This document discusses agency relationships and problems that can arise in a business. It defines an agency relationship as occurring when principals hire agents to perform services and delegate decision-making authority. There are two potential agency conflicts: between stockholders and managers, and between stockholders and creditors. As a business expands operations and hires more employees or takes on outside capital, agency problems have the potential to increase as it becomes more difficult for owners to oversee managers' actions directly. Various actions are discussed that can help mitigate agency problems, such as compensation packages tied to performance, monitoring costs, and restrictive covenants for creditors.

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The basic goal: to create stock-
holder value
Agency relationships:
1. Stockholders versus managers
2. Stockholders versus creditors
CHAPTER 1
An 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) bonus
Options 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.