1 - 0 Copyright © 2002 South-Western The basic goal: to create stock- holder value Agency relationships: 1.Stockholders versus managers 2.Stockholders versus creditors 3.Conflicts among stockholders, managers, and creditors CHAPTER 1 An Overview of Financial Management

1 - 1 Copyright © 2002 South-Western 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.

1 - 2 Copyright © 2002 South-Western 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.

1 - 3 Copyright © 2002 South-Western 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.

1 - 4 Copyright © 2002 South-Western 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.

1 - 5 Copyright © 2002 South-Western 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.

1 - 6 Copyright © 2002 South-Western There are 3 potential agency conflicts: Conflicts between stockholders and managers. Conflicts between stockholders and creditors. Conflicts among stockholders, managers, and creditors.

1 - 7 Copyright © 2002 South-Western 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.

1 - 8 Copyright © 2002 South-Western 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.

1 - 9 Copyright © 2002 South-Western 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. (More…)

Copyright © 2002 South-Western 2.Threat of firing. 3.Increase “monitoring” costs by making frequent visits to “off campus” locations.

Copyright © 2002 South-Western 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.

Copyright © 2002 South-Western What kind of agency problems might arise if the company encountered financial distress and faced bankruptcy? A decision must be made either to liquidate the firm by selling off its assets or to reorganize it and let it continue as a going concern. All bankruptcy reorganizations involve intense negotiations between creditors, stockholders, and managers. (More…)

Copyright © 2002 South-Western Creditors may want to liquidate, so as to get their funds relatively quickly. Managers generally want to preserve their jobs, hence to reorganize. Stockholders also want reorganization. Otherwise, they face getting nothing, or next to nothing, in liquidation. But managers may be willing to give too much to creditors to get agreement, at the expense of stockholders.

Copyright © 2002 South-Western “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?

Copyright © 2002 South-Western 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.

Copyright © 2002 South-Western 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. (More…)

Copyright © 2002 South-Western 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.