Lear Concept of Agency Theory - Essay Example

The theory between the shareholders & the company managers. This term includes the expense of solving the potential conflicts between the two relevant groups. According to this theory, because of incomplete information & uncertainty, two types of problems can arise. Such as- A potential agency problem arises whenever the manager of a firm owns less than 100% of the firm’s common stocks. However, if the owner-manager incorporates & then sells some of the stocks to outsiders, a potential conflict of interest immediately arises.

In most large listed companies, potential conflicts of interest are important, as those firms’ managers generally own only a small percentage of the stocks. In this situation, shareholder wealth maximization could take a back seat to any number of conflicting managerial goals. In addition to the conflict between stockholders & managers, there can also be conflicts between creditors & stockholders. Creditors have a claim on the part of the firm’s earning stream of payment of interest & principal on the debt, & they have a claim on the firm’s assets in the event of bankruptcy.

Stockholders have control of decisions that affect the profitability & risk of the firm. Creditors lend to the firm on the base of – 1) Capital Structure: A firm’s capital structure is that mix of debt & equity that maximizes the stock price. At any point in time, management has a specific target capital structure. Capital structure policy involves a trade-off between risk & return:- Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions. The greater the probable future needs for capital, & the worse the consequences of the capital shortage, the stronger the balance sheet should be.

Managerial conservatism or aggressiveness refers to some managers being more aggressive than others, hence some firms are more inclined to use debt to boost profits. This factor does not affect the true optimal, or value maximizing, capital structure, but it does influence the manager-determined target capital structure.