FMCF(KMBN-204)

MEANING OF FINANCE

Finance may be defined as the art and science of managing money. It includes financial
services and financial instruments. Finance also is referred as the provision of money at the
time when it is needed. The finance function is the procurement of funds and their effective
utilization in business concerns.
The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important
part of the business concern

According to Khan and Jain, “Finance is the art and science of managing money”.
According to Wheeler, “Business finance is that business activity which concerns with the
acquisition and conversation of capital funds in meeting financial needs and overall
objectives of a business enterprise”.

Corporate finance is concerned with budgeting, financial forecasting, cash management,

credit administration, investment analysis, and fund procurement of the business concern and
the business concern needs to adopt modern technology and application suitable to the global
environment.

According to the Encyclopedia of Social Sciences, “Corporation finance deals with the
financial problems of corporate enterprises. These problems include the financial aspects of
the promotion of new enterprises and their administration during early development, the
accounting problems connected with the distinction between capital and income, the
administrative questions created by growth and expansion, and finally, the financial
adjustments required for the bolstering up or rehabilitation of a corporation which has come
into financial difficulties”.

FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is concerned with the

duties of the financial managers in the business firm. The term financial management has
been defined by Solomon“It is concerned with the efficient use of an important economic
resource namely, capital funds”. S.C.Kuchalis that “Financial Management deals with
procurement of funds and their effective utilization in the business”.
Thus, Financial Management is mainly concerned with effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be
called as Corporation Finance or Business Finance.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management.
1. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with financial
management approaches. Investment decisions and micro and macro environmental factors
are closely associated with the functions of a financial manager.
2. Financial Management and Accounting
Accounting records include the financial information of the business concern. Both financial
management and accounting are treated as the same discipline and then it has been merged as
Management Accounting because this part is very much helpful to finance managers to take
decisions. But nowaday’s financial management and accounting disciplines are separate and
interrelated.
3. Financial Management or Mathematics
Modern approaches of financial management applied a large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order
quantity, discount factor, time value of money, the present value of money, cost of capital,
capital structure and working capital analysis are used as mathematical and statistical tools
and techniques in the field of financial management.
4. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to
multiply the money into profit. Profit of the concern depends upon the production
performance. Production performance needs finance, and the finance manager allocates the
appropriate finance to the production department.
5. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. marketing
and financial management are interrelated and depend on each other.
6. Financial Management and Human Resource
Financial management is also related to the human resource department, which provides
manpower to all the functional areas of the management. Financial managers should carefully
evaluate the requirement of manpower to each department and allocate the finance to human
resources.

OBJECTIVES OF FINANCIAL MANAGEMENT

Effective procurement and efficient use of finance lead to proper utilization of the finance by
the business concern. It is an essential part of the financial manager. Hence, the financial
manager must determine the basic objectives of financial management. Objectives of
Financial Management may be broadly divided into two parts such as :
1. Profit maximization
2. Wealth maximization
Profit Maximization
The main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring technique to
understand the business efficiency of the concern. Profit maximization is also the traditional
and narrow approach, which aims at, to maximize the profit of the concern. Profit
maximization consists of the following important features.
1. Profit maximization is also called as cash per share maximization. It leads to maximizing
the business operation for profit maximization.
2. Ultimate aim of the business concern is earning a profit, hence, it considers all the possible
ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favorable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the
business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter
of the business operation.
(iii)Profit reduces the risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets social needs also.
Unfavorable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practices, and unfair trade
practices.
(iii)Profit maximization objectives lead to inequalities among the sake holders such as
customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
The profit maximization objective consists of certain drawbacks also:
(i)It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinions regarding earning habits of the business concern.
(ii)It ignores the time value of money: Profit maximization does not consider the time value
of money or the net present value of the cash inflow. It leads certain
differences between the actual cash inflow and net present cash flow during a particular
period.
(iii)It ignores risk: Profit maximization does not consider the risk of the business
concern. Risks may be internal or external which will affect the overall operation of the
business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves the latest innovations
and improvements in the field of the business concern. The term wealth means shareholder
wealth or the wealth of the persons who are involved in the business concern. Wealth
maximization is also known as value maximization or net present worth maximization. This
objective is a universally accepted concept in the field of business

