1.3 The conflict of interest between the shareholders and managers has been referred to as the agency problem. Managers

“control" the firm and may do things in their own self-interest at the expense of the owners. Four methods are used to solve the agency problem:

(1) Establish outside audit committees to review and limit abuses.

(2) Limit the authority of lower levels of management over potentially troublesome items. e.g., hiring of additional staff and use of company cars.

(3) Provide managers with stock options, stock bonuses, and other forms of compensation that align their interest with those of shareholders.

(4) The market for corporate control—tender offers and mergers—will lead to a takeover if managers abuse their responsibilities, with the new owners replacing the old managers.