FINANCIAL GOAL & AGENCY

RELATIONSHIP CONFLICT

Speaker
Dr. Khursheed A. Butt
Professor
Dept. of Commerce. University of Kashmir
4th July, 2006
Copy right to Dr. Khursheed A. Butt

What Are the Learning

Goals?

Financial Goal & Agency Relationship Conflict

Learning Goals

Different Forms of Business

Organizations

Classification Of Finance
What Finance Is All About?
Analysis Of Financial Goals
Why To Maximize Shareowners Wealth Only

Forms Of Business
Organisations

FORMS OF BUSINESS ORGANIZATIONS

FORMS OF BUSINESS ORGANIZATIONS

Sole Proprietorship

Owned & Controlled By One Person

Unlimited Liability

Sources of Capital:

Personal sources
Borrowing.limited capacity

App 75% Businesses Sole Proprietorship

Forms Of Business Organizations

Partnership

Owned by Two Or More Persons

Unlimited Liability
Sources Of Capital

Personal Sources
BorrowingsRestricted Excess

1015% businessesPartnership Firms

Forms Of Business Organizations

Corporation Formed Under Law

Legal Entity.
Artificial Person..Perpetual Succession

Separate From Its Owners

Acquire Own, & Dispose-off Assets

Incur Liability
Enter Into Contract
May Sue Or Be Sued

Characteristics of Joint Stock Companies

Characteristics
C1: Limited Liability
C2: Transferability Of Ownership
C3: Easy Access to Capital
C4: Professional Management
C5: Continuity

What We Mean By
FINANCE??

MANAGEMENT OF FINANCES

What is Finance.?

To a Commoner Finance Refers to:

Cash or Funds or
Raising of Funds

But it has much wider

Connotation

Finance: What It Is All About?

To a Technocrat:.Finance

Mobilization of Funds Internally & Externally

Utilization of Funds
Distribution of Profits

Other Elements

Profit Planning, Working Capital Mgt

Implementing Financial Controls

Classification Of Finance

What is Financial Goal?

Corporate Financial Goal

HOWwwww?

Financial Goal: Profit Maximization V/S

Wealth Maximization

Profit
Maximisation

Profit Maximization

What Profi Maximisation..?

Maximization of Rupee Income

Measure of Efficiency
Quantitative Measure

Q:

Is it Operationally a Feasible Criterion

ANS:. No

Profit Maximization

Why?......Suffers From Certain

limitations

L1: It is Vague
L2: It Ignores Time Value
L3: Ignores Risk

Profit Maximization

Vague concept
It is Not Clear Whether PM Refers to:
Maximization of GP
Maximization of NP
Maximization of BTP
Maximization of ATP

Profit Maximization

Maximization of ATP
Example:ABC comp. has 10,000 shares outstanding,
its ATP are Rs 50,000. The comp. is considering to raise
Rs 5 lakh by selling 10,000 shares at Rs 50 P/share The
proposed investment is expected to earn ATP of Rs
25,000.

EPS (Before) = 50,000 / 10,000 = Rs 5

EPS (After) = 75,000 /20,000 = Rs 3.75

Profit Maximization

Time Value of Money

Money has Value.Which Varies

$ of Today is More in Value..$ Receivable in Future
Earlier CIF are Preferred Than Later CIF
Compare current CIFs with the Discounted
Future CIF

Logical:

To Consider Time Value Diff by

Discounting FV into PV

Profit Maximization

Profit Maximization:

..Irrational

R1: Not Considers Time Value

R2: Prefers Project With Highest CFs

Later Years Than the Project Having
Lowest CFs Initial Years

Profit Maximization

Profit Maximization

Risk

Probability of Earning Less Than The expected

Analyzed by Studying the Variability of Returns

Fact:

Businesspersons are Rational People

Prefer Projects Yielding More Returns &

Having Less Risk

Practice:

BusinesspersonsSensitive to Risk

Profit Maximization

Profit Maximization

Decision: Profit Maximization

Py.AcceptableMore

Profit

BR1:utMore
Unviable Decision
Probability to loose

R2: Px another option..no risk & Reas. Return

Viable Decision..Px

R1: No Risk
R2: Offering Reasonable Return
R3: BPs Rational People

Wealth Maximisation

Wealth Maximization

Wealth Maximization
Wealth =Exp. Div. +. MV of Stocks
Viability Is Assessed In Terms Of The
Impact On Wealth Rather Than On Profits

Viable Decision .PV CIFs > PV COFs

Or
Risk Adjusted Rate of
Return> Cost of Capital

Wealth Maximization

Most Appropriate Criterion to Assess

Viability of Financial Decisions

Because:

Compares Risk Adjusted Return With

Risk Adjusted Cost Of Capital

Takes into Account Time Value

Differences By Discounting FV into PV

Takes Into Account the Business Risk

Wealth Maximisation Stockholders

V/S
Maximisation of Social Wellbeing

Shareowners V/S Other Stakeholders

Q:

Why to Maximize Shareowners Wealth

OnlyOther Stakeholders?

