Principles of Financial Investment - Essay Example

? Principles of Financial Investment Introduction In corporate sector a relationship of agency exists. Shareholders contributing to the capital of the company are mostly large in numbers, particularly when the structure is that of public company. They are the owners and it is difficult for them mange the day to day affairs of the company. Moreover they are fragmented and meet only when legally required to do so. These principals of the company have created an agency in the shape of management to carry out day- to- day affairs in order to meet strategic objectives of the company. This relationship of principal and agent has its own repercussions that create agency problems. The effects of these agency problems create agency costs that work against the benefit of all stakeholders as well as for the company. This write up identifies those agency problems, its agency costs, and enumerate the ways to mitigate the agency costs in order to provide maximization of wealth of stakeholders as well as for the benefit of management and the company itself. Definition of agency problem The nature of conduct of business in respect of proprietorships, partnerships, and cooperative societies is that those are owner- managed organizations. But in case of companies the share holders, who are the owners of the companies, are not involved in the management of the affairs of the company. The management of the company is conducted by board of directors. Directors may or may not be professionally trained but they have little or no stake in the ownership of the firm. It is true that there are certain compelling reasons for separation of ownership and management, but a separate structure leading to conduct of management through the agency of board of directors leads to conflict of interest between managers (agents) and the shareholders, who are owners of the company. Therefore the agency problems emerge from this separation of ownership and control. In fact the agency problems are the identification of this separation of ownership and control over the management. Since the relationship between shareholders and management of a company fits the nature of working of an agency, it should be noted that issues that create problems in this relationship are associated with the issue of separation ownership from the control. “This pattern of widely held corporate ownership resulted in what came to be known as separation of ownership from control. More recently, the economists have called this as an agency problem or principal- agent problem. The managers of the company are entrusted with the responsibility to make company as profitable and valuable as possible for the benefit of owners. However, the owners (principles) may have difficulty in ensuring that the managers (agents) actually carry out this responsibility.” (Robert Edward Anderson, page 49)i Ownership is concerned with maximization of wealth of shareholders. Therefore owners are always ready to critically assess the actions of the management (agents) so that their slackness anywhere is pointed out so deficiencies are rectified in effort to enhance the wealth. Accordingly enhancement of wealth is possible by making an assessment or sort of observance of the actions of the management. The key factors that are judged in management’s performance are the composition and independence of board members, transparency of their actions, their outside reporting, observance of accounting standards, and adherence of strategic objective of enhancement of shareholders wealth. This monitoring or observance lead to difference of opinion with reference to strategic objectives of the corporation and give rise to agency problems in the corporate sector of management. Basically agency problems have two aspects. First aspect is the situation where it is not possible for the principal to verify the appropriateness of the actions of the agent. This generally is the case when goals or objective differ and create difficulties to verify what agent is doing. The second aspect of the agency problem is sharing the risks and rewards. Overall agency problem is the non- observance of basic principles of trust on each other. Agency theory may be an extension of division of labour, but in modern businesses this division is product of trust. When this trust is broken or shaken at the end of shareholders or management, agency problems are surfaced. The reasons of existence of agency problems Agency problems arise because of “this conflict of management objective of survival (personal goals) and maximizing owners’ value.” (M Y Khan, page 1-18)ii. When both sides of agency relationship have their ends to grind problems occur because of conflicting attitude. “Agency problems refer to the possibility of opportunistic behavior by the agent that works against the principal. Such behavior will occur when there is information asymmetry between the agent and the principal. The existence of outcome uncertainty, dependant outcome, and aggregate outcome make problem more difficult to solve through the proper design of remuneration contract. The divergent and independent utility functions of the principal and agent, and information asymmetry between them are recognized as the major sources of agency problems.”(Alexander S Preker, page 157)iii. The problems of agency have roots in the information asymmetry. In other managers are in possession of some information. The information that is in possession of connected stakeholder is a different version of such information. Different opinions are bound to occur leading to emergence of agency problems. As stated earlier that agency problems emerge because of separation of ownership from control over management, and this separation is the result following reasons: Generally the requirement of capital is necessary to achieve the economies of scale. Large capital becomes possible on pooling of small investments of large number of investors. It is impractical for all these investors to participate actively into the management of the business. Professional managers may be more qualified and have the capacity to run the business more efficiently and effectively. This is because of their technical expertise, experience, and personality traits. Separation of ownership and management permits unrestricted change in owners through share transfers without affecting the operations of the business and firm. It ensures that knowhow of the firm is not impaired, despite changes in the ownership of the firm. Uncertainty is the buzz word in business circle. Given economic uncertainties, investors would like to hold diversified portfolios of investments. Such diversification is possible when ownership and management are separated. While there are compelling reasons for separation of ownership and management, a separate structure leads to a possible conflict of interests between managers and shareholders. Though managers are agents of shareholders they are likely to act in ways that may not maximize the wealth of the owners. Managers enjoy substantial autonomy in practical operations of management of the business. All actions are the responsibilities of the management and under such situations vested interests are created. Under these circumstances they have a natural inclination to pursue their own goals. In order to prevent managers from pursuing their private goals some time it becomes necessary to remove them from their positions. To prevent from being dislodged from their