Chapter 1

Page 1 of 19

Introduction to financial management

Financial Management can be defined as: The management of the finances of a business / organization in order to achieve financial objectives Taking a commercial business as the most common organizational structure, the ke objectives of financial management !ould be to: " " " Create !ealth for the business #enerate cash, and $rovide an ade%uate return on investment bearing in mind the risks that the business is taking and the resources invested

&ccording to the 'nline (usiness )ictionar , financial management is defined as *The planning, directing, monitoring, organizing, and controlling of the monetar resources of an organization+* There are three ke elements to the process of financial management:

(1) Financial Planning

Management need to ensure that enough funding is available at the right time to meet the needs of the business+ ,n the short term, funding ma be needed to invest in e%uipment and stocks, pa emplo ees and fund sales made on credit+ ,n the medium and long term, funding ma be re%uired for significant additions to the productive capacit of the business or to make ac%uisitions+

(2) Financial Control

Financial control is a criticall important activit to help the business ensure that the business is meeting its objectives+ Financial control addresses %uestions such as: " &re assets being used efficientl " &re the businesses assets secure" )o management act in the best interest of shareholders and in accordance !ith business rules-

(3) Financial Decision-making

Page 2 of 19

The ke aspects of financial decision.making relate to investment, financing and dividends: " ,nvestments must be financed in some !a / ho!ever there are al!a s financing alternatives that can be considered+ For e0ample it is possible to raise finance from selling ne! shares, borro!ing from banks or taking credit from suppliers " & ke financing decision is !hether profits earned b the business should be retained rather than distributed to shareholders via dividends+ ,f dividends are too high, the business ma be starved of funding to reinvest in gro!ing revenues and profits further+

Page 3 of 19

Functions of Financial Management:

Estimation of capital requirements: & finance manager has to make estimation !ith
regards to capital re%uirements of the compan + This !ill depend upon e0pected costs and profits and future programmes and policies of a concern+ 1stimations have to be made in an ade%uate manner !hich increases earning capacit of enterprise+

Determination of capital composition: 'nce the estimation have been made, the
capital structure have to be decided+ This involves short. term and long. term debt e%uit anal sis+ This !ill depend upon the proportion of e%uit capital a compan is possessing and additional funds !hich have to be raised from outside parties+

Choice of sources of funds: For additional funds to be procured, a compan has man
choices like. ,ssue of shares and debentures 2oans to be taken from banks and financial institutions $ublic deposits to be dra!n like in form of bonds+ Choice of factor !ill depend on relative merits and demerits of each source and period of financing+

Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safet on investment and regular returns is possible+

Disposal of surplus: The net profits decision have to be made b the finance manager+
This can be done in t!o !a s: )ividend declaration . ,t includes identif ing the rate of dividends and other benefits like bonus+ 3etained profits . The volume has to be decided !hich !ill depend upon e0pansional, innovational, diversification plans of the compan +

Management of cash: Finance manager has to make decisions !ith regards to cash
management+ Cash is re%uired for man purposes like pa ment of !ages and salaries, pa ment of electricit and !ater bills, pa ment to creditors, meeting current liabilities, maintainance of enough stock, purchase of ra! materials, etc+

Page 4 of 19

Financial controls: The finance manager has not onl to plan, procure and utilize the
funds but he also has to e0ercise control over finances+ This can be done through man techni%ues like ratio anal sis, financial forecasting, cost and profit control, etc+

Page 5 of 19

Finance Functions
'ne of the most important finance functions is to intelligentl allocate capital to long term assets+ This activit is also kno!n as capital budgeting+ ,t is important to allocate capital in those long term assets so as to get ma0imum ield in future+ Follo!ing are the t!o aspects of investment decision : 1valuation of ne! investment in terms of profitabilit Comparison of cut off rate against ne! investment and prevailing investment+ ,nvestment decision not onl involves allocating capital to long term assets but also involves decisions of using funds !hich are obtained b selling those assets !hich become less profitable and less productive+ &n opportunit cost of capital needs to be calculating !hile dissolving such assets+ The correct cut off rate is calculated b using this opportunit cost of the re%uired rate of return 43335

