Question

Q1. Explain in details the agency problems ?

Q2. Define the debt ratio in your word ?

Answer 1

1.Agency problem is when a agent is appointed to care of the duties by the principal, problems arises when their is a conflict of interest between the principal and the person appointed as agent.

Agency problems is the conflict between managers and shareholders and shareholders and creditors.

The managers are hired for the best interest of the stockholders but sometimes they may not use the wealth of the business in the best interest of the shareholders infact they might try to use the funds for their own benefit. The managers might take decisions which are in their favor not not what would benefit the company as a whole. the stockholders encourage managers to work in the bets interest in the form of higher compensation,fear of getting fired or they might even self appoint managers to take decisions in their best interest.

creditors lend money to the company depending on its riskiness. the inflow of funds in the business might be used to repurchase shares to lower the share base and increase the share price ,which will benefit the shareholders. the cash flow in the business is the creditors main concern which might be affected in the long run due to the reduced cash flow as the level of debt in the company is increased. thus conflict arises between the stockholders and creditors.

debt equity ratio :

is the level of debt in the company/shareholders equity :it determines the level of financial leverage and is also called the gearing ratio.

it states that how much debt the company is using to finance its assets and increase the value of the company relative to the equity. As we all know the debt tax shield that a company enjoys by raising its level of debt increases the value of the company,and the cost of external financing is less than raising money through equity. if these benefits are greater than the interest paid on the debt then the company then it is good for its financial health and if the interest cost is more than the benefits of external financing then this may lead the company to financial problems and even insolvency.

Although a high debt equity ratio, may not instill confidence in the lender to provide more loan as it questions its ability to repay the loan,as a high level of debt signifies that the company is aggressive in its borrowings and is risky as the cash flows the company is affected because of higher interest payments. A lower debt equity ratio may encourage the lender to provide loan as the company is not already under a lot of debt.