2. Theoretical Background
In this section we present the main theoretical framework which we combined with the theories presented in Section 3 later base our hypotheses on.
2.1 Principal-agency theory – explaining the manager-owner conflict
We start by introducing the principal-agency theory which captures the fundamental problem of many companies, namely the separation between ownership and control. Put simply, this separation leaves the manager of the company (the agent) with significant discretion to influence shareholder (the principal) value. However, if the manager’s incentives are not fully aligned with shareholder interest, the manager will make decisions that benefit him at the expense of the owners (Berle and Means, 1932). The problem is twofold and derives partly from the fact that a manager without 100 percent ownership is not fully compensated for his effort – leading to inadequate effort – and partly from the fact that the manager does not bear the full cost of his actions – leading to inefficient consumption of perks. This has been shown theoretically by for example Jensen and Meckling (1976), who find that CEO-effort is correlated with managerial ownership. Their finding is that the more the CEO owns of the company, the more he enjoys the benefits from his effort, and thus he will exert more effort.
The principal-agency problem is further aggravated by the fact that managers and owners have different time horizons and different risk preferences (Byrd, Parrino and Pritsch, 1998). Shareholders generally have a longer time horizon than managers and favour all projects with positive net present value, regardless of when the cash flow occurs in time. The manager, on the other hand, prefers projects that generate ...