Question

Answer the following:
a) Explain the main reason that an agency relationship exists in the company form of business? What kind of problems can arise?

b) Why is the goal of financial management to maximise the current value of the company’s stock? In other words, why isn’t the goal to maximise the future value?

c) Discuss how company shareholders can encourage their managers to act in a way which is consistent with the objective of shareholder wealth maximisation

Answer 1

a) Explain the main reason that an agency relationship exists in the company form of business? What kind of problems can arise?

When a principal hires an agent to carry out specific tasks, the hiring is called a principal agent relationship or an agency relationship. When a conflict of interest between the requirements of the principal and the agent arises, this conflict is called an agency problem. In businesses, agency problems occur between the stockholders (principal) and corporate managers (agents). While the stockholders appoint the managers to take care of the company but the managers may look into their own desires first.

b) Why is the goal of financial management to maximize the current value of the company’s stock? In other words, why isn’t the goal to maximize the future value?

The company can plan its goal to maximize the current value of the company’s stock by better financial management which can bring better performance for company as well as growth. Profit maximization or maximizing the shareholders’ value can be achieved by better financial performance of the company. This goal can be determined by establishing a system for tracking the financial performances on various growth parameters like sales growth, return on investment etc. Even if the company will have the goal to maximize its future value then also it will reflect in the current value of the company’s stock. Therefore the goal of financial management is to maximize the current value of the company’s stock.

c) Discuss how company shareholders can encourage their managers to act in a way which is consistent with the objective of shareholder wealth maximization?

The primary goal of a corporation is the maximize shareholder’s wealth and value creation. A firm’s value can be maximized if its expected benefits are maximized in the long-run while profit maximization is relatively for short term. This is the primary goal above all others because maximizing stockholder’s value can be done by maximizing the revenue of the company and minimizing the cost so that the organizations can perform more efficiently. The good performance of the organization will finally reflect in the shares of the company and it will benefit the stock holders of the company. It will also benefit the managers of the company because it will help the company to continue its business and become competitive in long run. Therefore the company shareholders can encourage their managers to act in a way which is consistent with the objective of shareholder wealth maximization because it will ultimately benefit them also.