Introduction
The level of investments a business undertakes today determines how far into the future the business goes, and its future worth. Management of business finances is the most important factor and contributor in the determination of how long a business survives. The capital structure of the business and how well the business deals with agency theory problems help in the maximization of business welfare. Given that businesses are driven by the profit-making motive, it is the role of the management to maximize such profits.
Financial Management
Costs should be the minimum possible – given the desired level of output, while profits should be the maximum possible – given the input mix. However, attaining this would require consideration of further operations of the business. The business may incorporate stock or shareholders, whose welfare should be put among the interests of the business. Shareholders’ wealth must be maximized in line with the profitability of the business.
For the business to effectively remain in balance, the two concepts need to be brought together, and their relationship brought into a balance to avoid catastrophic eventualities in the business operations and its entire cycle. Business investments are long-term in nature and therefore such a cycle is a series of years that the business is expected to be in operation.
Managing Capital Structure
The capital structure of a business refers to the finances available to a particular business at a given point in time, and the way the finances are categorized. Business capital commonly occurs in two forms: debt and equity. Debt refers to the funds the business borrows at a cost, while equity refers to the funds obtained from the shareholders of the business and the capital initially put into the investment. Management of the two is vital to the survival of the business because proper and effective management guarantees maximization of the business’s wealth (Adizes, 2004). Therefore, the following paragraphs evaluate the need to mage capital structure effectively in maximizing the wealth of business organizations.
Economic Condition of the Business
The debt and equity portfolio of a business are important in determining the economic status of the business. Demand for capital and its supply in the economy affects businesses directly. When the cost of borrowing is high, businesses access to credit at expensive charges. Baeyens and Manigaart (2003) assert that the willingness to go into debt significantly goes down and hence, investment into the business reduces.
This results from the fact that it becomes hard for investors to take on investments at high-interest rates in case their investments were to be financed on credit. Therefore, a firm should have strong equity, and finance operations on equity to survive the effects of investment discrepancy.
Effective management of the capital structure of the business would ensure that the series of inconsistencies that would result from the high-interest rates are minimized. On the other hand, if interest rates are low, credit access would be relatively cheaper. Investments would shoot up from both new investors and the investments of the business itself. From the above, the economic condition of a business is an important aspect of the operations of the business. It should be kept on the right track to avoid irregular fluctuations in the business cycle. The capital structure chosen should be one that assesses a balance between debt and equity and maintains a long term balance on the two (Kayhan and Titman, 2004).
The Market Share
The percentage of the population associated with a particular business constitutes its market share. The higher the market share, the better the position of the business, and vice versa. Capital structure management is essential in determining the level of an organization’s market share. The more stable the business is, the larger the pool of the population it attracts. However, other key factors affect the market share of a business. These factors include product pricing, quality of the product, branding and packaging, advertisement, and availability of the product (Michelacci and Suarez, 2004).
All the factors that determine the market share of a business affect the costs. A business would require funds control of all the factors listed above. Again, the capital structure and its management come into the spotlight. Effective management of the capital structure would ensure that a business meets the costs of maximizing its market share and thus, maximizing its revenues. High revenues increase the profitability of the business. Consequently, the business stands at better grounds of maximizing its wealth at that time.
The market share of the business is also affected by the market condition in the economy: return on investment varies with changes in the interest rate in the economy. Low rates of return on investment discourage investments, while high rates of return attract investors. Hayne (1998) recommends that businesses should offer competitive returns on investments in their operations. For a given business to be able to do and achieve this, its capital management needs to be effective.
Operational Condition of the Business
Businesses are run on working capital in their day to day operations, but fixed costs and variable costs are also involved in the operations. Daily operational costs of the business need to be observed, as this would help in monitoring and practicing cost minimization measures. High fixed costs are not favorable for any business. They increase the cost of production when they are expected to yield no return at the same time.
This is because fixed costs are incurred, whether the businesses are producing or not. Again, variable costs adjust with changes in the level of production. An extra variable cost incurred is expected to produce revenue, unlike fixed costs. Thus, the operational condition of the company in terms of costs depends on how well the capital is managed (Stultz, 2000).
Business risk also falls under the operations category. An increase in competition and slow growth of the business depends on its operations. These two could be a result of high fixed costs. An increase in fixed costs in the business would result from high debts incurred by the business. The condition of repayment of debts in most cases poses a financial risk to the business, especially if capital management measures are not strong and effective (Myers and Nicholas, 1984).
Stock Capital
Issuing of the stock is an important step to make in managing capital and hence, costs of operations are due to fall significantly. This is because there would be no fixed payments to be made to investors in the business. Only dividend earning are made on stock issued. Another important aspect is that this kind of security does not mature. As a result, the invested capital is not repaid, and its impact on the business is welcome. In general, the business improves its creditworthiness (Stewart, 1999).
Debt Capital
Businesses rarely operate on stock capital only despite the advantages accrued from it. Firms mostly get into debt to finance their operations because debt financing has its advantages as well. Paid interests are tax-deductible according to the law of the firms that govern corporate entities. That is not all; the cost of debt is usually fixed and the principal amount invested does not change. Stability in business operations is maintained by this fact.
Returns on investment based on debt capital are always relatively lower than the stock. This gives the business a greater incentive to use debt financing since there are benefits that come with it. However, this would face out the fact that businesses also require stock capital. It is the role of the management to maintain a portfolio of the two in the business because it greatly determines the extent to which a business achieves maximization of its wealth (Stewart, 1999).