Financial Decision
Financial decision is et another important function !hich a financial manger must perform+ ,t is important to make !ise decisions about !hen, !here and ho! should a business ac%uire funds+ Funds can be ac%uired through man !a s and channels+ This mi0 of e%uit capital and debt is kno!n as a firm6s capital structure+ & firm tends to benefit most !hen the market value of a compan 6s share ma0imizes this not onl is a sign of gro!th for the firm but also ma0imizes shareholders !ealth+ 'ther than e%uit and debt there are several other tools !hich are used in deciding a firm capital structure+

Dividend Decision
1arning profit or a positive return is a common aim of all the businesses+ (ut the ke function a financial manger performs in case of profitabilit is to decide !hether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business+ ,t6s the financial manager6s responsibilit to decide a optimum dividend polic !hich ma0imizes the market value of the firm+

Liquidity Decision
Page 6 of 19

,t is ver important to maintain a li%uidit position of a firm to avoid insolvenc + Firm6s profitabilit , li%uidit and risk all are associated !ith the investment in current assets+ ,n order to maintain a tradeoff bet!een profitabilit and li%uidit it is important to invest sufficient funds in current assets+ Current assets should properl be valued and disposed of from time to time once the become non profitable+ Currents assets must be used in times of li%uidit problems and times of insolvenc +

Page 7 of 19

Financial Value Creation

The main job of an organization is to create value, according to $eter )rucker, one of the greatest business thinkers of the 78th centur + ,n toda 9s uncertain economic environment, most marketing investments 4for e0ample, branding campaigns, various initiatives, etc+5 need to be vetted b the finance department, and in general, must sho! a strong 3eturn on ,nvestment 43',5 in order to be funded+ Therefore, it is important for financial professionals to be able to intelligentl discuss true value creation from a financial conte0t+ ,9ve created an acron m as a mnemonic to help remember ho! a compan creates :,)13 levels of value+ :,)13 ;tands for :

W = Weighted verage Cost of Capital (WACC; pronounced Wack')

3ather than get into the particulars of ho! to compute a compan 9s :&CC, the main point to kno! is that it is a !eighted average of the compan 9s cost of debt 4e+g+, bonds floated at <=5 and e%uit 4e+g+, investors re%uire a return of 17= given the perceived risk of the business5+ 1ach of the terms is !eighted depending on the capital structure of the compan 4for e0ample, debt is 78= and e%uit is >8=5+ The :&CC is also called the discount or hurdle rate and is often used to discount cash flo!s in capital budgeting decisions+ :ith all of that said, if a compan is not getting a return on its capital that is higher than the cost of that capital, the are destro ing value vs+ creating value+ ,f ou kno! our compan 9s :&CC, and a project9s internal rate of return 4,33? an annualized rate of return, taking into account both the amount of mone invested and the length of time it has been invested5, then ou can determine !hether value creation is happening from a financial standpoint 4,33 should be @ :&CC5+ For each marketing investment 4e+g+, initiative, project, etc+5, tr to understand the :&CC that our compan is using and the different !a s that it might be able to lo!er this hurdle rate 4e+g+, restructuring capital costs, mitigating project risks, etc+5 4Aote: The :&CC ma differ b division and/or risk of a project/investment depending on the particular circumstances of the anal sis+ &dditionall , ,33 calculations can occasionall produce an un.interpretable result+5 , B ,nvestment &n investment b nature is generall non.recurring, long.term oriented, and is often one option among man + & compan can create value b making investments in projects that
Page 8 of 19

