Question

Question 1) First define the goal of financial management, then discuss WHY this goal is more important than any other....

Question 2) Define the agency problem, and discuss how to resolve it from the perspective of a stockholder.

Please more than 400 words for each question and to be briefly described.

Thanks

Answer 1

1) Goal of financial management:

It is a popular saying that "money is to an enterprise, what oil is to an engine". So management of money is very important to a business. The ultimate goal of financial management is increasing the value of shares. We can divide the goal of financial management into two. (i) Profit Maximization and (ii) Wealth Maximization.

(i) Profit Maximization:- A business exist for a reason and that reason is profit. So profit maximization is also an objective of financial management. Finance manager has to take decisions to maximize profit. That means each alternative, therefore, is to be seen as to whether or not it gives maximum profit.

But is profit maximization the sole objective of financial management? If not, why? There are number of reasons why finance managers do not give much importance to profit maximization. Some of these reasons are:

a)The term profit is vague: What is profit? It has different meaning to different people. Is it short term or long term. Is it total profit or rate of profit?

b)Profit maximization does not take into account social considerations: We know the public like to invest in businesses which has good reputation and fame. To increase the goodwill of the business has to take care of its employees, society, etc.

c)Relationship with risk and profit: Profit has a direct relation with risk. So the company might have to take higher risk to achieve higher profits. This objective does not look good in long term perspective.

(ii) Wealth Maximization: In this model the goal of financial management is to increase the market value of the firm. The wealth maximization approach also takes into account the time value of money. People buy shares of a company in expectation to increase their wealth when the company they invest in become wealthy.

Now the value of a firm is affected by many things. When a company is reporting a steady growth rate the probability of that firms market value is higher than a company which makes huge profit but not stable or consistent.

2)Agency Problem:

We know even the shareholders own the company still the managers takes decision for them. Managers are expected to take decisions in the best interest of the shareholders. Now there is a conflict of interest between these two. That is shareholders are concerned with their goal of wealth maximization while mangers are concerned with their remuneration. This situation is called agency problem.

Ways to resolve this problem:

Businesses employ many dynamic techniques to resolve agency problems, including monitoring, contractual incentives, soliciting the aid of third parties, or relying on other price system mechanisms. The study of agency problems is ongoing in both corporate and academic circles. Increasingly, contract design limits are recognized and corporations are turning to different incentive mechanisms.

One other way to resolve this problem is make managers are think like shareholders. That is to make the goal of wealth maximization the goal of managers too. How can this be done? This can be done by transferring some interest in the company to managers. In simple words giving shares to managers in form of remuneration. This will make managers to think like a shareholder. Now the goal of managers and shareholders are same., that is to increase the value of shares which will benefit mangers as well as shareholders.  

System of reputations: A powerful force in every voluntary market, the reputation mechanism provides an incentive for coordinating the actions of parties with limited information and trust. There are dozens of examples of reputation-based associations, the broadest of which is classified as corporate culture.

Full transparency: Here the agent that is the manager have to educate shareholders for every decisions they make and the reasons to take that decision.