Favorable Arguments for Wealth Maximization

(i) Wealth maximization is superior to profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated with
the business concern. Total value detected from the total cost incurred for the business
operation. It provides extract value of the business concern.
(iii) Wealth maximization considers both the time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to a prescriptive idea of the business concern but it may not be
suitable to present-day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of
profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv)Management alone enjoys certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize profit.
(vi) Wealth maximization can be activated only with the help of the profitable position of the
business concern
Functions: of Finance Manager: Finance manager is one of the important role players in the
field of the finance function. He must have entire knowledge in the area of accounting,
 finance, economics and management. His position is highly critical and analytical to solve
various problems related to finance. A person who deals finance related activities may be
called a finance manager.
1. Forecasting Financial Requirements: It is the primary function of the Finance Manager. He
is responsible to estimate the financial requirement of the business concern. He should
estimate, how much finances are required to acquire fixed assets and forecast the amount
needed to meet
the working capital requirements in the future.
2. Acquiring Necessary Capital: After deciding the financial requirement, the finance
manager should concentrate how the finance is mobilized and where it will be available.
3. Investment Decision: The finance manager must carefully select the best investment
alternatives and consider the reasonable and stable return from the investment. He must be
well versed in the field of capital budgeting techniques to determine the effective utilization
of investment. The finance manager must concentrate to principles of safety, liquidity and
profitability while investing capital.
4. Cash Management: Present days cash management plays a major role in the area of finance
because proper cash management is not only essential for the effective utilization of cash but
it also helps to meet the short-term liquidity position of the concern.
5. Interrelation with Other Departments: The finance manager deals with various functional
departments such as marketing, production, personnel, system, research, development, etc.
Finance managers should have sound knowledge not only in the finance-related area but also
well versed in other areas. He must maintain a good relationship with all the functional
departments of the business organization

IMPORTANCE OF FINANCIAL MANAGEMENT

Finance is the lifeblood of a business organization. It needs to meet the requirement of the
business concern. Each and every business concern must maintain an adequate amount of
finance for smooth running of the business concern and also maintain the business carefully
to achieve the goal of the business concern. The business goal can be achieved only with the
help of effective management of finance.
• Financial Planning: Financial management helps to determine the financial requirement
of the business concern and leads to take financial planning of the concern. Financial planning is
an important part of the business concern, which helps to the promotion of an enterprise.
• Acquisition of Funds: Financial management involves the acquisition of required finance
to the business concern. Acquiring needed funds play a major part of financial management,
which involves a possible source of finance at minimum cost.
• Proper Use of Funds: Proper use and allocation of funds leads to improving the
operational efficiency of the business concern. When the finance manager uses the funds
properly, they can reduce the cost of capital and increase the value of the firm.
• Financial Decision: Financial management helps to take sound financial decisions in the
business concern. A financial decision will affect the entire business operation of the concern.
Because there is a direct relationship with various department functions such as marketing,
production personnel, etc.
• Improve Profitability: The profitability of the concern purely depends on the effectiveness
and proper utilization of funds by the business concern. Financial management helps to improve
the profitability position of the concern with the help of strong financial control
• Increase the Value of the Firm: Financial management is very important in the field of
increasing the wealth of the investors and the business concern. The ultimate aim of any business
concern will achieve maximum profit and higher profitability leads to maximizing the wealth of
the investors as well as the nation.
 • Promoting Savings: Savings are possible only when the business concerned earns higher
profitability and maximizes wealth. Effective financial management helps to promote and
mobilize individual and corporate savings.
Nowadays financial management is also popularly known as business finance or corporate
finance. The business concern or corporate sectors cannot function without the importance of
the financial management

Sources Of Finance:
1. Based on the Period
(1) Long-term sources of finance include:
• Equity Shares
• Preference Shares
• Debenture
• Long-term Loans
• Fixed Deposits
(2)Short-term source of finance include:
• Bank Credit
• Customer Advances
• Trade Credit
• Factoring
• Public Deposits
• Money Market Instruments
2. Based on Ownership
 (1) An ownership source of finance include
• Shares capital, earnings
• Retained earnings
• Surplus and Profits
(2) Borrowed capital include
• Debenture
• Bonds
• Public deposits
• Loans from Bank and Financial Institutions.
3. Based on Sources of Generation
Sources of Finance may be classified into various categories based on the period.

