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Managerial Finance Conception Essay


Managerial Finance

    1. The relationship between the shareholders and the managers is well represented by the principal-agent theory. Discuss the mechanisms available to restrain the managers from pursuing their aims.

The agency theory deals with the contracts’ logistics between principals and agents. The aspect of principals delegating some tasks to hired agents underlines the existence of an agency relationship. Some of the most common “primary agency relationships include managers – stockholders and stockholders – debt holders’ relationships and the agency theory is mainly concerned with conflicts of interests between principals and agents” (Bamberg & Spremann, 1987, p. 73). The existence of agency relationships enhances business ethics and corporate governance. Agency costs are incurred in the process of sustaining a formidable agency relationship in the business world. Several issues influenced the formulation of the agency relationships in the past decades, which include “political philosophies, contract law, organizational economics, the works of Hobbes and Locke, and the property-right theories that existed in the past” (Bamberg & Spremann, 1987, p. 78).

Self-interested behavior is the main problem that the agency theory has raised in most organizations. Most managers and shareholders conflict due to the self-interest behavior by either of the parties. The company owners’ interests and goals may differ from those of the managers, as the shareholders are interested in profitability (Edwards, 2008). A potential conflict exists between managers and shareholders because the latter holds the former accountable in the administration of the firm’s assets in the quest to maximize the profits.

According to the agency theory, some managers seek ways of enriching themselves at the expense of the shareholders and this trend is rampant infallible capital markets. The managers can prioritize their interests because they are aware of the capabilities of the business in meeting the shareholders’ objectives as they have asymmetric information. Self-interested managers could be associated with the consumption of an organization’s resources as well as the avoidance of taking risky positions to save the business in cases where an investment requires such measures. If shareholders were managing an organization, the chances are that the business will prosper greatly because the shareholders are interested in maximizing their profit as they grow the business empire. In a bid to ensure that the organizations’ managers are positively involved in the profit maximization in a company, their shares should not be less than a hundred percent of the common stock.

It is easier for a business owner to venture into the risk-averted business opportunities in a bid to realize higher profits for his/her business as compared to a business in which the manager has no shares in the company. The utility will be measured by an individual’s wealth in the case where the business owner is the one managing the business. The business owner could sacrifice his/her leisure time and perquisites in a bid to make more money for the business. In a business where the manager is not a shareholder, it is difficult for him/her to trade his/her leisure time for business development (Holmstrom & Tirole, 2013).

In case the founder of the business decides to sell part of his/her business shares to outside shareholders, a conflict may arise. This scenario plays out because the business may end up making losses. After all, another manager without a stake in the company may take over. In this case, the new manager may not be passionate or committed enough to propel the company to great heights. To avoid such a scenario, a memorandum of understanding should be drafted to govern the business’ operations by one of the company shareholders. The best method to approach such a situation is allowing the incumbent shareholders to pursue a diversified approach. This goal is achieved by letting the shareholders buy shares in other companies in a bid to ensure that they diversify their portfolios. The shareholders can motivate the managers to promote the company’s interests through incentives like perquisites and good remuneration packages among other elements. The shareholders should be on the lookout to help change the negative behavior of the managers where possible.

In conclusion, the managers should be paid or rewarded as per the business performance progress coupled with considering the changes in the stock prices. Performance shares would be another important way of rewarding company executives.

    1. “Liquidity ensures the ability of the firm to honor its short-term commitments. The situation indicates that the firm has adequate cash to pay for its bills, to make unexpected large purchases that meet its contingencies, at all times”. Discuss

For any company to grow and survive the hardships of the business environment, it must owe a credible liquidity factor. Liquidity refers to the capability of a firm to settle its short-term obligations in its operational business environment (Nguyen & Puri, 2009). These short-term dues include debts owed by the firm to suppliers, wages, and salaries to permanent and temporary employees. In managing company finances, liquidity is a key factor as it defines the company standing in terms of assets and liabilities, which defines the activities that a company can undertake immediately and in the future (Visscher, Mendoza & Ward, 2011).

