Agency Costs and role of Finance Manager

These arise because of lack of coordination OR conflict of interests between equity holders, debt holders and managers of the company. These three groups affects maximization objective of finance function which contributes to agency costs.

Financial managers would always recommend for company diversification because the risk in one domain reduces. But equity shareholders would always oppose diversification as they want managers to be focused on one business. Market costs of diversified companies is lower than the ones which are not diversified and these costs contribute to agency costs.

Most of the agency problems occur because of lack of transparency in which case we can avoid it by designing suitable capital structure.

Agency problems may occur if there is not debt taken by the organization because no one can question finance managers (BoD) and hence they behave like monarchs (IPL for example) hence pull in some debt holders forcibly so that there will be someone to question managers. Finance Managers should encourage the directors to go and borrow outside.

Role of finance manager is to reduce agency costs by keeping these groups in line.

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Key issues in Finance Function- Assuring the Financial viability of Investments

  • Acquire capital at low cost
  • FM has  to assess whether the project is viable or not.
  • Managing cash flows: It is difficult to manage cash flows when there are deficits and surpluses in cash flows. At times of deficit we need to find ways of getting capital temporarily at low cost. Long term bonds – treasury bills: tax collection and expenditure are not balanced, they are uneven. Hence government raises treasury bills.
  • Design suitable long-term dividend policy: make sure the share holders are happy with dividends over time and hence plan for long term dividends with nominal amounts every year increasing over time. Note: One should make sure dividends increase over time.
  • Balancing Finance and Business Risk: Financial Risk is proportional to the amount of liabilities and Business Risk is proportional to the value of assets. When the business risk is high (asset value is very high), then try to run the business mostly with equity (i.e, very low financial risk) and vice versa.

Note: Fixed costs can be controlled through volumes. Variable costs can be controlled primarily by technology.

Break Even Point = (Fixed Cost)/contribution;
The contribution is the difference between the sales revenue and the variable cost of each unit sold or made.
Hnece when variable costs increases contribution comes down. BEP increases. Here business becomes high risk. Now we cannot go for borrowed money to run the business.

Note: In startup company we should start with equity, get stability in the market where financial risk becomes less and then look for liabilities to expand the organization.

Role of Finance Manager(FM); FM a Goal Keeper

The major role of finance manager is to raise money at low cost.

Note: The Balance sheet structure creates Risk. The liability/equity section suggests Financial risks. The Assets section suggests the Financial risk. FM’s responsibility is to Increase the Return of Equity and at the same time manage business risks.

Finance Function: One side of finance function is finance managers like HR Manager, Production Manager, Marketing Manager so on. All these managers need money in their day to day operations and hence they need to raise money from investors segment.

Now that they need to raise the capital, role of finance manager is to raise capital at lowest cost (interest rates). Like Marketing manager goes to the market to understand the market to sell the product at highest price, Purchasing Manager goes to the purchase market to understand the cheapest prices to deliver the product at minimum cost, finance managers also go to the capital markets and look for cheaper money based on the availability and cost of money.

Investors dont want to directly interact with the finance departments and hence dependency of Investors move from finance function to capital markets so that they can expose their cost of capital to the markets.

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Capital markets have two segments.

  •  Institution Segments: Institutions like banks collect savings, convert them into capital and then put them into markets.  In developing countries like India, Institution Segments take major share of capital markets. In developed countries they act less.
  •  Primary/Secondary Segments: these are direct cash flows.

So finance managers can approach capital markets through either directly (primary/secondary segment) or through institution segments.

Finance Managers act as goal keepers who are part of the game. When the company is financially week they will face troubles and when it is strong they will enjoy. Just like goal keeper in the match, he should analyze the team as well as the external markets.

Note: Accounts are called as score keepers who are outside the game.

Why at times liabilities can fetch over equity?

Liabilities versus Equity

Whenever the return on equity (ROE) is more than the interest charged on liabilities it implies that we can go for liabilities instead of  just owner’s equity.