have an ,33 4or 3',5 that is greater than their :&CC+ & compan ma !ant to have a portfolio of investments 4e+g+, global branding campaign, segmentation stud , etc+5, each having a particular risk.re!ard profile 4e+g+, some have an ,33 of C8= or 78=, etc+5, as long as the are each above a compan 9s :&CC+ ,n making a case to our senior leadership team to obtain funds, make sure that our marketing initiative/investment has an ,33 that more than clears our compan 9s hurdle rate+ ) B )ivestment ,n general, a compan should divest of units or projects that are negative value creators+ This anal sis entails a basic cost/benefit justification+ ,f a compan 9s funds cost 18=, and it has m riad projects and/or units that are returning D=, it !ill eventuall run out of current funds and/or have difficult raising ne! funds 4e+g+, stock offering5 given its value destro ing behavior+ &s another e0ample, if ou rent a propert for less than our mortgage pa ment on that propert , ou are not creating value for ourself nor acting in an economicall sustainable manner+ ,n general, the ke message is to divest of projects/units that are destro ing value or find !a s to %uickl increase our investments return+ 1 B 1fficienc Find !a s to make our current capital 4e+g+, marketing investments5 !ork more efficientl or productivel + ,f ou can cut costs, increase cash flo!s, and/or increase turns 4e+g+, inventor /asset turnover5, then ou can use our current capital in a more productive manner+ This process comes do!n to making sure that each marketing project/investment is operationall managed in an effective and optimal manner+ :hen presenting a business case for a marketing investment, detail ho! the project !ill be run, the controls that !ill be put in place, and the track record of the resources that !ill hit the budget and timeline targets+ 3 B 3eturn ,f companies are going to beat the market averages and their peer group, the need to go after high return projects/investments+ Marketing campaigns that pursue ne!, large customer segments and/or gro!ing and substantial markets could produce the high returns that our compan needs to break out of the pack and/or achieve ne! levels of gro!th+ &s stated above, high return projects tend to be of higher risk, but if managed !ell, and situated !ithin a diversified investment 4projects/units5 portfolio, the are essential for hitting stretch targets and giving marketing a ne!, gro!th oriented, order of magnitude focus+ Conclusion
Page 9 of 19

,n summar , the above acron m can be used to initiall evaluate current and future marketing investments !ithin an organization+ ,f companies are to ultimatel survive, and the marketing department is to be vie!ed as financiall accountable, then understanding hurdle rates and project returns is essential for making a tenable, cogent business case for ne! marketing initiatives+ ,n s nthesizing m previous article !ith this one, value creation can be vie!ed as both perceived costs and benefits from a customer9s perspective, and from distance above :&CC from an internal compan perspective+ (oth perspectives are needed to justif large marketing investments in toda 9s uncertain economic environment, or at an time for that matter+

Page 10 of 19

)efinition of 9&genc $roblem9 & conflict of interest inherent in an relationship !here one part is e0pected to act in another9s best interests+ The problem is that the agent !ho is supposed to make the decisions that !ould best serve the principal is naturall motivated b self.interest, and the agent9s o!n best interests ma differ from the principal9s best interests+ The agenc problem is also kno!n as the *principal/agent problem+*

,nvestopedia e0plains 9&genc $roblem9 ,n corporate finance, the agenc problem usuall refers to a conflict of interest bet!een a compan 9s management and the compan 9s stockholders+ The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that !ill ma0imize shareholder !ealth+ Eo!ever, it is in the manager9s o!n best interest to ma0imize his o!n !ealth+ :hile it is not possible to eliminate the agenc problem completel , the manager can be motivated to act in the shareholders9 best interests through incentives such as performance.based compensation, direct influence b shareholders, the threat of firing and the threat of takeovers+

Page 11 of 19

&genc Theor C'AF2,CT; (1T:11A M&A&#13; &A) ;E&31E'2)13; M1CE&A,;M; F'3 )1&2,A# :,TE ;E&31E'2)13.M&A&#13 C'AF2,CT; ;T'CFE'2)13; G13;H; C31),T'3;: & ;1C'A) &#1ACI C'AF2,CT &#1ACI G13;H; C'AT3&CT &#1ACI &A) 1TE,C; FH3TE13 31&),A#: &genc theor suggests that the firm can be vie!ed as a ne0us of contracts 4loosel defined5 bet!een resource holders+ &n agenc relationship arises !henever one or more individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision.making authorit to the agents+ The primar agenc relationships in business are those 415 bet!een stockholders and managers and 475 bet!een debtholders and stockholders+ These relationships are not necessaril harmonious? indeed, agenc theor is concerned !ith so.called agenc conflicts, or conflicts of interest bet!een agents and principals+ This has implications for, among other things, corporate governance and business ethics+ :hen agenc occurs it also tends to give rise to agenc costs, !hich are e0penses incurred in order to sustain an effective agenc relationship 4e+g+, offering management performance bonuses to encourage managers to act in the shareholders9 interests5+ &ccordingl , agenc theor has emerged as a dominant model in the financial economics literature, and is !idel discussed in business ethics te0ts+ &genc theor in a formal sense originated in the earl 1J<8s, but the concepts behind it have a long and varied histor + &mong the influences are propert .rights theories, organization economics, contract la!, and political philosoph , including the !orks of 2ocke and Eobbes+ ;ome note!orth scholars involved in agenc theor 9s formative period in the 1J<8s included &rmen &lchian, Earold )emsetz, Michael Kensen, :illiam Meckling, and ;+&+ 3oss+ C'AF2,CT; (1T:11A M&A&#13; &A) ;E&31E'2)13; &genc theor raises a fundamental problem in organization self.interested behavior+ & corporation9s managers ma have personal goals that compete !ith the o!ner9s goal of ma0imization of shareholder !ealth+ ;ince the shareholders authorize managers to administer the firm9s assets, a potential conflict of interest e0ists bet!een the t!o groups+ ;12F.,AT131;T1) (1E&G,'3+
Page 12 of 19

