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An agent is the person who has the authority to act on behalf of another party, the principal. The principal is the party who gives authority or permission to the other party to act on his or her behalf. Some situations in companies that can lead to agent- principal conflict are first difference in the objectives of the shareholders (principal) and managers(agent). As owners of the company, shareholders want to increase their wealth through increase in dividends ant stock prices. On the other side, managers who are agents want to maximize their salaries, fringe benefits and job security. Due to this divergence in expectations, there is probability of conflict arising between the two parties. Second, the risk tolerance level between agent and principal differences. Shareholders prefer projects that are risky but have high cash-inflows unlike managers who would want projects that less risky and would not cost them their jobs in case they fail. Third, managers could use corporate resources for their own benefits and not for the intended purpose. An example of this is when managers use company’s money for perquisites such as payment for expensive membership to country clubs, lavish office, large personal staff among others. This is in contrary to what shareholders would expect and as such could lead to conflict.   Finally, managers could fail to take the correct decision that would benefit the company. For instance, the manager could fail to fire a worker who is not performing well because of personal reasons. Therefore, the manager decides to take the popular decision in order to maintain the status quo instead of firing the employee who could be close friend. In the long run, they end up causing more harm to the company thus leading to a conflict with the shareholders.

Corporations can structure management contract to help control managers in several ways. First, the contrast can be made based on performance. In such a scenario the managers salaries and other benefits are pegged against their overall performance. When the company performs well, the managers receive higher salaries and benefits.  Secondly, the contract could have caps that state that managers cannot award themselves any benefits or increase in salaries without prior approval by the majority shareholders. This ensures that the company managers cannot award themselves hefty packages as they wish.

The pros of using stick options to compensate managers ate first the company does not have to use is cash flow to pay them hence more returns to investors. Another advantage is that managers will be determined to work hard since they will be owning part of the company. The cons are; first the managers could wait until the stock prices rise therefore, they could be motivated to use unconventional methods to hike the stock prices.

Corporate governance is important to investors because it determines how a company is run and the likelihood of a non-performing managers being fired. It also protects the investors from managers who are unethical such as the case of Enron.