Company A (in Cr)

Company (in Cr)

Fixed Assets + Current Assets

500 (total equity)

500 (300 is equity and 200 is liabilities at 15% interest)

Operating Profit/Profit Before Interest and Tax (PBIT)

100

100

Interest

0

30

Profit Before Tax (PBT)

100

70

Income Tax

30

21

Profit After Tax

70

49

Return On Equity (RoE)

70/500 = 14%

49/300 = 16.33%

In general the perception is that company ‘A’ would be at profit but from the analysis it might not be the case.

In company ‘A’, we are returning 14% profit for the equity holders even though 100% of assets are funded from equity, whereas in company ‘B’, we are returning 16.33% profits at equity of 300 only.

Going for liabilities can also be termed as imposing Financial Risk.

Taking Financial Risk not advisable when there is already high Business Risk.

BRICS Bank – Is it a Good Idea for India?

In order to understand weather the new bank proposed for the BRICS a good or Bad, we need to know to whom is it considered good/bad. The Bank will be setup using a 50 Billion USD as a seed capital. Before deciding on things, we need to get answers to the following questions

  1. What will be the criteria for joining the bank? Will anyone be part of it? Will it allow Euro countries to join today? Especially Cyprus?
  2. Will it be confined only to the members of the grouping? And or Will only developing nations be part of the Bank?
  3. Will the entire participating members have equal voice?
  4. Will the bank allow differential interest rates in sanctioning loans to countries, or will it have a standard interest rate through all cases?
  5. Where will the location of the Bank will be?

Once the above questions are answered, it would lead to a governance formation and I believe will set the ball rolling.

The other facts that we need to understand is none of the BRICS nations are at wars although they are target of the terrorism. India and China suffer from brittle boundary issues, while Brazil has strong relationships with its neighbors. Russia to some extent has a problem of its own. So the political scenario arising out of this might ruin this bank.

The beauty of BRICS is each country is good at some aspect of economy. While India and Russia are good at providing services using its manpower, China and Brazil are good at manufacturing. South Africa although is small when compared to Brazil and China, has got immense natural resources and can mine it out when needed. So, it is imperative that these countries can depend on each other and hence need of a Bank which can help them expand them in the

Now let us look at each of the country:

Brazil has become a new external creditor in the last 6 years or so and is expected to do so for the next few years since the inflation, interest and poverty are controlled via set of measures and fiscal discipline. Formal job creation is strong, Real salary is also growing and so is Business Confidence. The Sovereign credit rating is also increasing year on year. Overall, Brazil is a country which has money to lend in the 3 to 5 years horizon. [Ref: http://www.bcb.gov.br/pec/appron/apres/Alexandre_Tombini_Amcham_Florida-26-03-12.pdf%5D

China has very good balance of payment and can give credit to any country in the world. They can bail out Europe from recession if it wants to. Hence, it can afford to lend money. If one can recollect, it was ready to give South Africa loan for free.

Russia is an upcoming nation which has talent tool and skill. It also has huge natural resources. However, it borrows money for internal infrastructure and is a heavy commodity driven market. The weather causes major damage to Russian economy. It is slowly moving towards services driven section with IT accounting to 4% of the world share. Russia borrows money from World Bank on strategic initiatives.

South Africa is smallest of all and has been borrowing from World Bank. However, it has found a new friend in China who is helping SA gain importance in the world. With over 25% of its population looking for work, it is important for it to participate in the world economy and start getting into services.

India is net borrower of money and is looking for countries that can provide. However, in reality, the borrowing of money has reduced over the last few years. It has even once been a net creditor to World Bank. But what ails India is the huge labour force who is not being productive. India needs to invest in manufacturing facility so that the labour can move to them and increase India GDP and exports.

To whom will the bank help?

In my opinion, the bank being setup will first be used by nations supporting it. It will then expand its horizon in African countries where China has a stronger hold. It will also rope in Latin American countries and sway them away from World Bank. I would say it can setup its headquarters in Mumbai as Mumbai is slowly getting towards being the financial hub. One area of concern is that this Bank should try to stop themselves being bulldozed into financing the oil producing nations which can fund its nuclear missile program bringing un-stability to the macro economy of the world.

Only Time will tell how it will help the world, but for now, it looks like India can get benefits in long run, chine will reap in shot run. Let us hope for the best

Demand functions: How to read?

