Introduction
Business
owners also engage in some form of strategic management where they get to
choose whether to directly run their businesses or involve the services of
professional managers. Firms are formed by individuals with an aim of providing
a certain product or service to consumers. In order to be able to deliver on
its mandate, the firm requires real assets to carry on its business. At first,
the founders of the firm will provide the necessary finances required to
organize the firm’s activities and will directly be involved in the running of
the business. The capital provided by the founders and owners is referred to as
equity capital (equity financing). Individual will start a venture or firm to
earn a return on their investment and therefore increase their wealth. As such,
the major objective of the firm will therefore be the maximization of the
wealth of the owners of the firm.
In
a strategic management context, agency relationships will exist in an organization
in two ways: the owner versus the managers; and the financing institution
versus the shareholders. The business enterprise will eventually grow and
become big and therefore the owners might not have time or the expertise to run
organizations of such a magnitude. In essence, the owners will hire
professional managers to manage the firm on their behalf. As such, the managers
become representatives of the owners at the company, i.e. agents with the
owners taking the position of the principal. Thus there is a principle-agent
relationship between the managers and the shareholders. On the other hand, the
expansion of the firm brings about increased need for funds to finance growing
demand and expansion. The shareholders on their own might not be able to raise
the required funds to meet the firm needs.
At
the same time, equity finance is relatively expensive as compared to other
sources of finance as it is exposed to the firms operating risks. Therefore the
firm might seek to finance part of its operations from secured sources of
capital which creates an obligation to pay the amount borrowed plus a fixed
amount of income on the amount borrowed for a specific period of time (Pandey,
2004). Since the lenders will provide capital funds to the firm with the
promise that their interest will be secured by a charge on the assets of the
company, and the company promises a fixed annual income, its expected that the
management of the company will ensure that the asset pledged are secured and
proper levels of liquidity are maintained to ensure that the income on money
advanced to the firm is duly paid to the lenders. Therefore, a principal-agent
relationship exists between the lenders and the managers (Pandey, 2004). This
makes financiers interested parties in ensuring that effective strategic
management is exercised for as long as their debts are outstanding.
While
it is explicit that the various sources of long-term finances create various
agency relationships within the firm, the continued adherence to the agency
duties and responsibilities is not guaranteed. An agency relationship requires that
the agent acts in the best interest of the principal. However, the agents might
not have the same interests as their principals and if left on their own will
work for their own interest but not for the interest of the principal. It
therefore becomes imperative for the principal to put in place measures to
monitor the acts of the agents. Ideally, performance monitoring and control
becomes an important aspect of strategic management that can be invoked in
managing agency relationships effectively. The monitoring process gives rise to
a number of costs commonly referred to as the agency costs. The agency costs
might also include the failure to achieve optimal shareholders’ wealth
maximization. It has been argued out that agency costs can be reduced by
employing debt in the firm’s capital structure. The question is how practical
is this supposition?
Capital Structure
A
firm decides which way to finance its capital projects. The capital structure
is the mix of debt and equity capital a firm employs in financing its capital projects.
The company can elect to increase the owners’ claims on the assets of the
company or the creditors’ claims on the assets of the company. The capital
structure decision is a very significant strategic management decision which
affects the risk and return on the shareholders funds. In most cases, companies
are expected to plan their capital structures during their preparation for
incorporation (promotion). However, firms will also make capital structure
decisions when raising funds to finance an investment. The decision will
involve an analysis of the existing capital structure and factors that might
affect the present decision.
Financing
decisions are very crucial in the strategic management of any organization. The
mix between debt and equity in the capital structure has an implication on the
risk and return of the shareholders, and therefore eventually affects the cost
of capital and the market value of the firm. In essence, the management of a
firm is faced by the decision of determining the proportions of debt and equity
in the capital structure. Debt financing binds the company legally to pay the
principal and interest on the amount borrowed as they fall due. Debt financing
is fixed charge source of funds and its use in the capital structure is
referred to as financial leverage. Leverage is the ability of gaining advantage
through help. In essence, the firm is able to benefit from funds provided by
lenders since the interest charged on debt is taxed deductable hence has a potential
of increasing the earnings attributed to the ordinary shareholders. The return
on shareholders’ equity will be levered above rate of return on total assets if
the after tax cost of debt is less than the return on investment. This is one
of the most observed merits of using debt financing in a firms capital
structure.
