project 2:

Expected profit = (500000 * 0.85) - (10000 * 0.15) = 423500

As I can see the Project 1 is more interesting for the manager.

The manager's interests may not align with the shareholders' interests. The manager might be inclined to take on higher-risk projects, such as Project 1, to potentially gain a larger reward.

Task 2. Propose and justify 2 measures that would force the manager to act in the interests of shareholders.

1. Performance-based compensation - tie the manager's compensation to the company's long-term financial performance rather than short-term outcomes. For example: return on investment (ROI), return on equity (ROE), market share growth.
2. Equity ownership - grant the manager equity ownership in the corporation, providing it with a direct stake in the company's success. For example: by giving the manager personal financial stake in the corporation.