Business Finance

University Degree Business and Administrative studies

AGENCY RELATIONSHIP PROBLEM

1.1 Introduction

A lot of people may think that business finance and accounting is the same thing but in actual fact, they are not the same. Accounting is involved with financial record keeping, the production of periodic reports, statements and analyses, and the dissemination of information to managers and, to some extent, to investors and the world outside the firm. Whereas, business finance acts like an investment agencies or intermediaries to manage investments by relying heavily on accounting reports and accounting database generally, i.e. to do all those things necessary to create and sell the goods and services in the provision of which the firm is engaged in.

1.2 Objective of the company

What company is seeking to achieve is of course maximization of profits. Since shareholders are the owners of a corporation and they purchase stocks because they want to earn a good return on their investment without undue risk exposure. In most cases, shareholders elect directors who then, hire managers to run the company. Although the managers cannot affect the interest rate, they can increase the market value of each shareholder’s stake in the company as they represented the shareholders.

In order to achieve the goal of maximizing shareholder wealth, managers will have to adjust the goal of profit maximisation in order to deal with the complexities in a real-world environment because many things that are happening in it, will affect share prices. A wealth maximization objective should cause managers to take financial decisions that balance returns and risks in such a way to maximize the benefits, through dividends and enhancement of share price to the shareholders. For example, shareholders will response to poor investment or dividend decisions by causing the total value of the company’s share to fall ...

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1.3 Agency Problem

Being a public listed company, a number of shares are listed on the stock exchange, allowing public members to purchase it and becomes shareholder in a company. Although they are the shareholders and bondholders, they cannot participate in the running of the company. Although, in the recent years, it has been generating much debates on the issue of corporate governance, used to describe the ways in which the businesses are directed and controlled. In businesses of any sizes, corporate governance is important because those who owed the business-that is the shareholders are usually separated from the day-to-day control of the business. Since professional managers are employed by the shareholders to manage the business on their behalf. These managers may be viewed as agents of the shareholders, who are the principals.

It seems safe to assume that mangers will be guided by the requirements of shareholders when making decisions. In other words, the wealth objectives of shareholders will become the managers’ objectives. However as managers are also human and they may have both corporate and personal goal. If the company has a weak a board of directors, they may feel that they will not be removed. In such case, management is said to be entrenched. Such a company faces a high risk of being poorly managed, because entrenched managers are able to pursue their own interests such as increasing their salary and ‘perks’ (investing in lavish office, expensive cars and so on). Because these perks are not actually cash payments to the managers, they are called non-pecuniary benefits.

Also, entrenched managers are often reluctant to reduce fixed costs by closing or selling off redundant plants, laying off employees whose services are no longer needed and abandoning projects that show little promise of future profits. Managers often hate to admit mistakes and they are also reluctant to lay off people, especially old friends and colleagues, even when these actions really should be taken. Entrenchment also enables managers to acquire other companies at too high a price, as well as to accept projects that make the company larger but that have a negative market value added (MVA). These actions occur because managerial prestige and salary are associated with larger size and they result in things that are bad for shareholders but good to the managers. Thus, the costs, known as agency cost of undertaking some sort of management audit to monitor the manager’s decision are both costly and difficult to measure.

However, if competitive forces are weak, or if information concerning management activities is not available to shareholders, the risk of agency problems will be increased. Shareholders must be alert to such risks and should take steps to ensure that the managers operate the business in a manner that is consistent with shareholder needs.

UNIVERSITY OF WALES, BUSINESS FINANCE – WA206