In
addition, the suppliers of debt have limited participation in the company’s
business and profits and therefore will insist on protections in earnings and
in values represented by ownership equity. Debt financing is majorly sourced
through the issue of various instruments, depending on whether it is short-term
or long-term. For short-term purposes, the company might issue commercial
papers, certificates of deposit, or bills of exchange. On the other hand the
company might issue bond indentures, debentures and mortgage certificates in
order to raise long-term capital funds. These items are legal documents with
binding provisions which the company must adhere to during the life of the debt
instrument. The instruments create legal obligations which the management has
no other alternative but to meet the obligations even if they conflict with
their managerial interest at that particular point. Any failure to meet the
obligations as spelled out in the debt instruments exposes the firm to the risk
of bankruptcy. The obligation of any strategic manager is to weigh the risks
and ensure that the organization only assumes risks it can bear; without
running the risk of being insolvent.
Agency Relationships
The
firm is made up of many stakeholders who have particular sets of associations
found around the operations and objectives of the firms. Effective strategic
stakeholder management involves understanding these stakeholders and ensuring that
their interests are accommodated as effectively as possible. For instance, a
firm is made up of shareholders who are the owners of the firm, creditors or
lenders who are the debt holders (outsiders who have a claim on the assets of
the firm by virtue of the amounts they contribute) but are not owners, the
regulatory authorities like the tax authorities and government, customers,
among other stakeholders (Brigham and Daves 2009, p. 9). An agency relationship
arises whenever an individual called the principal, hires someone else, called
an agent, who performs some duties that are delegated to him by the principal.
For the case of the firm, the primary agency relationships are usually
established between shareholders and management; and between shareholders and debt
holders.
Shareholders Vs Management
Ideally,
managers are given mandate by the shareholders of the firm to make strategic
management decisions that are beneficial to the organization. The main aim is
of course to maximize wealth for these shareholders. An agency problem might
arise in the event that managers do have their own interest and might choose to
pursue them at the expense of the shareholders interest (Brigham and Daves
2009, p. 9). If the firm is managed by its owners, the firm will be run with an
objective of maximizing the welfare of its owners. The welfare of the owners is
presumably measured in terms of increase in the wealth, more leisure or more
perquisites for the shareholders. In the event that the proprietor decides to
incorporate the firm and sell part of it to external investors a potential
conflict of interest arises. The owner/manager might decide to work less
strenuously, take more perquisites or might increase his salary. Since the
managers own only a small percentage of the firm the objective of shareholders
wealth maximization may take a backseat to management personal goals. Managers
might pursue huge executive compensation schemes of could strive to maximize
the size of the firm (empire building), as opposed to the wealth of the
shareholders. All these management pursuits are in direct conflict with the
overall objective of the firm which is shareholders wealth maximization.
In
an attempt to encourage managers to act in the interest of shareholders, the
shareholders use a raft of measures such as incentives, constraints and
punishments (Burkart and Panunzi, 2005). These measures are often borrowed from
theories of strategic human resource management with shareholders focusing on
how to motivate managers to deliver as much as possible. These measures lead to
the incurrence of agency costs by the shareholders which include all costs
borne in encouraging managers to pursue wealth maximization as the primary goal
of the firm. It’s vital that the firm incur the cost associated with agency
relationship so as to arrest the possible effect of the agency conflict which
could mean that the firm winds up altogether. The firm will in most cases incur
three major agency costs, i.e. expenditure to monitor managerial action (auditing
costs), costs associated with limiting undesirable managerial action through
appointment of an independent board or directors, and opportunity cost of the
lost opportunity resulting from restrictions on managerial decision making. As
earlier observed, shareholders risk loosing their entire wealth if they fail to
make any effort to affect managerial behaviour, which will most probably be
self-dealing. On the other hand, agency costs would be exceedingly high if
shareholders attempt o ensure that every managerial action coincides exactly
with shareholders interest. It has been argued out that if the firm managers
are compensated solely based on the long-term price of the firm stock, then the
expected agency costs would be low since managers would have a huge incentive
by maximizing the wealth of the shareholders.
The
use of debt financing in the capital structure has been cited as one of the
methods that can drastically reduce the expected agency costs. This assertion
confirms the reason why strategic management teams would often opt to go for
loans even where shareholders are capable of providing the funds needed. Debt
instruments are accompanied by a number of legally binding documents whose
provisions must be observed by the management of the company. The commonly used
debt documentations are the bond indenture and covenant. The two documents have
a raft of conditions that must be met during the life of the debt instrument.
They state the required minimum levels of firm liquidity, profitability, asset
management, future investments, future financing and managerial behaviour.
These measures ensure that management makes decisions that add value to the
firms bottom-line, hence securing their investment. Failure to adhere to these
requirements has the potential of leading the firm into bankruptcy meaning that
the managers loose their jobs. In essence, management will strive as much as
possible to make decisions that maximize the welfare of the stakeholders hence
negating the need to put in place costly strict compliant measures (Albuquerque
and Wang 2005).