Liquidity can be determined using the current ratio, which measures the ratio of assets to current liabilities associated with the firm. If this ratio is high, it means that the firm can easily settle the debts owed to creditors and have enough to invest in other company activities (Brander, 1992). On the other hand, a small current ratio is an indication of a fiscal deficit to the firm. As a result, a company cannot engage in further business speculation, thus limiting its investment and future planning activities. In case these debts accrue interest at the end of a certain period such as loans, a firm may be forced to end some of the ventures in a bid to cut down the costs involved in different operations and manage debts or even be forced to shut down entirely (Nesvetailova, 2010).

In a bid to ensure that liquidity is maintained, firm managers should be in a position to keep updated records of cash flows, which capture the cash and profit from the company ventures. This situation is crucial to small and start-up businesses in a bid to keep liquidity at a desired level. For example, if a business does not keep records of accrual accounting when giving credit to its customers, then it will reach a point whereby a big portion of the interest and working capital is in the hands of debtors. In such a situation, most company activities cannot be conducted. It is deemed necessary to update these records and establish the desired level of liquidity, below which the business cannot offer any credit facilities to its customers. The majority of companies that have remained on the competitive edge have been in a position to manage the amount of cash flow rather than just having lots of capital at their disposal (Ovanhouser, 2009). This aspect enables them to know when to offer credit and other promotions to their customers while ensuring a stable company base in terms of liquidity.

One way to maintain liquidity is through borrowing. For a company to procure liquidity, expand, or even embrace diversification in its investment, borrowing may be inevitable in some cases. The only important aspect is the interest rate on the borrowed funds. A good loan is one that spreads over a long period, small repayment installments, and low-interest rates that cannot drain the profits that are made by the investment. Another way to sustain high liquidity in a company is by devising measures that aid to cut down the operational costs of the company (Caballero & Krishnamurthy, 2008). A current ratio that is below the required level indicates a smaller output as compared to the input cost of production in the firm. In such a situation, some of the investment enterprises are not performing and some human resources are not fully utilized. To bring the company to a stable position, the management has to identify the underperforming enterprises, solve the issues leading to poor performance, or close down the whole unit (Rindi, 2008). Moreover, if there are any underutilized and unnecessary personnel, they are kicked out of the company or relocated to other departments where they can benefit the firm.

Additionally, firms must be in a position to persuade their customers into quicker repayment terms of goods and services that are offered on credit to avail the capital boosting liquidity. At the same time, the managers should be in a position to negotiate for extensive repayment periods with the suppliers of goods and services to buy time to solidify the firm’s liquidity (Brunnermeier & Pedersen, 2009).

For any firm to attain success in business, capital is a vital factor during a positive cash flow if a sign of the current and future survival is embedded in the liquidity of the investment. The situation explains why some companies succeed even in hard times while others fail.

    1. Retained earnings are funds accumulated over the years, of the company, by keeping part of the profits generated, without distributing them as dividends to its shareholders. The funds so generated become one of the major sources of funding for the company to finance its expansion and diversification program. Explain

The term ‘retained earnings’ refers to the portion of a company’s net income that is kept by the business instead of being shared by the company owners as annual profits or dividends. The level of the retained earnings depends on the company’s earnings in that particular year and the more the earnings in a year, the more the retained earnings and vice versa. Any potential investor looks at the level of the retained capital from the company’s shareholders. The main objective for any business entity is to make as much profit as possible for the shareholders and this aspect explains why the potential incumbent investors look at the company’s reported profits before committing to investing in that particular company. After accessing the profit, it is important to evaluate what the company does with it after each year. If the levels of the retained earnings are negative, “it may be referred to as an accumulated loss, retained loss, or accumulated deficit” (Shim, 2009, p. 112). Retained earnings or losses are gotten from the company’s annual profit or loss accumulations. The reports of the “retained earnings are found in the equity’s section on the shareholder’s column of the company’s balance sheet and the retained losses and earnings are presented in the statements of retained losses and retained earnings respectively” (Shim, 2009, p. 116).

