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CHAPTER 1
An Overview of Financial Management

 The basic goal: to create stock-

holder value
 Agency relationships:
1. Stockholders versus managers
2. Stockholders versus creditors
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What is an agency relationship?

An agency relationship arises

whenever one or more individuals,
called principals, (1) hires another
individual or organization, called an
agent, to perform some service and
(2) then delegates decision-making
authority to that agent.
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If you are the only employee, and only

your money is invested in the
business, would any agency
problems exist?

No agency problem would exist. A

potential agency problem arises
whenever the manager of a firm
owns less than 100 percent of the
firm’s common stock, or the firm
borrows. You own 100 percent of
the firm.
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If you expanded and hired additional

people to help you, might that give rise
to agency problems?

An agency relationship could exist

between you and your employees if
you, the principal, hired the employees
to perform some service and delegated
some decision-making authority to
them.
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If you needed additional capital to buy

computer inventory or to develop
software, might that lead to agency
problems?

Acquiring outside capital could lead

to agency problems.
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Would it matter if the new capital came

in the form of an unsecured bank loan,
a bank loan secured by your inventory
of computers, or from new
stockholders?

Agency problems are less for

secured than for unsecured debt,
and different between stockholders
and creditors.
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There are 2 potential agency conflicts:

 Conflicts between stockholders and

managers.
 Conflicts between stockholders and
creditors.
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Would potential agency problems

increase or decrease if you expanded
operations to other campuses?

Increase. You could not physically be

at all locations at the same time.
Consequently, you would have to
delegate decision-making authority to
others.
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If you were a bank lending officer

looking at the situation, what actions
might make a loan feasible?

Creditors can protect themselves

by (1) having the loan secured and
(2) placing restrictive covenants in
debt agreements. They can also
charge a higher than normal
interest rate to compensate for risk.
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As the founder-owner-president of the

company, what actions might mitigate
your agency problems if you expanded
beyond your home campus?

1. Structuring compensation packages

to attract and retain able managers
whose interests are aligned with
yours.

(More…)
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2. Threat of firing.
3. Increase “monitoring” costs by
making frequent visits to “off
campus” locations.
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Would going public in an IPO increase or

decrease agency problems?

By going public through an IPO, your

firm would bring in new shareholders.
This would increase agency problems,
especially if you sell most of your stock
and buy a yacht. You could minimize
potential agency problems by staying on
as CEO and running the company.
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Why might you want to (1) inflate your

reported earnings or (2) use off
balance sheet financing to make your
financial position look stronger?

A manager might inflate a firm's

reported earnings or make its debt
appear to be lower if he or she wanted
the firm to look good temporarily. For
example just prior to exercising stock
options or raising more debt.
(More…)
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What are the potential consequences

of inflating earnings or hiding debt?

If the firm is publicly traded, the stock

price will probably drop once it is
revealed that fraud has taken place. If
private, banks may be unwilling to lend
to it, and investors may be unwilling to
invest more money.
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What kind of compensation program

might you use to minimize agency
problems?

 “Reasonable” annual salary to meet

living expenses
 Cash (or stock) bonus
 Options to buy stock or actual shares
of stock to reward long-term
performance
 Tie bonus/options to EVA
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Is it easy for someone with technical

skills and no understanding of
financial management to move higher
and higher in management?

No. Investors are forcing managers

to focus on value maximization.
Successful firms (those who
maximize shareholder value) will not
continue to promote individuals who
lack an understanding of financial
management.
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Why might someone interviewing for

an entry level job have a better shot at
getting a good job if he or she had a
good grasp of financial management?

Managers want to hire people who can

make decisions with the broader goal
of corporate value maximization in
mind because investors are forcing top
managers to focus on value
maximization.

(More…)
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Students who understand this focus

have a major advantage in the job
market. This applies both to the initial
job, and the career path that follows.