Shareholders Vs Creditors
A
relationship subsists within the firm between the shareholders (agents) and
creditor (principals). The creditors have a claim on the earning stream and the
assets of the firm in the event of bankruptcy. On the other hand, shareholders
have control over the firm through their agents the managers and take decisions
that affect the riskiness of the firm. Creditors will advance funds to the firm
at rates that are reflective of the risk of the firm at the time of
transaction. The lending decision is entirely based on strategic management
considerations that often incorporate gauging the riskiness of the firm’s
existing assets; the expected risk of the firm’s future assets; the existing
firm’s capital structure; and expectations of future capital structure changes.
The expectation by the creditors is that the company will not make decisions
that increase the riskiness of the firm after the credit transaction has been completed
(Adair, 2011). The shareholders are the owners of the company and through their
oversight roles should ensure that managers do not make decisions that threaten
the funds contributed by creditor. However, shareholders might approve projects
which by virtue of them being profitable increases their wealth but raises the
risk profile of the firm. Such decisions create a conflict of interest between
the shareholders and creditors. Shareholders are interested in the project
return while the creditors are only interested in the risk of the project. At
the center of the conflict is the fact that for any risky project taken by the
firm, the shareholders are bound to benefit a lot if all goes well as such
projects attracts much bigger returns. The creditors will not in any way
benefit from the projects since their share in the earnings of the firm are
fixed when the credit transaction is completed. However, if the project goes
wrong, the creditors are bound to be negatively affected since the higher risk
increases the expected cost of debt hence reducing the value of the debt held
by the creditors of the company.
The
question has been whether the shareholders should, through their managers, take
advantage of the creditor by approving risky projects? It is not good business
practice for the firm to deal with the creditors unfairly. Unethical behaviour
is against best practices in business and if creditors perceive that the firm’s
managers are trying to treat them unfairly, they might refuse to enter into any
further dealings with the firm or might only lend to the company at a higher
cost. Increased cost of credit is detrimental to the shareholders in the
long-term (Adair, 2011). In essence, the major indirect agency cost arising
from the conflict between shareholders and creditors is the higher cost of
capital the firm will have to content with in such a situation. However, the
debt financing has inborn measures that attempt to reduce the potential of the
firm engaging in unfair practices against the creditor and therefore
effectively reduce the expected cost of agency relationship between the
shareholders and creditors. The strategic response of the creditors to such
risks is the inclusion of restrictive covenants in the debt agreements.
Restrictive covenants put a limit to the extent of management decision relating
to new debt financing, capital structure decisions, investments decisions,
assets management and working capital decisions. The covenant might restrict
adoption of risky projects, payment of cash dividends and taking of additional
borrowings. Constraints and sanctions within debt instruments, management
actions that would be detrimental to the wealth of shareholders and the welfare
of other stakeholders like customers, the community, suppliers and employee is
effectively curtailed and therefore reduces the need to institute strict
monitoring measures by the shareholders (Brigham and Daves 2009, p.15). Debt
financing is therefore an essential factor in reducing the expected cost of
agency conflict.
Conclusion
Debt
financing is an alternative source of capital to equity finance in providing
long-term finances. Debt instruments have legally binding agreements which
govern management behaviour during the life of the debt instruments. By use of
restrictive covenants and bond indentures, management behaviour is limited to
stakeholder welfare maximization. Violation of these provisions puts the firm
at risk of bankruptcy and therefore management will strive to uphold them. In
essence, debt financing reduces the need by shareholders to monitor management
actions since the inherent debt agreements which do not need extra costs serve
the same purpose. Strategic management teams also tend to go for debt financing
since it is a cheaper source of financing that enables them to not only improve
the organisations’ bottom-lines but also be able to benefit from the
performance-based rewards available.
References
Adair,
T 2011, Corporate Finance Demystified, New
York: McGraw-Hill
Albuquerque,
R and Wang, N 2005, ‘Agency Conflict, Investments and Asset Pricing’, [Online]
Available at <www.nyu.edu/econ/user/galed/fewpapers/FEW
F06/Albuquerque-Wang.pdf> Accessed on 24th March, 2011
Brigham,
E.F and Daves, P. R 2009, Intermediate
Financial Management, New Jersey: Cengage Learning
Burkart,
M and Panunzi, F 2005, ‘Agency Conflict, Ownership Concentration, and Legal
Shareholder Protection’, Journal of
Financial Intermediaries, Vol. 15, pp. 1-3, [Online] Available at <www.elsevier.com/wps/find/journaldescription.cws_home/622875/description#description> Accessed on 24th March, 2011
Pandey,
I.M 2004, Financial Management, New
Delhi: Vikas
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