When the retained earnings are recorded in a double-entry, the surplus cash that is available for the company is not featured or represented because the business entity has managed its profit returns. In case the company reinvests the retained earnings, they are usually recorded as the reductions to the liabilities in the balance sheet or as increases in the business assets. Factors that may affect the amount of money that a company can retain include the “age of the business entity, quantum on the net profit, the long-term plans regarding expansion and modernization, and the dividends policy” (Weygandt, 2013, p. 63).

The use/importance of the retained earnings to a company

Retained earnings are used to “grow and expand the existing business to maintain the day-to-day operations and increase sales as much as possible” (Weygandt, 2013, p. 92). However, companies in the manufacturing industry face different challenges because they have to use big proportions of their profits in putting up new equipment and plants to support the existing operations (Weygandt, 2013). In some other cases, investors are faced with the challenges of repairing and replacing costly equipment constantly and in such cases, the retained earnings are minimal. In other cases, some business entities require big amounts of money to keep running and maintain day-to-day business operations (Shim, 2009). Every investor should know the amount of money that is required to set up the business entity that s/he is contemplating to venture into coupled with ensuring that the management keeps a track of how much and when the company’s shareholders are provided with the returns of their already invested capital.

For a business to grow, it should retain and reinvest its retained earnings in the most promising business opportunities that could generate viable returns. Putting money to work is the best investment policy for successful businesses (Soffer, 2001). Money security is in viable investments. Companies should change from the traditional behavior of using the retained capital to maintain the status quo. Retained earnings should be used to produce more returns rather than paying them to shareholders for consumption. Determining the rates of return on the retained capital by the business enterprises helps the shareholders to tell how much to trust their business managers in making more profits for their already invested capital.

In conclusion, all the company shareholders need to keep on determining the rates of returns on the retained earnings and make the market evaluations on the amounts of the retained earnings to evaluate the performance and the progress of their businesses with the help of their managers. External auditors could be outsourced to evaluate the rate of business prosperity and ascertain the rates of transparency by managers as they manage the shareholders’ investment. Shareholders need to evaluate whether their management team is ready or can be trusted to operate the business as well as generating more profits.

    1. A high earning per share (EPS) may not always maximize the stock price”. Discuss

EPS is the amount of money earned per the outstanding share in the common stock of a company. Earnings per share are evaluated from the following statements extraordinary items, continuing operations, net income, and discounted operations. When calculating the earnings per share, it is important to note that the outstanding shares can always change over time, and thus it is necessary to consider the weighted value of the outstanding shares dividend by the reporting component.

EPSs are calculated as shown below using three different formulas

Earnings per Share = profit-preferred dividends/ weighted average common shares- using the basic formula (Shim, 2009).

Earnings per share = income from the continuing operations-preferred dividends/weighted common shares using the continuing operations formula.

Earnings per share= net income-preferred dividends/average common shares- using the net income formula (Shim, 2009).

Diluted earnings per share are the company’s earnings that are calculated when the convertible bonds, stock option, and the grants are included (Chaitanya & Griffiths, 2008). Diluted earnings per share reflect the issuance of warrants, outstanding options for all the stocks, and the convertible securities that contribute to the reduction of the earnings per share in most cases.

The diluted EPS is calculated as

Diluted Earnings Per Share = net income- preferred stock/ weighted average shares of the common stock in the past year (Garrison, Noreen & Brewer, 2013).

In the determination of a share’s price, earnings per share are the most important component to evaluate by the investors. The capital used to generate the net income is usually “ignored in the calculation of the earnings per share” (Garrison et al., 2013, p. 105). For instance, two investor companies could generate the same earnings per share value, but one of the companies would be more efficient as compared to the other if its calculation of the earnings per share were done with less equity because it uses its capital to generate more income (Edwards, 2008). Investors need to use the statement analysis together with at least one financial measure to be aware of the returns’ manipulation that would affect the earnings value.

It is important to note that the earnings per share are calculated on the company’s profit as the numerator and the number of outstanding shares as the denominator. Therefore, as a business owner, a larger denominator due to a constant numerator should raise a red flag as such a trend results in a reduction of the value of the earnings per share. In such situations, it is unlikely for anyone to convert shares at once (Masry, 2006). On the other hand, if all the options were converted into a common stock, it would result in a potential dilution of the company’s shares.

