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AMITY GLOBAL BUSINESS SCHOOL

Chandigarh

Agency costs refer to costs which arise due to an agency problem, which is also called principal agent problem or agency dilemma, occurs when an agent acts on behalf of the principal. The problem arises because agents interests and priorities may be different from that of the principal

AMITY GLOBAL BUSINESS SCHOOL

Chandigarh

Agency costs are costs that a principal incurs to decrease or eliminate the agency problem by providing agent with incentive to act in the best interests of the principal as well as by monitoring the agents actions to ensure the agent is acting honestly and in the best interests of the principal. Agency problem, in the context of an organization, refers to the tendency of management to pursue its own needs as a first priority, which may be at the expense of the needs of the shareholders.

AMITY GLOBAL BUSINESS SCHOOL

Business Activities

Chandigarh

Production Marketing Finance

AMITY GLOBAL Real SCHOOL BUSINESSAssets

Vs. Financial Assets Chandigarh

Real Assets: Assets used to produce goods and services. E.g. land, building, patent etc. They contribute directly to the productivity of the economy.

Financial Assets: Claims on real assets or the income generated by them. E.g. shares, bonds etc. They do not contribute directly to the productivity of the economy. These are claims on the income generated by real assets.

AMITY GLOBAL BUSINESS SCHOOL

Finance Functions

Chandigarh

Investment or Long Term Asset Mix Decision Financing or Capital Mix Decision Dividend or Profit Allocation Decision Liquidity or Short Term Asset Mix Decision

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Finance Managers Role Chandigarh

Raising of Funds Allocation of Funds Profit Planning Understanding Capital Markets

AMITY GLOBAL BUSINESS SCHOOL

Financial Goals

Chandigarh

Profit maximization (profit after tax) Maximizing Earnings per Share Shareholders Wealth Maximization

AMITY GLOBAL BUSINESS SCHOOL

Profit Maximization

Chandigarh

Maximizing the Rupee Income of Firm Resources are efficiently utilized

Appropriate measure of firm performance


Serves interest of society

AMITY GLOBAL Objections BUSINESS SCHOOL

to Profit Maximization Chandigarh

It is Vague It Ignores the Timing of Returns It Ignores Risk Assumes Perfect Competition In new business environment profit maximization is regarded as
Unrealistic Difficult Inappropriate Immoral

AMITY GLOBAL BUSINESS SCHOOL

Maximizing EPS

Chandigarh

Ignore time and risk of the expected benefit Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares Maximizing EPS implies that the firm should make no dividend payments so long as funds can be invested at positive rate of returnsuch a policy may not always work

AMITY GLOBAL Shareholders BUSINESS SCHOOL

Wealth Maximization Chandigarh

Maximizes the net present value of a course of action to shareholders. Accounts for the timing and risk of the expected benefits. Benefits are measured in terms of cash flows. Fundamental objectivemaximize the market value of the firms shares.

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Risk-return Trade-off

Chandigarh

Risk and expected return move in tandem; the greater the risk, the greater the expected return. Financial decisions of the firm are guided by the risk-return trade-off. The return and risk relationship: Return = Risk-free rate + Risk premium Risk-free rate is a compensation for time and risk premium for risk.

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Risk-Return relationship Chandigarh

AMITY GLOBAL BUSINESS SCHOOL

Risk-Return relationship Chandigarh

AMITY GLOBAL BUSINESS SCHOOL

Agency Theory

Chandigarh

It deals with the potential conflict of interest between personal goals of managers that compete with shareholder wealth maximization.

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Agency Relationship

Chandigarh

It arises when one or more individual called the principal, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision making authority to that agent.

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Agency Problem/Conflict

Chandigarh

The conflict between the interest of shareholders and managers or shareholders and creditors is called agency problem/conflict and it results into agency cost. Agency Cost: it includes all cost borne by the shareholders to encourage managers to maximize the firms stock price rather than act in their own self-

AMITY GLOBAL AP 1: Stockholders BUSINESS SCHOOL

Vs. Managers Chandigarh

Managerial Compensation Direct intervention by shareholders The threat of firing The threat of takeover. Hostile takeovers

AMITY GLOBAL AP 2: Stockholders BUSINESS SCHOOL

Vs. Creditors Chandigarh

Conflict arises basically because of the change in the risk exposure.

