Strayer University Bookshelf ACP Financial Theory Practice
1242018 Strayer University Bookshelf Acp Financial Theory Practic
Deciphering Financial Theory and Practice: Key Concepts and Corporate Governance
Paper For Above instruction
Financial theory and practice encompass foundational concepts that underpin effective management and decision-making within corporations. These include understanding agency relationships, agency costs, conflicts of interest, managerial behaviors, and various intervention mechanisms such as corporate governance. This paper explores these essential principles, illustrating their roles in promoting corporate efficiency and aligning the interests of managers, shareholders, and other stakeholders.
Definitions of Key Terms
An agent is an individual or entity authorized to act on behalf of another, termed the principal. An agency relationship exists when the principal delegates decision-making authority to the agent, such as shareholders appointing managers to operate a company.
Agency cost refers to the expenses associated with monitoring and incentivizing agents to act in the best interests of principals, including supervision, audits, or implementing incentive schemes.
The basic types of agency conflicts include conflicts between managers and shareholders (managerial egotism or empire-building), shareholders and debt holders (risk-shifting or asset substitution), and controlling shareholders versus minority shareholders (expropriation).
Managerial entrenchment occurs when managers establish barriers—such as staggered boards, poison pills, or voting restrictions—to deter hostile takeovers, thus securing their positions.
Nonpecuniary benefits refer to non-financial perks managers may enjoy, such as prestige, job security, or personal power, which may influence their decision-making.
Greenmail is a tactic where a company pays a premium to buy back its shares from a potential acquirer to prevent a takeover.
Poison pills are strategies—like issuing additional shares or rights—that make hostile takeovers prohibitively expensive or unattractive.
Restricted voting rights limit voting power for certain shareholders, often to prevent hostile actions or safeguard control.
Specific Terms
A stock option grants the holder the right, but not the obligation, to purchase a company's stock at a fixed exercise price within a specified period. An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that enables employees to acquire ownership in the company, aligning their interests with corporate performance.
Agency Conflicts Between Inside Managers and Outside Shareholders
Within a firm, managers (inside owners) may pursue personal goals such as empire-building, excessive compensation, or avoiding risky projects that could jeopardize their position, even if these are not aligned with shareholder interests. Outside shareholders generally seek maximization of stock value, which may conflict with managers' preferences for job security or non-financial perks. This divergence may lead managers to undertake suboptimal investments or engage in empire-building, reducing overall firm value.
Agency Conflicts Between Borrowers and Lenders
Borrowers may undertake riskier projects once debt is secured, knowing they will benefit if successful while lenders bear the downside if risks result in default—this is called risk-shifting or asset substitution. To mitigate these conflicts, lenders often impose covenants, restrict certain activities, or include collateral requirements to ensure borrowers act in their best interests.
Actions of Entrenched Management That Harm Shareholders
Management may pursue self-serving actions detrimental to shareholders, including embezzling assets, resisting takeover bids, excessive executive compensation, engaging in related-party transactions, manipulating earnings, or delaying strategic decisions to protect their positions. These behaviors can significantly diminish shareholder value.
Valuation of Stock Options Despite Unfavorable Stock Prices
Stock options may retain value if market volatility is high or if options are deep in-the-money—meaning the stock price exceeds the exercise price significantly—thus providing potential upside. Additionally, options can be valuable as part of a compensation package because they align managers' interests with shareholders and incentivize performance, even if current stock prices do not meet expectations.
Agency Relationship Explanation
An agency relationship involves a principal delegating authority to an agent to perform tasks on their behalf, such as shareholders appointing managers. Initially, if a sole owner manages the company without outside investors or managers, agency conflicts are minimal, as the owner makes all decisions and monitors themselves.
Expansion and Agency Problems
Hiring additional personnel introduces potential agency conflicts between owners and employees, who may prioritize personal interests over company goals. When outside investors buy stock, conflicts of interest may arise regarding firm strategy, risk-taking, and dividend policy. Shareholders controlling voting rights can influence managerial decisions, sometimes leading to opportunistic behaviors.
Agency Costs with External Funding
With outside lenders, agency costs include monitoring expenses and covenants designed to limit risky behavior. Lenders can mitigate these issues through collateral, stricter loan conditions, or requiring regular financial reporting to ensure alignment of interests.
Managerial Behaviors That Can Harm Firm Value
Potential destructive managerial behaviors include excessive risk aversion or risk-seeking, self-dealing, nepotism, short-termism, delaying necessary investments, and resisting beneficial takeover offers. Effective corporate governance seeks to curb such behaviors.
Corporate Governance and Internal Provisions
Corporate governance involves mechanisms to align management interests with those of shareholders and ensure accountability. Internal provisions include a clear separation of roles between the board of directors and management, performance-based compensation, audit committees, internal controls, shareholder voting procedures, transparent disclosure policies, policies against conflicts of interest, and codes of conduct.
Effective Board Characteristics
An effective board typically comprises independent, diverse, and experienced directors capable of providing objective oversight, strategic guidance, and ensuring accountability. Regular evaluations and active engagement further enhance governance quality.
Provisions Affecting Takeovers
Provisions such as staggered boards, supermajority voting requirements, poison pills, and restrictions on shareholder rights can slow or prevent takeover bids, thereby affecting corporate control and strategic flexibility.
Use of Stock Options in Compensation
Stock options are used to motivate managers by aligning their interests with shareholders, encouraging performance. However, potential problems include excessive risk-taking, manipulation of earnings to inflate stock prices, and dilution of ownership.
Block Ownership and Governance
Block ownership refers to large shareholders holding significant portions of shares. Such ownership can influence governance by either providing stability and oversight or enabling control that may be detrimental to minority shareholders.
Regulatory and Legal Impact on Corporate Governance
Regulatory agencies and legal systems establish rules and standards—such as securities laws, reporting requirements, and fiduciary duties—that promote transparency, accountability, and fair treatment of shareholders, thus shaping effective corporate governance practices.
Conclusion
Understanding the intricate dynamics of agency relationships, conflicts, and governance mechanisms is crucial for the efficient operation of corporations. By implementing internal controls, fostering transparency, and aligning interests, companies can mitigate agency costs and enhance shareholder value, ensuring sustainable growth and stakeholder trust.
References
Journal of Financial Economics, 3(4), 305-360. Journal of Law and Economics, 26(2), 301-325. The Journal of Finance, 52(2), 737-783. Business Lawyer, 48(1), 59-77. Journal of Corporate Finance, 48, 510-532.