Companies seek to compensate their employees using the best stock options as they form the largest convertible securities. The approach of using the stock option enables employers to pay their employees without reducing earnings or expending cash (Zopounidis, 1999). It is great for employers to allow employees to own some shares in the company because it boosts their morale and attitude to work hard for the company’s success. Every shareholder is interested in seeing the price of the stock go up. Financial analysts use the diluted earnings per share to measure the performance because it is not the shareholders alone who are entitled to claim the company’s share (Shahrokhi, 2008). Most managers repurchase the stock as encouraged by the management of the diluted earnings per share. They are accurate in their timing to repurchase the firm’s stock (Moretto, 2008). Even though the repurchasing of the stock boosts the management’s working morale as an incentive to the employees, it does not favor the business owners.

In conclusion, from the components that are involved in the calculation of the earnings per share and the logistics that are involved in the calculation of the diluted earnings per share, it suffices to say that high earnings per share may not always maximize the stock price. Besides, managers should not be allowed to repurchase the company’s stock throughout, as this aspect adds no value to company owners. The repurchase of stock has a short-term effect on the company even though it increases the stock price for some time, and thus it should be done with a lot of caution.

References

Bamberg, G., & Spremann, K. (1987). Agency Theory, Information, and Incentives. New York, NY: Springer.

Brander, J. (1992). Managerial compensation and the agency costs of debt finance. Managerial and Decision Economics, 13, 55-64.

Brunnermeier, M., & Pedersen, L. (2009). Market Liquidity and Funding Liquidity. The Review of Financial Studies, 22(6), 2201-2238.

Caballero, R., & Krishnamurthy, A. (2008). Collective Risk Management in a Flight to Quality Episode. Journal of Finance, 63(5), 2195-2230.

Chaitanya, S., & Griffiths, M. (2008). The role of computer usage in the availability of credit for small businesses. Managerial Finance, 34(2), 103 – 115.

Douglas, A. (2007). Managerial opportunism and proportional corporate payout policies. Managerial Finance, 33(1), 26 – 42.

Edwards, S. (2008). Financial markets volatility and performance in emerging markets. Chicago, IL: University of Chicago Press.

Garrison, R., Noreen, E., & Brewer, P. (2011). Managerial accounting. New York, NY: McGraw Hill.

Holmstrom, B., & Tirole, J. (2013). Inside and outside liquidity. Cambridge, MA: MIT Press.

Masry, A. (2006). Derivatives use and risk management practices by UK nonfinancial Companies. Managerial Finance, 32(2), 137 – 159.

Moretto, E., & Rossi, S. (2008). Exchange ratios for merging companies. Managerial Finance, 34 (4), 262-270.

Nesvetailova, A. (2010). Financial alchemy in crisis the great liquidity illusion. New York, NY: Pluto Press.

Nguyen, D., & Puri, T. (2009). Systematic liquidity, characteristic liquidity, and asset pricing. Applied Financial Economics, 19(11), 853-868.

Ovanhouser, R. (2009). Financial crisis in America. Hauppauge, NY: Nova Science Publishers.

Rindi, B. (2008). Informed Traders as Liquidity Providers: Anonymity, Liquidity, and Price Formation. Review of Finance, 12 (3), 497-532.

Shahrokhi, M. (2008). E‐finance: status, innovations, resources, and future challenges. Managerial Finance, 34(6), 365 – 398.

Shim, J. (2009). The art of mathematics in business: analyzing facts and figures for smart business decisions. London, UK: Global Professional Publishing.

Soffer, L. (2001). Market reactions to repeat preannouncements. Managerial Finance, 27(12), 40 – 56.

Visscher, F., Mendoza, D., & Ward, J. (2011). Financing transitions: managing capital and liquidity in the family business. New York, NY: Palgrave Macmillan.

Weygandt, J. (2013). Principles of Accounting. Hoboken, NJ: Wiley.

Zopounidis, C. (1999). Operational Tools in the Management of Financial Risks. New York, NY: Springer.

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