In our last quiz, we saw some demand equations with questions on elasticity, inferior/normal good, complimentary or substitute good, etc. Here I’ll explain how to deduce these from a demand equation. It was horrifying to look at complex equations, with an expectation to understand them, and then derive conclusions. On googling around, I found out that the rules are generic, and can be applied to any equation, given that the micro economics basics are clear. It boils down to common sense finally.

Lets define few things first:

Price Elasticity: If demand increases/decreases a lot more than price decrease/increase respectively, then it’s termed as more elastic. Lets say insulin, demand will not decrease if price increases, as there’s no substitute, hence it’s inelastic. Take coffee, demand will decrease much more than price increase, as there are many substitutes in place.

Complementary/ Substitute: This is self explanatory. Tea and coffee are substitutes. Tea and biscuits are complementary.

Inferior/Normal Good: If users stop using a particular good when their income increases, it’s termed as inferior good. On other hand, if demand of a particular good increases with increase in income, it’s a normal good. Examples, Hyundai Santro is an inferior good, as with more income I’ll buy Fortuner 🙂 . Gold is a normal good( in fact more than normal). If my income rises, I buy more.

Coming to equation:

Q = 100Px(-1.2) Pz(0.5) Y(0.7)

Q = Quantity demanded for X

Px = Price of X

Pz = Price of good Z

Y is the income

Is it price elastic or inelastic?

We see that Q is inversely proportional to Px, which is true for demand function. Now, lets make Px double i.e. Px = 2 Px. Other things equal, quantity demanded will decrease by 2(1.2) times, which is more than 2. Hence change in quantity > change in price, so this is price elastic.

Is Z a substitute or complement?

Increase price of Pz and you can see that quantity demanded for X will also increase. It means that X and Z are substitutes. On increasing price of Z, people are substituting it with X, and hence demand of X is increasing.

Is X inferior or normal good?

Increase the income, and you will see demand of X is rising. So it’s a normal good. Had it been inversely proportional, story would have been different.

Hope above was a simple analysis, and can be applied to any demand equation.

 

Sample Question: Golf champion Tiger Woods discontinued Stanford Univ. education midway, not because he failed

The following basic concept of Micro-economics can be used to explain the situation mentioned in this question-
The central idea of economics is that people make “purposeful” choices with “scarce” resources, and “interact” with other people when they make these choices. More than anything else, economics is the study of how people deal with scarcity.
Scarcity is a situation when people’s resources are limited. In Tiger Wood’s case, the resource in question was Time. In order to focus on one of his pursuits, he had to make a choice to forgo another. Having won three U.S. amateur titles, he was fully qualified to go Pro. He chose to go Pro as had he continued with the Standford Univ. education, he wouldn’t have been able to fully devote to his ambitions to be come Pro. This move paid as within a year of him turning Pro, he won a Masters Tournament and was also selected as a Sportsman of the year.
Tiger Woods would not have had the same opportunity had he not been able to “interact with people”. People in this case were- Golf fans- who enjoyed watching him play and even paid to see him play. Other set of people included Executives and Sponsors like Nike, who paid him for endorsement.
[Please feel free to comment alternative views]

Sample Question: Mushrooming of Management colleges in India

This question can be explained using the three facets of the market economies
1. Prices serve as a “signals” of what should be produced and consumed (when there are changes in tastes or changes in technologies).
2. Prices provide “incentives” to people to alter their production or consumption.
3. Prices affect the “distribution of income” or who gets what in an economy.

(A market economy unlike command economy is characterized by several key elements such as freely determined prices, property rights, and freedom to trade irrespective of location).

Applying this concept to explain the Mushrooming (increase) of Management colleges in India.
The media (almost) worships the Management graduates getting very high starting salaries by giving huge coverage. The visible high salary for management graduates (akin to “Price”) serve as a signal to the population and gives rise to increase in number of MBA aspirants (High salary- an incentive for people to alter their choice of career- can be related to consumption of goods). More the demand of Management courses result in more institutes opening up, which in-turn affects the distribution of Income for Faculties.

[Please feel free to add comments/alternate perspectives]

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