(1)Internal source of finance includes

• Retained earnings
• Depreciation funds
• Surplus
(2)External sources of finance may be include
• Share capital
• Debenture
• Public deposits
• Loans from Banks and Financial institutions

The risk/return tradeoff only indicates that higher risk levels are associated with the
possibility of higher returns, but nothing is guaranteed. At the same time, higher risk also
means higher potential losses on an investment.Higher risk is associated with greater
probability of higher return and lower risk with a greater probability of smaller return. This
trade off which an investor faces between risk and return while considering investment
decisions is called the risk return trade off.
• Higher risk is associated with greater probability of higher return, lower risk with a
greater probability of smaller return.
• This trade off which an investor faces between risk and return while considering
investment decisions is called the risk return trade off.
Risk and return
Every saving and investment product involves different risks and returns. The investors are
exposed to both systematic and unsystematic risks.
1. Systematis risk is the risk inherent to the entire market or market segment, and it can
affect a large number of assets. Also known as undiversifiable risk, volatility and market risk,
systematic risk affects the overall market – not just a particular stock or industry. This type of
risk is both unpredictable and impossible to avoid completely. Examples include interest rate
changes, inflation, recessions and wars.
2. Unsystematic risk on the other hand, risk affects a very small number of assets. Also
called non-systematic risk, specific risk, diversifiable risk and residual risk, this type of risk
refers to the uncertainty inherent in a company or industry investment. Examples include a
change in management, a product recall, a regulatory change that could drive down company
sales and a new competitor in the marketplace with the potential to take away market share
from a company in which you’re invested. It’s possible to mitigate unsystematic risks through
diversification.

Market risk: The risk of investments declining in value because of economic developments
or other events that affect the entire market. The main types of market risk are equity risk,
interest rate risk and currency risk.
• Equity risk – applies to an investment in shares. The market price of shares varies all
the time depending on demand and supply. Equity risk is the risk of loss because of a
drop in the market price of shares.
• Interest rate risk – applies to debt investments such as bonds. It is the risk of losing
money because of a change in the interest rate. For example, if the interest rate goes
up, the market value of bonds will drop.
• Currency risk – applies when you own foreign investments. It is the risk of losing
money because of a movement in the exchange rate. For example, if the U.S. dollar
becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth
less in Canadian dollars.
2. Liquidity risk: The risk of being unable to sell your investment at a fair price and get your
money out when you want to. To sell the investment, you may need to accept a lower price.
In some cases, such as exempt market investments, it may not be possible to sell the
investment at all.
3. Concentration risk: The risk of loss because your money is concentrated in 1 investment
or type of investment. When you diversify your investments, you spread the risk over
different types of investments, industries and geographic locations.
4. Credit risk: The risk that the government entity or company that issued the bond will run
into financial difficulties and won’t be able to pay the interest or repay the principal at
maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk
by looking at the credit rating of the bond. For example, long-term Canadian government
bonds have a credit rating of AAA, which indicates the lowest possible credit risk.
5. Reinvestment risk: The risk of loss from reinvesting principal or income at a lower
interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest
rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk
will also apply if the bond matures and you have to reinvest the principal at less than 5%.
Reinvestment risk will not apply if you intend to spend the regular interest payments or the
principal at maturity
6. Inflation risk:The risk of a loss in your purchasing power because the value of your
investments does not keep up with inflation. Inflation erodes the purchasing power of money
over time – the same amount of money will buy fewer goods and services. Inflation risk is
particularly relevant if you own cash or debt investments like bonds. Shares offer some
protection against inflation because most companies can increase the prices they charge to
their customers. Share prices should therefore rise in line with inflation. Real estate also
offers some protection because landlords can increase rents over time.
7. Horizon risk:The risk that your investment horizon may be shortened because of an
unforeseen event, for example, the loss of your job. This may force you to sell investments
that you were expecting to hold for the long term. If you must sell at a time when the markets
are down, you may lose money.
8. Foreign investment risk:The risk of loss when investing in foreign countries. When you
buy foreign investments, for example, the shares of companies in emerging markets, you face
risks that do not exist in Canada, for example, the risk of nationalization.

Corporate Governance
Corporate governance is a system that guides the conduct of the people within an
organization, as well as the direction of the organization itself.
Corporate governance is altogether different from the daily operational decisions and
activities that are executed by the management of an organization. Corporate governance is
the domain of the Board of Directors, as opposed to its management team (such as
the CEO and other C-suite executives).
 Corporate governance is a system (or a function); it’s not a job title or a specific role.