&genc theor suggests that, in imperfect labor and capital markets, managers !ill seek to ma0imize their o!n utilit at the e0pense of corporate shareholders+ &gents have the abilit to operate in their o!n self.interest rather than in the best interests of the firm because of as mmetric information 4e+g+, managers kno! better than shareholders !hether the are capable of meeting the shareholders9 objectives5 and uncertaint 4e+g+, m riad factors contribute to final outcomes, and it ma not be evident !hether the agent directl caused a given outcome, positive or negative5+ 1vidence of self.interested managerial behavior includes the consumption of some corporate resources in the form of per%uisites and the avoidance of optimal risk positions, !hereb risk.averse managers b pass profitable opportunities in !hich the firm9s shareholders !ould prefer the invest+ 'utside investors recognize that the firm !ill make decisions contrar to their best interests+ &ccordingl , investors !ill discount the prices the are !illing to pa for the firm9s securities+ & potential agenc conflict arises !henever the manager of a firm o!ns less than 188 percent of the firm9s common stock+ ,f a firm is a sole proprietorship managed b the o!ner, the o!ner.manager !ill undertake actions to ma0imize his or her o!n !elfare+ The o!ner.manager !ill probabl measure utilit b personal !ealth, but ma trade off other considerations, such as leisure and per%uisites, against personal !ealth+ ,f the o!ner.manager forgoes a portion of his or her o!nership b selling some of the firm9s stock to outside investors, a potential conflict of interest, called an agenc conflict, arises+ For e0ample, the o!ner.manager ma prefer a more leisurel lifest le and not !ork as vigorousl to ma0imize shareholder !ealth, because less of the !ealth !ill no! accrue to the o!ner.manager+ ,n addition, the o!ner.manager ma decide to consume more per%uisites, because some of the cost of the consumption of benefits !ill no! be borne b the outside shareholders+ ,n the majorit of large publicl traded corporations, agenc conflicts are potentiall %uite significant because the firm9s managers generall o!n onl a small percentage of the common stock+ Therefore, shareholder !ealth ma0imization could be subordinated to an assortment of other managerial goals+ For instance, managers ma have a fundamental objective of ma0imizing the size of the firm+ ( creating a large, rapidl gro!ing firm, e0ecutives increase their o!n status, create more opportunities for lo!er. and middle.level managers and salaries, and enhance their job securit because an unfriendl takeover is less likel + &s a result, incumbent management ma pursue diversification at the e0pense of the shareholders !ho can easil diversif their individual portfolios simpl b bu ing shares in other companies+ Managers can be encouraged to act in the stockholders9 best interests through incentives, constraints, and punishments+ These methods, ho!ever, are effective onl if shareholders can observe all of the actions taken b managers+ & moral hazard problem,
Page 13 of 19