AMITY GLOBAL Financial Goals BUSINESS SCHOOL

and Firms Mission Chandigarh and Objectives

Firms primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them Firms state their vision, mission and values in broad terms Wealth maximization is more appropriately a decision criterion, rather than an objective or a goal. Goals or objectives are missions or basic purposes of a firms existence

AMITY GLOBAL Financial Goals BUSINESS SCHOOL

and Firms Mission Chandigarh and Objectives

The shareholders wealth maximization is the second-level criterion ensuring that the decision meets the minimum standard of the economic performance. In the final decision-making, the judgment of management plays the crucial role. The wealth maximization criterion would simply indicate whether an action is economically viable or not.

AMITY GLOBAL The common BUSINESS SCHOOL

stockholders are Chandigarh the owners of the corporation!

Stockholders elect a board of directors who in turn hire managers to maximize the stockholders well being. When stockholders perceive that management is not doing this, they might attempt to remove and replace the management, but this can be very difficult in a large corporation with many stockholders.

AMITY GLOBAL BUSINESS SCHOOL

Chandigarh

More likely, when stockholders are dissatisfied they will simply sell their stock shares.
This action by stockholders will cause the market price of the companys stock to fall.

AMITY GLOBAL BUSINESS SCHOOL

Chandigarh

When stock price falls relative to the rest of the market (or relative to the rest of the industry) ...
Management is failing in their job to increase the welfare (or wealth) of the stockholders (the owners).

AMITY GLOBAL BUSINESS SCHOOL

Chandigarh

Conversely, when stock price is rising relative to the rest of the market (or industry), ...
Management is accomplishing their goal of increasing the welfare (or wealth) of the stockholders (the owners).

AMITY GLOBAL The goal BUSINESS SCHOOL

of the firm should be to Chandigarh maximize the stock price!

This is equivalent to saying the goal is to maximize owners wealth. Note that the stock price is affected by managements decisions affecting both risk and profit. Stock price can be maintained or increased only when stockholders perceive that they are receiving profits that fully compensate them for bearing the risk they perceive.

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The Principal Agent Problem Chandigarh


Question: Who has the power?

Shareholders = Owners

Answer: Managers
Managers = Employees

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Incentive Issues

Chandigarh

Monitoring - Reviewing the actions of managers and providing incentives to maximize shareholder value.

Free Rider Problem - When owners rely on the efforts of others to monitor the company. Management Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.

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Management Compensation Chandigarh

Agency costs include costs which arise due to maintenance of corporate governance structure of the organization. The goal is to give the management incentive to treat the needs of shareholders as a priority as well as ensuring honest dealings of management and monitoring managements performance To tie rewards of management to the shareholders wealth maximization, management may be given portion of shares of the company. Therefore, management becomes shareholders as well and their needs and interests become more aligned with other shareholders.

AMITY GLOBAL Management is BUSINESS SCHOOLgiven stock options which will Chandigarh allow purchasing stock at the market price set at the time when stock options are granted at some point in the future. This gives management an incentive to be interested in shareholders wealth maximization since management will be able to benefit from it personally by buying appreciated shares at some point in the future at the price set at the time stock options were granted (at the lower price).

To tie rewards of management to the performance of the company, management may be evaluated based on their ability to achieve certain measures such as EPS. Performance shares or cash bonus may be given to reward management for meeting specific performance measures.

The other AMITY GLOBAL ways which help to decrease the agency problem in organisations is the BUSINESS SCHOOL Chandigarh pressure that shareholders place on the management and negative implications which will materialize if management cannot meet shareholders expectations. Another factor that helps to decrease the agency problem in organisations is the threat of takeover by an individual, group or company which believes that company could be managed better. It serves as impetus for management to work harder in meeting shareholders needs.