positions, managers may try to achieve a certain acceptable level of performance as far shareholders welfare is concerned. However, beyond that their personal goals like presiding over a large business empire, pursuing their pet projects, diminishing their personal risks, and enjoying generous compensation and lavish perquisites tend to acquire priority over shareholder welfare. The lack of perfect alignment between interests of managers and shareholders results in agency costs which may be defined as the difference between the value of an actual firm and the value of a hypothetical firm in which management and shareholders’ interests are perfectly aligned. The problems that can be caused by agency problems Management may not act with the required prudence of astute business persons. This perhaps is the real effect of agency problem created by the separation of ownership from control in the corporate sector. Conflict between shareholders and managers are not the only principal- agent problems. Just as shareholders need to encourage managers to work for the shareholders’ interest, so senior management need to think about how to motivate everyone else in the company. Many times unresolved agency problems make a company vulnerable to a financial crisis. “The unresolved agency problems can not only trigger financial crisis but can also act as propagating mechanism for external shocks ( such as currency risk) that could result into financial crisis.” (T T Ram Mohan and others, page 169)iv Even though there is a small external shock to a company, but its significant unresolved agency problem can such crises that bring it to the point of no return like insolvency. Agency problems “create monitoring difficulties giving the potential for management to take non- value maximization actions.” (Johanna Miettinen, page 12)v Inefficiencies go unnoticed and in the process there are adverse effects on the finances of the company. In a situation where there free cash flows lying at the mercy of management in confrontation with ownership chances are that “ in the presence of high cash flows management has opportunity to make expenditure that have negative net present value (NPV) rather than paying dividend to shareholders or purchase stock.” (Johanna Miettinen, page 12)vi. In other words agency problems entail wastage of valuable resources that could otherwise be utilized for maximization of wealth of the company as well as its shareholders. ”Agency cost may result in two significant problems: underinvestment and over investment. First under investment is likely to occur where agency costs are not effectively reduced. Second, rather than underinvestment, danger of managerial opportunism in firms exists in firms with excess cash flows and insufficient opportunities for growth. Here the managers may reinvest free cash flows in suboptimal assets.” (John E Parkinson and others, page 269)vii Agency costs can also arise in normal workings. The banks and bondholders who lend the company are united with the shareholders in wanting the company to prosper, but when firm gets into trouble, this unity of purpose breaks down. At such time decisive actions are necessary to rescue the firm, but lenders are concerned to get their money back and are reluctant to see the firm making risky changes that could imperil the safety of their loans. As observed these agency costs are the direct result of conflict between principals and agents. In fact “agency costs are the direct and indirect costs of attempting to ensure that agents act in the best interest of principals as well as the loss resulting from failure to get them to act this way. If management are acting for the maximization of shareholders wealth debt holders have reasons to fear for agency problems, because there may be actions which potentially benefit the owners at the expense of lenders.” (Glen Arnold, page 816)viii Mechanism that can be used to reduce agency costs The resultant agency costs from agency problems are detrimental to the financial health of corporation. The problems are required to be mitigated as early as possible. Basically agency costs are informational problems. Principal- agent problems would be easier to solve if everyone had the same information. That is rarely the case in finance. Mangers and shareholders may all have different information about the value of a real or financial asset. These misinformation or non-information is the basic cause of all agency problems. There are two forces that prevent or minimize such agency costs. One force is called market force. That means major shareholders, particularly when those are institutional investors. These holders of large block of company’s shares often threaten to use their voting rights or liquidate their holdings if the management does not work in direction of maximization of wealth for the owners of the company, and for the benefit of all concerned. Also these large share holders can threat for takeover of the company and pressurize the management. When there is a constant threat of takeover, management is motivated to act in the best interests of owners and all other stakeholders of the company. The second force is maintenance of a corporate governance structure. This monitors management behaviors and ensures against dishonest act of management. In turn this provides management a financial incentive to maximize share price. Financial incentive is a powerful approach. This is an “expensive approach to structure management compensation to correspond with share price maximization. The objective is to give mangers incentives to act in the best interests of the owners. In addition, the resulting compensation packages allow firms to compete for and hire the best managers available.” (Lawrence J Gitman, page 20)ix The reality is that company is considered as a pie by the stakeholders. This pie is divided among a number of claimants. These include management, shareholders, company’s workforce, investors, and even the govt. Govt. has to recover profits from company’s margins. All claimants will work together in a complex web of agreements and understandings. But agency problems create an atmosphere where these claimant start working against each other. When agency problems are mitigated its related costs will be eliminated. Accordingly this non- occurrence of agency cost will encourage all stakeholders to ensure a positive stake for all in the pie. Conclusion The agency relationship between shareholders (principals) and management (agent) is that ingredient of corporate organizational structure which is responsible for conflicts between ownership and the management. Agency problems are created as shareholders want management to increase the value of the firm, but managers have their own axe to grind. Agency costs are incurred because of these agency problems. Even though all stakeholders work together as they are bound by a complex web of contracts and understandings, but they stand against each other when their individual objectives are defeated as or because of these agency costs. Agency costs occur as asymmetrical information is provided to different stakeholders. These costs can be avoided in two ways. One is when a large block shareholder threatens the very existence of the management, and second is through the application of corporate governance rule. Under corporate governance management is attracted by remunerative incentives to maximize the wealth of shareholders and the value of the firm. Word Count: 2507 References: Read More