 Some of the many domains for which the corporate governance function is respons-
ible include risk management, strategic planning, talent management, and succession
planning.

 Evolving market dynamics and economic realities are putting pressure on the corpor-
ate governance functions at organizations around how stakeholder needs are identified
and managed.

 A healthy corporate governance function requires a clear and formal separation of du-
ties between management and the Board.

Corporate Governance Deployment

The corporate governance function must steer the direction of an organization across a vari-
ety of important dimensions. These dimensions include, but are not limited to:
 Enterprise Risk Management – This includes identifying and mitigating strategic,
operational, reputational, and even financial risks within an organization.
 Strategic Planning – This is all about identifying and capturing opportunities today
in order to position for (and to create) enduring competitive advantages and future
value.
 Accounting & Disclosure – The corporate governance function must support finan-
cial recordkeeping, as well as approve public stakeholder reporting (including finan-
cial statements, 10Ks, and sustainability and/or ESG disclosures).
 Talent Management – This requires that leaders understand how to attract, retain,
and improve human resources within the organization. This area is often referred to
as Human Capital Management (or HCM).
 Succession Planning – This is effectively talent management but with the intention of
“future-proofing,” particularly at the leadership levels. This helps to ensure that a
strong leadership “pipeline” exists within the organization.
Organizational Hierarchy
A relatively standard organizational structure typically looks like this:
The C-suite is operational decision makers within the organization, with the CEO being the
senior-most person. The CEO reports to
the Board of Directors (BOD).
The BOD (led by the Chair of the
Board) is responsible for the direction
and execution of the corporate gover-
nance function.
All appointments to the Board must be
voted upon by the shareholders of the
company. In many respects, this makes
the BOD beholden to shareholders. His-
torically, most BODs have operated un-
der this line of thinking.
The concept is referred to as shareholder primacy; it’s an implicit understanding that all deci-
sions within an organization must be made with the best interest(s) of shareholders in mind.
More recently, however, the growing popularity of Environmental, Social & Gover-
nance (ESG) as an analysis framework has put pressure on organizations (and their corporate
governance functions) to consider the concept of stakeholder primacy more rigorously.

Difference between Shareholders and Stakeholders

Shareholder is a person, who has invested money in the business by purchasing shares of the
concerned enterprise.
Stakeholder implies the party whose interest is directly or indirectly affected by the com-
pany’s actions. The scope of stakeholders is wider than that of the shareholder, in the sense
that the latter is a part of the former. Stakeholders represent the entire micro-environment of
the business.
BASIS FOR
SHAREHOLDER STAKEHOLDER
COMPARISON
Meaning The person who owns the shares of The party, who is having a stake in the
the company is known as a company, is known as Stakeholder.
Shareholder.
Who are they? Owners Interested Parties
What is it? Subset Super set
Company Only a company, which is limited Every company or organization has
by shares, has shareholders. stakeholders.
Includes Equity shareholders, Preference Shareholders, Creditors, Debenture
shareholders holders, Employees, Customers,
Suppliers, Government etc.
Focuses on Return on investment Performance of the company
Key Differences between Shareholders and Stakeholders
The following are the differences between shareholders and stakeholders:
1. The person holding the shares of the company is known as Shareholders. The party
having a stake in the company or organization is known as Stakeholder.
 2. Shareholders are the owners of the company as they had bought the financial shares,
issued by the company. Conversely, Stakeholders are the interested parties who affect
or get affected by the company’s policies and objectives.
3. Shareholders are a part of the Stakeholders. It can also be said that shareholders are
stakeholders, but the stakeholders are not necessarily the shareholders of the com-
pany.
4. Shareholders lay emphasis on the return on their investment made in the company. On
the other hand, Stakeholders focuses on the performance, profitability, and liquidity of
the company.
5. The scope of stakeholders is comparatively wider than the shareholders because there
are other constituents also apart from shareholders.
6. Only the company limited by shares has shareholders. However, every company or or-
ganization has stakeholders, whether it is a government agency, nonprofit organiza-
tion, company, partnership firm or a sole proprietorship firm.

