Question

Corporate Financial Management:

7. In corporate finance, explain what is meant by the agency relationship. Discuss how agency costs come about and at least three ways in which these costs can be reduced.

(50 %)

2. Explain what is meant by corporate governance. Why is corporate governance important to the shareholders of a firm? Critically assess the following statement: “the same corporate governance rules should be applied to all companies”.

(50 %)

Answer 1

7. In corporate finance, agency relationship refers to the relationship between the principal and the agent. The principal may hire and appoint an agent to carry out a task. The agent represents the principal and deals with the third party. The costs that will be incurred in this relationship is due to the conflict that occurs between the agent and the shareholders. The shareholders would want the agent to work for increasing the shareholder's wealth. The principal would also want the agent to work for the maximizing the shareholder's wealth. But the agent may not agree with this, it may lead to a conflict as the agent would like to maximize his/her own interests.

Agency costs can be reduced by:

i) Evaluating the Performance of the agent

ii) Taking corrective measures

iii) Rewarding the agents

b. Corporate governance is the way by which a company should be directed and managed. It keeps in mind the best interests of the shareholders in mind. It clearly mentions the responsibilities of the management and the guiding the leadership to implement the corporate governance principles. The statement "Same corporate governance rules should be applied to all companies" means that the rules of corporate governance are based on the same fundamental principles of honesty,integrity, transparency etc.This should be kept common for all companies irrespective of the type of company.