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The basic goal: to create stock-holder value

Agency relationships:

1. Stockholders versus managers

2. Stockholders versus creditors

CHAPTER 1An Overview of Financial Management

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What is an agency relationship?

An agency relationship arises whenever one or more individuals, called principals, (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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If you are the only employee, and only your money is invested in the business, would any agency

problems exist?

No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock, or the firm borrows. You own 100 percent of the firm.

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If you expanded and hired additional people to help you, might that give rise

to agency problems?

An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them.

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If you needed additional capital to buy computer inventory or to develop

software, might that lead to agency problems?

Acquiring outside capital could lead to agency problems.

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Would it matter if the new capital came in the form of an unsecured bank loan, a bank loan secured by your inventory

of computers, or from new stockholders?

Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors.

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There are 2 potential agency conflicts:

Conflicts between stockholders and managers.

Conflicts between stockholders and creditors.

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Would potential agency problems increase or decrease if you expanded

operations to other campuses?

Increase. You could not physically be at all locations at the same time. Consequently, you would have to delegate decision-making authority to others.

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If you were a bank lending officer looking at the situation, what actions

might make a loan feasible?

Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge a higher than normal interest rate to compensate for risk.

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As the founder-owner-president of the company, what actions might mitigate your agency problems if you expanded

beyond your home campus?

1. Structuring compensation packages to attract and retain able managers whose interests are aligned with yours.

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2. Threat of firing.

3. Increase “monitoring” costs by making frequent visits to “off campus” locations.

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Would going public in an IPO increase or decrease agency problems?

By going public through an IPO, your firm would bring in new shareholders. This would increase agency problems, especially if you sell most of your stock and buy a yacht. You could minimize potential agency problems by staying on as CEO and running the company.

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Why might you want to (1) inflate your reported earnings or (2) use off

balance sheet financing to make your financial position look stronger?

A manager might inflate a firm's reported earnings or make its debt appear to be lower if he or she wanted the firm to look good temporarily. For example just prior to exercising stock options or raising more debt.

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If the firm is publicly traded, the stock price will probably drop once it is revealed that fraud has taken place. If private, banks may be unwilling to lend to it, and investors may be unwilling to invest more money.

What are the potential consequences of inflating earnings or hiding debt?

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“Reasonable” annual salary to meet living expenses

Cash (or stock) bonusOptions to buy stock or actual

shares of stock to reward long-term performance

Tie bonus/options to EVA

What kind of compensation program might you use to minimize agency

problems?

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Is it easy for someone with technical skills and no understanding of

financial management to move higher and higher in management?

No. Investors are forcing managers to focus on value maximization. Successful firms (those who maximize shareholder value) will not continue to promote individuals who lack an understanding of financial management.

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Why might someone interviewing for an entry level job have a better shot at getting a good job if he or she had a

good grasp of financial management?

Managers want to hire people who can make decisions with the broader goal of corporate value maximization in mind because investors are forcing top managers to focus on value maximization.

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Students who understand this focus have a major advantage in the job market. This applies both to the initial job, and the career path that follows.