Benefits of Corporate Governance

 Good corporate governance creates transparent rules and controls, provides guidance
to leadership, and aligns the interests of shareholders, directors, management, and
employees.
 It helps build trust with investors, the community, and public officials.
 Corporate governance can provide investors and stakeholders with a clear idea of a
company's direction and business integrity.
 It promotes long-term financial viability, opportunity, and returns.
 It can facilitate the raising of capital.
 Good corporate governance can translate to rising share prices.
 It can lessen the potential for financial loss, waste, risks, and corruption.
 It is a game plan for resilience and long-term success.
The Principles of Corporate Governance
While there can be as many principles as a company believes make sense, some of the more
well-known include the following.
Fairness
The board of directors must treat shareholders, employees, vendors, and communities fairly
and with equal consideration.
Transparency
The board should provide timely, accurate, and clear information about such things as finan-
cial performance, conflicts of interest, and risks to shareholders and other stakeholders.
Risk Management
The board and management must determine risks of all kinds and how best to control them.
They must act on those recommendations to manage them. They must inform all relevant
parties about the existence and status of risks.
Responsibility
The board is responsible for the oversight of corporate matters and management activities. It
must be aware of and support the successful, ongoing performance of the company. Part of
its responsibility is to recruit and hire a CEO. It must act in the best interests of a company
and its investors.
Accountability
The board must explain the purpose of a company's activities and the results of its conduct.
It and company leadership are accountable for the assessment of a company's capacity, po -
tential, and performance. It must communicate issues of importance to shareholders.
Example of Corporate Governance

PepsiCo
It's common to hear about examples of bad corporate governance. In fact, it's often why
companies end up in the news. You rarely hear about companies with good corporate gover-
nance because their corporate guiding policies keep them out of trouble.
One company that has consistently practiced good corporate governance and seeks to update
it often is PepsiCo. In drafting its 2020 proxy statement, PepsiCo sought input from in -
vestors in six areas:
 Board composition, diversity, and refreshment, plus leadership structure
 Long-term strategy, corporate purpose, and sustainability issues
 Good governance practices and ethical corporate culture
 Human capital management
 Compensation discussion and analysis
 Shareholder and stakeholder engagement5
The company included in its proxy statement a graphic of its current leadership structure. It
showed a combined chair and CEO along with an independent presiding director and a link
between the company's "Winning with Purpose" vision and changes to the executive com -
pensation program.
Current Trends & Corporate Governance Pressures
Beyond the expansion in scope from shareholder to stakeholder primacy, there are some in-
teresting, current trends that are putting significant pressures on the corporate governance
functions within organizations of all sizes.
Some examples are:
The “Great Resignation”
The so-called “Great Resignation” has created an environment where the very nature of work
(as we once knew it) has changed. Firms must consider remote and hybrid working arrange-
ments when planning to hire.
While this presents challenges, it has also opened the door to a much broader talent pool
since companies are no longer required to hire people that live within commuting distance of
the nearest office.

Climate change
Leadership at many organizations is realizing that climate change presents more than just en-
vironmental risks – it can present existential risks to business operations (due to physical cli-
mate impacts, regulatory-driven “transition risks,” and potential reputational damage).
With so many organizations making pledges to meet “Net Zero” or even carbon neutral emis-
sions targets, having BOD representation with some ESG experience has become paramount
in order to navigate the ESG disclosure landscape and to avoid the perception of green wash-
ing.

Geopolitical and Economic Uncertainty

Russia’s invasion of Ukraine in 2022, coupled with strained relations between two of the
world’s economic superpowers (the US and China), are a few of many factors that have con-
verged to create chaos in supply chains, as well as subsequent economic uncertainty on a
global scale.
A strong leadership team and effective corporate governance function must identify and seize
upon opportunities while simultaneously identifying and mitigating risks accordingly.

Technology & Data

In an increasingly digital world (and economy), technological advancements have changed
the landscape of virtually every business. Employees, customers, and other stakeholders are
increasingly concerned about privacy; therefore, it’s incumbent upon organizations to take
these issues seriously.
Secure warehousing of sensitive information, deployment of communication tools, and gen-
eral data protection and integrity are all major topics of discussion in boardrooms around the
world.

Agency Problem
An agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, an agency problem usually
refers to a conflict of interest between a company's management and the company's
stockholders.
The agency problem can be defined as a conflict when the agents entrusted with the responsi-
bility of looking after the interests of the principals choose to use the power or authority for
their benefits and in corporate finance. It is a conflict of interest between its management
and stockholders.
It is a common problem in almost every
organization, whether a church, club,
company or government institution. A
conflict of interest occurs when respon-
sible people misuse their authority and
power for personal benefits. However, it
can be resolved if only the organizations
are willing to fix it.

