FINANCIAL MANAGEMENT ASSIGNMENT
SNEHAJA R.L THAPA
Q2. How agency problem can be solved?
ANS 2. The agency problem arises in business when one party, known as the agent,
faces the expectation of acting in the best interest of another party, known as the
principal. Conflicts of interest can arise if the agent personally gains by not acting in
the principal’s best interest. You can overcome the agency problem in your business
by requiring full transparency, placing restrictions on the agent’s capabilities, and
tying your compensation structure to the well-being of the principal:
A. Illustrating the Agency Problem: Imagine receiving a windfall of money and
hiring a financial advisor to invest it for you. In this relationship, you’re the principal,
and the advisor is the agent. The advisor has a fiduciary responsibility to act in your
best interest. Unfortunately, incentives may exist for the advisor to undermine your
interests and put his needs first. Suppose the advisor, after learning your financial
goals, knows that a growth stock mutual fund is the best vehicle for your money. The
advisor also knows they can make a higher commission by placing your funds in an
annuity, even though doing so compromises your goals. This is an example of the
agency problem. The conflict of interest stems from the financial advisor the agent
having a clear financial incentive to act in a manner not in the best interest of you, the
principal.
B. Full Transparency: Agency problems are most prevalent when there’s a disparity
in knowledge between the agent and the principal. It’s too easy and too tempting for
the agent to exploit the knowledge gap for personal gain. When agent-principal
relationships arise in your business, practicing full transparency can help close the
knowledge gap and prevent the agency problem from emerging. The agent should
educate you, the principal, on everything that’s going on, rather than leaving you in
the dark while the agent makes decisions on your behalf.
C. Restrictions on the Agent’s Capabilities: Giving the agent too much power to act
on your behalf opens the door for future challenges and can lead the financial advisor
to perhaps make poor choices. Most successful governments practice checks and
balances because it tempers the power of any one individual or entity, keeping
corruption to a minimum. You can practice the same principles in your business by
limiting the power of the agent.
D. Commission and Bonus Structures: Perhaps the simplest method for eliminating
the agency problem is to remove financial incentives that encourage conflicts of
interest. Returning to the financial advisor example, the agency problem exists in that
scenario because the advisor’s compensation is tied to the specific financial products
he offers you. The products that pay the highest commissions aren’t always the best
choices for you, the client. Often the advisor is forced to choose between doing right
by his client and maximizing his paycheck. If the advisor receives a set salary or
earns commission based on total assets under management rather than specific
product sales, the agency problem disappears.
E. Mediation: When a problem has been made public, then an agency can attempt to
solve the problem by mediating the conflict between the involved. In some cases, a
senior member of the company may act as mediator. However, in other cases, to
maintain impartiality, the company may hire an outside mediator to come in and help
the warring parties solve their differences. The mediation is designed to satisfy both
parties as much as possible.
F. Discussion: One way in which problems can be resolved is by creating an open
forum for discussion. If problems are not brought out into the open, then they tend to
fester. By creating a forum in which employees can bring management's attention to
problems, without fear of reprisal, the agency takes a first step to resolving the issues
that need addressing. An agency should consider a town hall forum or other public
space.
Q1. Proper trade off between liquidity and profitability assist to increase shareholders
wealth, How?
ANS 1. liquidity and profitability are very important part of any business and
organization. The management between the liquidity and profitability helps us to
identify the structure and future of the company. Liquidity can be referred as the
firm’s capacity to meet the short-term obligations. For example, in case of bank there
must be some amount of cash with bank which could be withdrawn at any time the
customers want that money. If the bank doesn’t have liquid cash then that would
dissatisfy the customers. Profitability is the amount that is generated when the firm’s
revenue exceeds the firm’s cost or expense. The investors that are in the market are
more attracted towards the dividend that the firm provides or companies which
provide more profitability ratios. When there is low profit margin this would show
the ineffective management and investors would not be encouraged to invest in the
market. Liquidity and profitability are very contradicting when financial manages
have to take a decision. A company must earn profit to its shareholders and at the
same time, they must keep sufficient liquidity to satisfy the withdrawal needed for the
company’s customers. Maximum liquidity can be achieved when high proportion of
cash against deposit and this would not generate any income or profit for the
company. If a company decided to lend the money to earn larger interest rate than
there will be lower liquidity in the company which means this would expose to higher
liquidity risk. As these two elements contradict with each other, increase in one
aspect would affects the progress of another aspect and vice versa. The investor is
more focused in the wealth maximization and increasing its share value rather than
increasing the liquidity in the company. This could be achieved with the proper
tradeoff between liquidity and profitability. when the company earns revenue and the
greater portion of that is used to increase the value of business in order to increase the
value of the shares held by shareholders than this would maximize the shareholders
wealth. This would than decrease the liquidity in the company. The company would
have fewer liquid cash and may affect the normal transactions for the customers and
might create financial insolvency.