Antagonists

A1: Pursuing the Goal of SWM is Bad

A2: Pursue Some Noble GoalMSW

Protagonists:

A1: Not at the Cost of Others

A2: Benefits Other Stakeholders

Shareowners V/S Other Stakeholders

Q:
Ans:

Does Corporate have Responsibility

Towards Society?

R1:
R2:
R3:
R4:
R5:
R6:
R7:
R8:

YES
Fair hiring practices
Operate in a safe manner
Not polluting the environment
Avoid forming monopolies
Ensure product safety
Not to evade taxes
Not to indulge in socially unacceptable actions
Fair with investors, creditors & employees

Shareowners V/S Other Stakeholders

Q: Should Compliance be mandated or left

to the discretion of companies

Ans:

Mandated

L1:

MRTP Act

L2:
L3:
L4:

Labour Laws
Pollution Laws & Tax Laws

Investor Protection Laws

L5: Spend 3% of 5-year Avg Profits

Maximization Of Social Wellbeing

Analysis

: MSW is an impractical preposition

R1: No Personal Reward.No Motivation

R2: Failure of PSU.Enough Proof

rofit Centered Free Economies Have Proved

SuccessfulSocialistic Economies
Have Failed

Maximization Of Social Wellbeing

Arguments:

A1: Laws ..Prevent Managers

Forming Monopolies
Operating in Unsafe Manner
Polluting the Environment

A2: Consistent with the Wealth Maximization

of other stakeholders

Customers
Management & Employees
General Public

Pyramid Of Corporate Stakeholders

Share
Owners
Management
Employees

Creditors
Public
Customers

Agency Relationship

AGENCY RELATIONSHIP CONFLICT

Agency Relationship
When an individual or group of individuals
Hire an individual or group of individuals to
perform certain services &
Delegates them decision making authority

Primary Agency Relationships

Stockholders Managers
Stockholders - Debt holders

AGENCY RELATIONSHIP
CONFLICT

AGENCY RELATIONSHIP
CONFLICT

WHY CONFLICT?

Agency Relationship Conflict: Stockholders-mgt.

Management:

Voracious Appetite for Higher Salaries

Habit of Living Relaxed Life Styles
Donate Corporate Dollars to Their
Favorite Charities

Avoid taking high risk investments otherwise

are essential for SNW in order to play safe

AGENCY RELATIONSHIP CONFLICT: STOCKHOLDERS-MGT.

Reasons:
R1: Leads to Maximization of Their
Own Wealth/ Welfare

R2: Wastage of Corporate Resources

Not at Their Cost

R3: Suffer From a Belief That the Wealth

created by Their Efforts Benefits to Owners

AGENCY RELATIONSHIP CONFLICT: STOCKHOLDERS-MGT

Mechanisms Needed to Check :

M1: Managerial Compensation

To Attract & Retain Able Managers

To Align the Managerial Actions with

SWM

AGENCY RELATIONSHIP CONFLICT: STOCKHOLDERS-MGT

Structure:

Specified Fixed Annual Salary

Variable Component Linked to
Profitability

Option to Buy Stocks

AGENCY RELATIONSHIP CONFLICT: STOCKHOLDERS-MGT

M2: Threat of Takeover

Threat Arises.. Stocks are Undervalued

Relative to its Potential & Mgt. are Worst
Sufferers.

M3:

Direct Intervention by IIs

Mutual funds
Insurance companies
FIs

M4: Threat of Firing

Agency Relationship Conflict

Between
Stockholders & Creditors

Agency Conflict: Stockholders-debt Holders

tockholdersOwners of
Company

Debtholders
Generally

..Lenders

Free to Use Borrowed Funds

or Using Funds.. Interest Paid

to Lenders

Agency Conflict:

Stockholders - Debt Holders

HOW CONFLICT?

Agency Conflict:

Stockholders - Debt Holders

Expropriate the Wealth of Debt Holders

A1: Divest from Low Risk Assets & Invest in
High Risk Assets

Implication:

Imp1: If New Investment Takes-Off

Stockholders Only Will Benefit
Imp2: If New Investment Fails Debt Holders
are Likely to Loose

Game: Heads I WinTails You Loose

Agency Conflict:

A2:

Alter Capital Structure by Using

More Debt

Implication:
A3:

Stockholders - Debt Holders

Exposes Debt Holders to

More Risk

Payment of Dividends not

Commensurate with the Earnings
Implication: Little assets left for the
Debt Holders.

Agency Conflict:

Stockholders - Debt Holders

Mechanisms used to Prevent

M1: Restrictive Covenants
R1: Restrictions on Using More Debt

R2: Undertaking New Investments

With Their Permission

R3: Restrictions on Payment of Div.

Thanks