 An agency problem is a conflict

of interest inherent in any rela-
tionship where one party is ex-
pected to act in the best interest
of another.

 Agency problems arise when incentives or motivations present themselves to an agent

to not act in the full best interest of a principal.

 Through regulations or by incentivizing an agent to act in accordance with the prin-

cipal's best interests, agency problems can be reduced.

Types of Agency Problems

The management of an organization may have goals that are most likely derived to maximize
their benefits. On the other hand, an organization’s stockholders are most likely interested in
their wealth maximization. This contrast between the goals and objectives of the
management and stockholders of an organization may often become a basis for agency
problems. Precisely speaking, there are three types which are discussed below: –

 Stockholders vs. Management – Large companies may have many equity holders. It
is always crucial for an organization to separate management from ownership since there is
no reason to form a management part. Segregating rights from management has endless ad-
vantages as it does not affect regular business operations. The company will hire profession-
als to manage the key functions of the same. But hiring outsiders may become troublesome
for stakeholders. The managers hired may make unjust decisions and misuse the sharehold-
ers’ money, which can be a reason for the conflict of interests between the two and agency
problems.

 Stockholders vs. Creditors – The stockholders might pick up risky projects to make
more profits. This increased risk might elevate the required ROR on the company’s debt.
Hence, the overall value of the pending debts might fall. If the project sinks, the bondholders
will supposedly have to participate in losses, resulting in agency problems with the stock-
holders and the creditors.

 Stockholders vs. Other Stakeholders – The stakeholders of a company may have a

conflict of interests with other stakeholders like customers, employees, society, and com-
munities. For example, the employees might be asking for a hike in their salaries which, if re-
jected by the stakeholders, there is a probability of agency problems occurring.
Example

ABC Ltd. sells gel toothpaste for $20. The company’s stockholders raised the selling price of
the toothpaste from $20 to $22 to maximize their wealth. This sudden unnecessary rise in the
cost of toothpaste disappointed the customers and boycotted the product sold by the com-
pany. Few customers who bought the product realized a fall in the quality and were utterly
disappointed. It resulted in agency problems between the stockholders and the loyal and regu-
lar customers of the company.

Causes of Agency Problems

To explain in more depth, listed below are the main causes of agency problems:
 When a conflict of interest arises between the principal and the agent
 When the agent is making decisions on behalf of the principal that is not in the best
interest of each associated party
 The agent may act independently from the principal in order to obtain some sort of
previously agreed upon incentive or bonus
 Confidentiality breach regarding the personal and financial information of the prin-
cipal
 Insider trading with the information provided by the principal
 When the principal acts against the recommendations provided by the agent.
Considering there is power/trust allocation, it is not surprising that there is an entire theory
that explores the relationship and interactions between a principal and an agent.
Reducing Agency Problems
In order to reduce the likelihood of conflict, there are certain measures and principles that can
be followed by both the principal and agent.

1. Transparency
To reduce the potential influx of agency problems, it is crucial for both the principal and the
agent to be completely transparent with one another.
Decisions and transactions that will be implemented must be agreed upon by each party and
must be reasonably fair.
Once transparency is present, conflict is reduced due to the fact that there is less confusion on
decision-making and fewer implications that one party is against the other.

2. Restrictions
Imposing restrictions or abolishing negative restrictions is a good way to significantly reduce
the effect of agency loss.
Setting specific restrictions on factors such as agency power allows the principal to feel more
confident in their relative agent.
Conversely, abolishing negative restrictions is beneficial because it instills trust within the
agent and allows them to make decisions freely on behalf of the principal.

3. Bonuses
Introducing and eradicating incentives and bonuses lessens the chances of a relationship that
consists of conflicts and disagreements.
Introducing bonuses is a good way to motivate an agent and will allow them to make deci-
sions with the best intentions of the principal in order to achieve their desired incentive.
Contrarily, bonuses may motivate the agent to make decisions just for financial gain, disre-
garding the best intentions of the principal to only achieve the incentive.
Each relationship between a principal and agent is different, it is crucial to choose the best-
fitted methods for each specific situation to ensure a positive, healthy relationship.