Question

Question 1
a. Discuss the factors that are likely to influence the desired level of cash of a company (5
marks)
b. Outline the advantages and disadvantages of using short term debt, as opposed to long
term debt, in the financing of working capital
c. Why cash flows rather than profits are most desirable in financial management? (5
marks)
d. Explain the term “agency relationships” and discuss the conflicts that might exist in the
relationship between’
i) Shareholder and managers
ii) Shareholders and creditors
What steps may be taken to overcome these conflicts?

Answer 1

Part A

Factors that are likely to influence the desired level of cash of a company are as follows:

1. Inventory turnover. If inventory turnover is not more or if inventory is kept with company for large period, then our working capital will be blocked.

2. Credit terms and policies of company with their creditors. It affects the cash level as if the credit policy will be of less period, then we need to pay the amount in shorter period which directly affects our cash level.

3. Terms of Credit with their debtors. It affects the cash level as if the credit policy will be of long period, then we will receive amount from our receivables/ debtos in large period which can affect our working capital including cash.

Part B

Advantages	Disadvantages
Improve In Credit Rating. In short term loans, company can easily pay the interest amount and principal amount as it involves small amount of loan which can improve the credit rating of an organization.	The flexibility, convenience, and easy availability of short-term loans can make you a seasonal borrower. You may find yourself hooked towards borrowing whenever you need some money which is a risky not good. This means that you may end up spending more than you can afford or waste a lot of money.
Interest is less in case of short term debt as compared to long term loans. So there is less burden on a company.	Short term loans attract high rate of interest and high amount of monthly payments.
Short terms loans offers flexibility and it can also be chosen over long term loan as it reduces stress of owing the lender money for a longer period.	Late repayment of short term debt can lead to adverse effect on your credit score also.
Short term loans are approved fastly as compared to long term loans as it includes a smaller amount.

Part C

Cash flows are more desirable in finance management than profits because of 2 main reasons:-

1. A company can only survive by EPS or profits alone for a limited period of time. Eventually, it will need actual cash or cash flows to pay the piper, suppliers and, most importantly, the bankers.

2. Cash Flows are harder to manipulate as compared to profits. Profits can be manipulated by adding some fake expenses. But cash flows cannot be manipulated for longer time.

Part D

An agency relationship arises when the principal hires an agent to perform some services or the decision-making authority is delegated to the agent. However, the agent is not fully responsible for the decision that is made. Since the agent and the principal may have different goals, the agency relationship creates a potential conflict of interest.

Conflicts which can arise in Relationship between Shareholder and Manager:

1. Managers may not strive hard to improve shareholders wealth since that wealthwill not accrue to them.

2. Managers can take non-optimal decisions in investment, financing or labour recruitment.

3. Managers can take expensive business trips wholly financed by shareholders.

4. Managers spending unreasonable amounts of money on office renovations financed by shareholders

Steps which can be taken to solve conflicts between Shareholder and Manager:

1. Incur costs in monitoring management actions by conducting regular audits.

2. Performance based compensation- design the remuneration of managers as salary plus bonus paid at year end based on profits earned. (Solution to point 1 of conflict)

3. Threat of firing top management team should be made aware that they can be fired for poor performance.

4. Restructure the organization in such a way as to limit management behavior e.g.appoint outside investors who are non-shareholders to the board of directors