Page info: *Author: Mathiesen, H. *Document version: 2.5. *Copyright 1997-2017, ViamInvest. Legal notice.



 

Exhibition: Excessive control by owners, creditors, or managers

 

Introduction: This exhibition shows that excessive control (opportunistic and inefficient decision making) can be a phenomenon of managers, owners or creditors: Controlling managers facing investment project 1, 2, 3, 4 and 5 maximize their own profits by selecting project 1 which is the second most inefficient of the five projects (This point is similar to the one made by Jensen and Meckling [1976, page 334]). Controlling owners facing projects 1, 2, 3 and 4 will maximize their own profits by selecting project 1 which is the second most inefficient of the four projects. Controlling creditors facing projects 1, 2, 3 and 4 will maximize their own profits by selecting project 3 the most inefficient of the four projects.

 

Case assumptions:

In a two-period world a firm invests $9.000 in a project in period one and gathers the return in period two. The return depends on the selected project and on the outcome of the two equally likely states of the world in period two. Furthermore, the investment is financed with $6000 of debt and $3000 of equity, and to simplify debt receive zero interests. Shareholders, creditors and managers are all assumed to choose the project that respectively maximizes their expected return. Managers are assumed to get 0,1% of a good state return and 0% of a bad state.

 

Example calculating returns of project 1 (for simplicity the manager's pay is excluded calculating shareholders' and creditors' return):

Shareholders' return = 1/2*argmax(0;20,000-6,000) + 1/2*argmax(0;2,000-6,000) = $7,000

Creditors' return = 1/2*argmin(6,000;20,000) + 1/2*argmin(6,000;2,000) = $4,000

Managers' return = 1/2*0.1%*20,000 + 1/2*0*2000 = $10

 

Return in period 2:

Project 1

Project 2

Project 3

Project 4

Project 5

Good state return

20,000

18,000

12,000

18,200

15,000

Bad state return

2,000

5,000

9,000

5,800

11,000

Shareholders' expected return:

7,000

6,000

4,500

6,100

7,000

Creditors' expected return:

4,000

5,500

6,000

5,900

6,000

Manager's expected return:

10

9

6

9.1

7.5

Total expected profits:

11,000

11,500

10,500

12,000

13,000

Copyright 1997-2017, ViamInvest. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Legal notice.