!hereb agents take unobserved actions in their o!n self.interests, originates because it is infeasible for shareholders to monitor all managerial actions+ To reduce the moral hazard problem, stockholders must incur agenc costs+ C';T; 'F ;E&31E'2)13.M&A&#1M1AT C'AF2,CT+ &genc costs are defined as those costs borne b shareholders to encourage managers to ma0imize shareholder !ealth rather than behave in their o!n self.interests+ The notion of agenc costs is perhaps most associated !ith a seminal 1J<D Journal of Finance paper b Michael Kensen and :illiam Meckling, !ho suggested that corporate debt levels and management e%uit levels are both influenced b a !ish to contain agenc costs+ There are three major t pes of agenc costs: 415 e0penditures to monitor managerial activities, such as audit costs? 475 e0penditures to structure the organization in a !a that !ill limit undesirable managerial behavior, such as appointing outside members to the board of directors or restructuring the compan 9s business units and management hierarch ? and 4L5 opportunit costs !hich are incurred !hen shareholder. imposed restrictions, such as re%uirements for shareholder votes on specific issues, limit the abilit of managers to take actions that advance shareholder !ealth+ ,n the absence of efforts b shareholders to alter managerial behavior, there !ill t picall be some loss of shareholder !ealth due to inappropriate managerial actions+ 'n the other hand, agenc costs !ould be e0cessive if shareholders attempted to ensure that ever managerial action conformed !ith shareholder interests+ Therefore, the optimal amount of agenc costs to be borne b shareholders is determined in a cost.benefit conte0tgenc costs should be increased as long as each incremental dollar spent results in at least a dollar increase in shareholder !ealth+ M1CE&A,;M; F'3 )1&2,A# :,TE ;E&31E'2)13.M&A&#13 C'AF2,CT; There are t!o polar positions for dealing !ith shareholder.manager agenc conflicts+ &t one e0treme, the firm9s managers are compensated entirel on the basis of stock price changes+ ,n this case, agenc costs !ill be lo! because managers have great incentives to ma0imize shareholder !ealth+ ,t !ould be e0tremel difficult, ho!ever, to hire talented managers under these contractual terms because the firm9s earnings !ould be affected b economic events that are not under managerial control+ &t the other e0treme, stockholders could monitor ever managerial action, but this !ould be e0tremel costl and inefficient+ The optimal solution lies bet!een the e0tremes, !here e0ecutive compensation is tied to performance, but some monitoring is also undertaken+ ,n addition to monitoring, the follo!ing mechanisms encourage managers to act in shareholders9 interests: 415 performance.based incentive plans, 475 direct intervention b shareholders, 4L5 the threat of firing, and 4M5 the threat of takeover+ Most publicl traded firms no! emplo performance shares, !hich are shares of stock given to e0ecutives on the basis of performances as defined b financial measures such
Page 14 of 19

as earnings per share, return on assets, return on e%uit , and stock price changes+ ,f corporate performance is above the performance targets, the firm9s managers earn more shares+ ,f performance is belo! the target, ho!ever, the receive less than 188 percent of the shares+ ,ncentive.based compensation plans, such as performance shares, are designed to satisf t!o objectives+ First, the offer e0ecutives incentives to take actions that !ill enhance shareholder !ealth+ ;econd, these plans help companies attract and retain managers !ho have the confidence to risk their financial future on their o!n abilitieshich should lead to better performance+ &n increasing percentage of common stock in corporate &merica is o!ned b institutional investors such as insurance companies, pension funds, and mutual funds+ The institutional mone managers have the clout, if the choose, to e0ert considerable influence over a firm9s operations+ ,nstitutional investors can influence a firm9s managers in t!o primar !a s+ First, the can meet !ith a firm9s management and offer suggestions regarding the firm9s operations+ ;econd, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders9 meeting, even if the proposal is opposed b management+ &lthough such shareholder.sponsored proposals are nonbinding and involve issues outside da .to.da operations, the results of these votes clearl influence management opinion+ ,n the past, the likelihood of a large compan 9s management being ousted b its stockholders !as so remote that it posed little threat+ This !as true because the o!nership of most firms !as so !idel distributed, and management9s control over the voting mechanism so strong, that it !as almost impossible for dissident stockholders to obtain the necessar votes re%uired to remove the managers+ ,n recent ears, ho!ever, the chief e0ecutive officers at &merican 10press Co+, #eneral Motors Corp+, ,(M, and Fmart have all resigned in the midst of institutional opposition and speculation that their departures !ere associated !ith their companies9 poor operating performance+ Eostile takeovers, !hich occur !hen management does not !ish to sell the firm, are most likel to develop !hen a firm9s stock is undervalued relative to its potential because of inade%uate management+ ,n a hostile takeover, the senior managers of the ac%uired firm are t picall dismissed, and those !ho are retained lose the independence the had prior to the ac%uisition+ The threat of a hostile takeover disciplines managerial behavior and induces managers to attempt to ma0imize shareholder value+ ;T'CFE'2)13; G13;H; C31),T'3;: & ;1C'A) &#1ACI C'AF2,CT ,n addition to the agenc conflict bet!een stockholders and managers, there is a second class of agenc conflictshose bet!een creditors and stockholders+ Creditors have the primar claim on part of the firm9s earnings in the form of interest and principal pa ments on the debt as !ell as a claim on the firm9s assets in the event of bankruptc + The stockholders, ho!ever, maintain control of the operating decisions 4through the
Page 15 of 19

