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.

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