Cases of excessive control by owners, creditors or managers

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