http://valuationacademy.com What is Moral Hazard? — Valuation Academy

What is Moral Hazard?

Moral hazard is the act of engaging in activity that serves the interest of the managers over the owners of the corporation. It is the result of the principal/agent problem, where the person who makes the decisions does not bear the consequences of that decision. Moral hazard encompasses four areas: 1. Insufficient Effort, 2. Investment in Extravgant Projects, 3. Entrenchment Strategies, 4. Self- Dealing.

1. Insufficient Effort- When the manager cares more about his time on the golf course and entertaining celebrities more than the inner workings of the company, the company is weaker. Manager’s may avoid unpleasant tasks, such as firing incompetent employees or monitoring key operations. Insufficient effort may be the result of incompetence or of significant extra-curricular activities.

2. Investments in Extravagant Projects- Manager’s engage in pet projects to build an “empire” or because of a certain personal interest at the expense of shareholder’s. Empirical evidence has proven that these extravagant projects do not result in a positive shareholder benefit. This is typically a problem when the company has excess cash to spend.

3. Entrenchment Strategies- An entrenchment strategy is an effort by a manager to make himself irreplaceable. A manager may pursue a strategy that may not be in the best interest of shareholders, but would make the manager look good because he runs it efficiently. In addition, a manger may attempt to resist a takeover even though it may benefit the shareholder.

4. Self-Dealing- This is when the manager uses the company credit card as a personal benefit. Examples include using company assets for personal use, using company funds for a favored political candidate, or lavish office decoration expenses.