firm9s managers5 that affect the firm9s cash flo!s and their corresponding risks+ Creditors lend capital to the firm at rates that are based on the riskiness of the firm9s e0isting assets and on the firm9s e0isting capital structure of debt and e%uit financing, as !ell as on e0pectations concerning changes in the riskiness of these t!o variables+ The shareholders, acting through management, have an incentive to induce the firm to take on ne! projects that have a greater risk than !as anticipated b the firm9s creditors+ The increased risk !ill raise the re%uired rate of return on the firm9s debt, !hich in turn !ill cause the value of the outstanding bonds to fall+ ,f the risk capital investment project is successful, all of the benefits !ill go to the firm9s stockholders, because the bondholders9 returns are fi0ed at the original lo!.risk rate+ ,f the project fails, ho!ever, the bondholders are forced to share in the losses+ 'n the other hand, shareholders ma be reluctant to finance beneficial investment projects+ ;hareholders of firms undergoing financial distress are un!illing to raise additional funds to finance positive net present value projects because these actions !ill benefit bondholders more than shareholders b providing additional securit for the creditors9 claims+ Managers can also increase the firm9s level of debt, !ithout altering its assets, in an effort to leverage up stockholders9 return on e%uit + ,f the old debt is not senior to the ne!l issued debt, its value !ill decrease, because a larger number of creditors !ill have claims against the firm9s cash flo!s and assets+ (oth the riskier assets and the increased leverage transactions have the effect of transferring !ealth from the firm9s bondholders to the stockholders+ ;hareholder.creditor agenc conflicts can result in situations in !hich a firm9s total value declines but its stock price rises+ This occurs if the value of the firm9s outstanding debt falls b more than the increase in the value of the firm9s common stock+ ,f stockholders attempt to e0propriate !ealth from the firm9s creditors, bondholders !ill protect themselves b placing restrictive covenants in future debt agreements+ Furthermore, if creditors believe that a firm9s managers are tr ing to take advantage of them, the !ill either refuse to provide additional funds to the firm or !ill charge an above.market interest rate to compensate for the risk of possible e0propriation of their claims+ Thus, firms !hich deal !ith creditors in an ine%uitable manner either lose access to the debt markets or face high interest rates and restrictive covenants, both of !hich are detrimental to shareholders+ Management actions that attempt to usurp !ealth from an of the firm9s other stakeholders, including its emplo ees, customers, or suppliers, are handled through similar constraints and sanctions+ For e0ample, if emplo ees believe that the !ill be treated unfairl , the !ill demand an above.market !age rate to compensate for the unreasonabl high likelihood of job loss+ &#1ACI G13;H; C'AT3&CT
Page 16 of 19