Problems of Agency Theory
Agency relationships result when the top management employs a different party called an agent to whom decision making authorities are delegated. In business, an agency relationship is evident between managers and stockholders (shareholders), and between stockholders and debt holders (Bamberg and Klaus, 1987). These relationships are from time to time characterized by conflicts of interests between the parties. When this happens, an agency theory problem arises. This is a conflict between the employed agents and the management, which is also called the principal in the agency theory. These conflicts constitute agency theory problems.
Principal’s and Agent’s Self-interest Behavior
This problem arises when either of the party seeks to maximize its benefits from the business at the expense of the other. Drawing from the agency theory, managers seek to maximize their utility, given imperfect labor and capital market (Marshall and Heffes, 2004). The managers are always in a better position to do this because of the information asymmetry that exists between the managers and the shareholders in the business. The principals can act for their interests rather than that of the organization because they always have first-hand information on whether they are in a position to meet the expectations of the shareholders or not (Stultz, 2000).
Sometimes, businesses are characterized by uncertainty. However, managers are always in a better position to make a sound prediction based on the flow of events in a period shortly before uncertainty arises. Managers also use corporate resources for their purposes owing to the uncertainty in the sector, where risk lover’s managers invest in relatively risky securities using corporate funds.
Another way that managers take advantage of the shareholders is by ignoring investment opportunities that are profitable to the business, citing that risks involved would affect the business negatively (Shankman 1999); this is mostly done by risk-averse managers. Such profitable investments maximize the welfare of the shareholders. If the shareholders are denied a chance to do so, a conflict is expected to arise.
Agency Costs
This is another problem of agency theory. Agency costs are the expenses incurred by the shareholders to provide an incentive to the managers to act on their interests. These costs are mainly aimed at influencing managers to shift their attention to the stockholders and minimize their efforts on their self-interest gains. Agency costs occur in the form of bonuses that the shareholders grant to the managers (Bamberg and Klaus, 1987).
Additionally, agency costs are divided into three types. First, costs of monitoring managerial activities: these costs relate to the expenses incurred in carrying out an audit on the books of account. Such costs are derived by the shareholder who initiates the process. Auditing tends to relate the purported report on the use and generation of funds in the business with what is recorded. Any misrepresentation in the accounts seeks the explanation of the management through the department of accounts and finance (Bowie and Freeman, 1992).
The second category is the expenditure that accrues from the need to structure the management in a way that limits the occurrence of undesirable behavior. This includes and is limited to appointing external members to the board of directors (Jansen and William, 1976). The final category of expenditure that the shareholders incur is the opportunity cost that shareholders suffer if some decisions are passed by the voting and the result affects their welfare negatively. An opportunity, in this case, arises if the decision that the managers ought to make would have improved shareholders’ wealth maximization (Ang and Lin, 2000).
Role of Effective Financial Management in Addressing Agency Theory Problems
Managers’ Compensation
This financial-based solution of agency problems regards the entire compensation of managers relative to the changes in the stock prices. Impacts of this to the shareholders are maximization of their wealth and at the same time, achieving minimum agency costs. Shareholder wealth maximization is overseen by the managers since the compensation grants them an incentive to do so. Managers now shift their attention from being self-centered to the other extreme of minding the welfare of the stockholders (Stultz, 2000).
Shareholders Responsibility
Shareholders can take part in administering financial roles in solving agency problems. They can do this by monitoring every action that the managers take (Hayne, 1998). However, this method can be extremely expensive to the shareholders. Shareholders are always driven by the motive of having their welfare maximized. For that reason, they are likely to go for the option that maximizes their wealth. However, if the opportunity cost they would incur is higher when they do not monitor the actions of the managers, then they would prefer to pay the monitoring fee. Consequently, the result still improves their welfare. Though, it is important to note that in the same case, the opposite is true (Stewart, 1999).
Compensation for Performance
Favorable and efficient solutions to agency problems are the best strategy to use in combating agency problems. This kind of solution has it that compensation is tied to the performance of the managers. This means that compensation is only available to the manager that performs. Compensation for performance is an important attribute in business operations. It reduces the mismanagement of business funds and combats agency problems (Stiglitz, 1974).
When managers are compensated for their efforts and consideration of shareholders’ welfare, the compensation provides them with a greater incentive to do so with ease. This follows the fact that they expect to look up to if they act for the benefit of the stockholders (Bowie and Freeman, 1992).
Some monitoring should not be left aside, even with compensation that is based on performance. It should be consistent and regular to enhance documentation of changes that managers effectuate in the business and how such changes affect the shareholders (Fama and Michael, 1983). Monitoring and compensation for performance can be backed up by some other mechanisms through which the agency problems can be eradicated.
These mechanisms include Interventionism by shareholders directly, where they raise their concerns directly to the managers and air their views and opinions on things they have observed; The threat to fire, where nonperforming managers face the threat of being sacked by the shareholders; and finally, the threat to take over, where shareholders aim at replacing ineffective principals in the management panel (Bamberg and Clause, 1987).
Conclusion
The fundamental objective of a business is to obtain a capital structure that is optimal for the operations and capacity of the business. An appropriate capital mix is a major long-term driving factor of the business. Such a mix needs to be effectively and efficiently evaluated, and levels of debt and equity to accumulate in the business determined. A capital mix that is right for the business is one that maximizes the welfare of the shareholders, alongside that of the business. At the same time, the pros and cons of the capital mix chosen should be critically evaluated to determine its worth for incorporation into the business.
Agency problems on the other hand are better when internalized. Management, control, and eradication of the agency problems ensure benefits at low costs, thereby resulting in positive externalities for the shareholders, managers, and the business. The achievement to choose the right capital mix or input mix for the business makes it easier for the management to project on the prospects of the business, and consequently determine how far the business will be in operation. In essence, long term plans at that point have high chances of success, given that the future is uncertain.
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