See: Principal. See: Agent.
You're a billionaire. Your parents made a fortune in aardvark farming during the 1980s, but were killed in a tragic stampede in 1993. You inherited the fortune, but don't have much interest in actually overseeing your investments, or keeping your aardvark empire intact. Instead, you split time between your Formula 1 racing team and a Lithuanian female wrestling league you bought a few years ago.
For your other investments, you've hired a manager: Earvin, a guy you met in prep school. You probably haven't noticed, but you've run directly into the principal-agent problem.
The term describes the underlying tension between the interests of the people who own an asset and the interests of the people who run it. For instance, Earvin has an incentive to pay himself a big salary. You'd rather pay him as little as possible. Earvin might be tempted to skim a little here and there, since you're distracted by racing and Lithuanian wrestlers. You, of course, hope he'll be honest and completely devoted to promoting your interests, even at the cost of his own. That tension defines the principal-agent problem.
It comes up in subtle ways in real life. The CEO of a company is supposed to do what's in the best interest of shareholders. That might involve flying coach if he needs to get to Washington DC for a meeting with regulators. But the corporate jet is just sitting there. Sure, the flight will cost $30,000 rather than the $225 it would cost to fly Southwest. But hey, it's not the CEO's money. Besides...all that waiting in the airport is a waste of valuable CEO time, right?
The principal-agent problem was among the key drivers in the rise of stock options and other equity compensation for executives. The tactic sought to align the interests of the owners and the managers more closely, by giving the managers an ownership stake in the company.
The principal-agent problem also exists outside the financial space. Take government. Elected officials are meant to manage the affairs of the citizens who voted them into office. They are the agents...we are the principals. But the same tension comes up. Just rerun the commercial flight/private jet scenario again. In this case, though, it's the regulator flying to a meeting with a corporate exec, and its the government picking up the cost. What do you think the government employee will pick, left to their own devices: crammed into coach, or flying in luxury on the private jet?
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Finance: What is principal?707 Views
finance a la shmoop what is principle answer its the loan amount you borrow
when you do you sign a bunch of papers promising to pay back the principal and [Person signs paper]
the interest that goes with it and that interest is like rent you have to rent
that money you swear up and down you'll pay back the principal that princess is
not necessarily your pal it might be a monkey on your back it might be a mule [Mule kicking a man]
that kicks you the wrong way but you owe it you owe that principal to the lender
who loaned it to you and you want to put it on a diet as fast as you can
why well because when that principal shrinks the rent you owe on it shrinks
as well all right here's some simple math you borrow 40 grand by a
three-year-old ludicrous mode enabled Tesla with a few minor dents and you [Man driving a supercar]
know you got a few shards of deer antlers stuck in the grille there for
free you are considered a risky bet by the lenders loaning you your money or
principle partly because of the way you drive so the rent on that principle 12%
a year or 1% a month big interest rates because well you're such a crappy driver
so on 40 grand of principal the cost to rent that money is 400 bucks a month or
$4,800 a year that is just to stay even on the principle you've borrowed you [Principal interest payment chart appears]
have to pay $400 every month and that's just the interest if you paid 30 40 50
60 months of 400 bucks a month well you would still owe that principal of 40
grand because all you did was baby interest or rent on it
ouch but what if he went six months paying a full thousand dollars a month
yes much would go from not eating or something like that well what would [Guy driving blue tesla]
happen think about that first month you've quote overpaid unquote by 600
bucks so if your loan resets or recalibrates every month well then you
get to put your principal at least a little bit on a diet so after that first [Principal constricted by tape measure]
month of paying a grand your 40 grand in debt goes down to thirty nine thousand
four hundred dollars pay a thousand bucks another month and while you're
still paying twelve percent a year or one percent a month to rent that money
only now that monthly rent was reset at one percent of thirty nine thousand four
hundred or 394 bucks right six dollars cheaper
than the 400 you started with but you paid a grand so now you get to use 606
dollars to pay down the principal and see the math there the new principal
thirty nine thousand four hundred minus at six hundred six it's now thirty eight
thousand seven hundred ninety four dollars that you owe do a grand another
month and you get to pay down even more of the principal about three hundred
eighty eight bucks is attributable to interest but you paid a grand so that's
a thousand minus the three eighty eight there so then that goes to principal pay
down or $612 a principal pay down alright you're getting the gist here as
you paid down the principal you get to attribute more and more of that made-up [Clock ticks as money stacks land]
thousand dollars a month payment so check out what happens when you just
keep going and as we look a couple of years into the future just look at how
little interest there is now here relative to what there was when we
started so yeah it's totally worthwhile to pay
more than minimum payments when you can and you know really as much as you can
manage that way when your bank statement for what you owe arrives in the mail you [Bank statement appears through letter box]
you know don't feel like a dear
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