&lthough the notions of agenc and contract are closel intert!ined, some academics bristle at the suggestion the are essentiall the same+ ;pecificall , the point out a number of uni%ue features of agenc versus contractual relationships+ There are t!o major sets of differences+ First, agents are usuall retained not for an particular or discrete set of tasks, but for a broad range of activities, !hich ma change over time, that are consistent !ith basic objectives and interests set forth b the principals+ ,n this instance principals must be concerned to some degree about agents9 personal attitudes, dispositions, and other characteristics that are usuall not a concern in contractual agreements+ $rincipals hire out broad objectives to be fulfilled instead of specific tasks+ ;econd, in an agenc relationship there is t picall much less independence bet!een agent and principal than bet!een contracting parties+ T picall this also means that the principal.agent relationship is more hierarchical and po!er.driven than a contractual relationship, and included in this po!er is greater latitude for principals to re!ard, punish, and control agents+ & conventional vie! holds that agenc is a special application of contract theor + Eo!ever, some argue that the reverse is true: a contract is a formalized, structured, and limited version of agenc , but agenc itself is not based on contracts+ &#1ACI &A) 1TE,C; ;ince agenc relationships are usuall more comple0 and ambiguous 4in terms of !hat specificall the agent is re%uired to do for the principal5 than contractual relationships, agenc carries !ith it special ethical issues and problems, concerning both agents and principals+ 1thicists point out that the classical version of agenc theor assumes that agents 4i+e+, managers5 should al!a s act in principals9 4o!ners95 interests+ Eo!ever, if taken literall , this entails a further assumption that either 4a5 the principals9 interests are al!a s morall acceptable ones or 4b5 managers should act unethicall in order to fulfill their *contract* in the agenc relationship+ Clearl , these stances do not conform to an practicable model of business ethics+ & familiar real.life e0ample is large corporations9 la off dilemma+ Conventional !isdom holds that investors are re!arded !hen companies thin their emplo ment rosters because operating costs are lo!ered, in theor leading to greater profits+ This e0pectation is often made e0plicit in ne!s reporting surrounding a do!nsizing episode? the reports highlight !hether investors seem pleased or displeased !ith an announcement of a mass la off, and the often.stated assumption is that corporate management has undertaken the la offs in part, if not in !hole, to please shareholders and enhance their !ealth+ ,n this instance it is obvious that shareholders9 interests are advanced to the detriment of at least one other constituenc , namel the emplo ees+ ,n such cases, observers %uestion !hether it is ethical to serve the principals9 interests !hen
Page 17 of 19

those actions harm a large number of people, and !hether the benefits shareholders receive are commensurate !ith the harm inflicted on the laid.off emplo ees+ &long the same lines, others have noted that traditional agenc theor makes little mention of !hat obligations, moral or other!ise, principals have to their agents+ The emphasis lies almost e0clusivel on !hat agents should or must do for the principals, rel ing, in turn, on a vague assumption that principals !ill compensate agents ade%uatel ven more than ade%uatel or their services+ ;ome ethics scholars argue that principals have obligations as !ell+ ,n the e0ample above, some !ould argue that not onl is it unethical to harm emplo ees to obtain improvements 4often marginal5 in shareo!ners9 !ealth, but also that the shareholders have moral obligations directl to the emplo ees as an e0tension of the ethical emplo er/emplo ee relationship 4i+e+, not to harm them arbitraril , among other obligations5+ This ethical problem is onl complicated b the realit that, as noted above, principals are often institutions rather than individuals+ Mean!hile, consistent !ith the conventional formulation of the theor , agents are seen as having ethical duties to the principals+ ,f managers act in self.interest rather negative assumptionnd it fails to serve the best interests of the shareholders, the ma , according to some vie!s, have fallen short on their ethical responsibilities+ ,n a larger sense, some see the traditional agenc model as a simplistic, even deceptive, justification for traditional economic po!er relationships, specificall that large !ealth holders can e0tract concessions from !eaker economic beings+ Certain scholars have argued that from a broader social perspective, there are man kinds of principal.agent relations, and included among these is the fact that shareholders ma be seen as agents to managers, emplo ees, and the broader societ +

Page 18 of 19

&genc Theor 'vervie! $rincipal.agent relationships should reflect efficient organization of information and risk.bearing costs Hnit of anal sis Contract bet!een principal and agent Euman assumptions ;elf interest (ounded rationalit 3isk aversion 'rganizational $artial goal conflict among assumptions participants 1fficienc as the effectiveness criterion ,nformation as mmetr of bet!een principal and agent ,nformation ,nformation as a purchasable &ssumption commodit Contracting problem &genc 4moral hazard and adverse selection5 3isk sharing $roblem domain 3elationships in !hich the principal and agent have partl differing goals and risk preferences 4e+g+ compensation, regulation, leadership, impression management, !histle blo!ing, vertical integration, transfer pricing5 Fe idea

)iagram/schematic theor

Page 19 of 19