In the corporate finance, agency problems are those that refer to the conflicts that exist between the management of the company and their stockholders. These conflicts are relevant to corporate finance since the managers of the company, who are meant to act for the best interest of the shareholders often, fail to do so as expected of them. These managers, who act as agents of the shareholders, are meant to make decisions, which are geared towards maximizing the stockholders’ wealth. However, they fail to do so, owing to their desire to maximize their own wealth. In essence, these agency problems are related to the corporate finance in the sense that they help in understanding and analyzing the stockholder’s equity, corporate governance, and agency costs. Corporate stakeholders are often faced with the conflict of interest to pursue personal goals other than the intended objectives of the company.
Therefore, there is need to put in place appropriate mechanisms so as to effectively deal with the potential conflicting issues in the organization. For instance, there should be clear policies and management guideline to facilitate running of the corporation. The stipulated management principles will act as a guide to control and monitor the activities of all the stakeholders in the corporation. For example, when a manager engages in some other activities that conflict with those of the company, there is need to put in place stiffer penalties for the offenses and malpractices committed. In certain cases, the management team might reward themselves with high amounts of bonuses without necessarily considering the amount of net revenues earned from the operation of the company.
In fact, such instances will definitely make the company to incur high expenses, which consequent reduce the net earnings and the profitability of the company. As a result of this, the shareholders would not be entitled to receive some good dividends, as returns on their investments. Moreover, the conflict of interest among the stakeholders of the company has made the shareholders to pass a vote-of-no-confidence on some of the board members during the members’ board meetings. The presidents of the company are awarded bonuses due to their hard work so as to motivate them. However, when the performance is dwindling as witnessed in the Kodak Company, the stakeholders might be forced to terminate the contracts of the top management team of the corporation.
Indeed, the dividend policy of any firm can be regarded as irrelevant owing to the fact that corporations that often pay a lot of dividends to the shareholders give little price appreciation, but must offer the same sum of revenue returns to the investors, depending on their risk characteristics as well as the cash-flows generated from the investment ventures. In fact, since there are lack of taxes, but, if there is any, both the capital gains as well as the dividends are often taxed under a similar rate. Therefore, the investors ought to be indifferent to get their expected returns in both the price appreciation as well as in dividends, under such circumstances. Importantly, some assumptions must be incorporated in this argument for it to be true. First, it must be assumed that the transaction costs are lacking, thus making it impossible to convert price appreciation into some cash.
Therefore, it is not easy for the investors who might need cash urgently to receive their sum of dividends. Second, it has been assumed that companies, which offer a lot of dividends, are capable of issuing their stock, without both the transaction costs and the floatation costs. As a result, this implies that the stocks are priced fairly. Third, in most cases, it can be assumed that the firm’s investment decisions are not affected by the dividend decisions of the company, and its operating cash-flows are not affected by the adopted dividend policy. Finally, it has been assumed that the management members of the company just pay few dividends, and do not waste the free cash-flows allocated to them so as to pursue their own personal interests and gains.
Contrary to the former statement, dividend policy may matter in the real word owing to several imperfections that are eminent. Some of these imperfections can be attributed to conflict of interests among the stakeholders, information asymmetries, and taxes levied. Under these circumstances, the dividend policy matters. For instance, when the corporation’s management team members tend to waste the resources of the company, then the shareholders would prefer to have large sums of dividends, though this will eventually raise the taxes to be paid by the company. According to Kevin Rock and Merton Miller, the information and signalling content in dividend announcements can be defined as the way the dividend announcements present information to the investors/shareholders about the future prospects of the company.
The empirical validity of this concept can be ascertained under the fact that stock prices often increase when there is some increase announced on the dividends or when the dividends. On the contrary, the stock prices often fluctuate when there is decrease in the prices of dividends announced or when no dividend has been declared. As a result, many investors will shy away from investing in such companies. In fact, this is cause by the dividends information content. In situation whereby the cost of new equity capital is more than the retained earnings it would mean that the company lacked sufficient funds to compensate its shareholders. In such a case, the firm might be forced to source for more equity funds.
However, when many new investors are brought on board the company’s ownership and control might be diluted in the process, as a result of the new investors. On the other hand, it is not a worthy venture for the company to issue new stocks so as to pay dividends in the same financial year or accounting period. This is quite irrational in the sense that the new stocks are floated in the market at some costs. Besides, it takes time before all the stock is sold in the market so as to raise the required amount of capital. Therefore, it would not be easy to pay dividends using the expected funds during that same year. In addition, the performance of the stock market is not accurately predictable in the sense that it is pegged on so many factors such as history of the firm, the management ofthe firm, its liquidity, and credit worthiness among other factors.
Therefore, before the company declares and pays dividends to the investors, it is not likely to sell many of its stock in the market. Therefore, the decision to pay dividends using the new issue of stocks during the same year is not a rational one. The free cash flow hypothesis ascertains that the financial performance of a company is always calculated on its operating cash flow, once the capital expenditures have been subtracted. Therefore, the free cash flow is the amount of money that the company is left with after putting aside the money required for the maintenance and expansion of assets. This is important for both the company and the investors since it is able to pursue its goals as well as to enhance the shareholder value.
Therefore, the free cash flow theory makes it possible for the company to pay its debts, pay dividends, make acquisitions, and to develop new products. In essence, the free cash flow can help in understanding the motives behind the mergers and acquisition by availing the sufficient amount of cash to carry out such business transactions. This will be important for the company in the sense that it does not necessarily need to source for capital from the outsiders since there is sufficient funds for expansion. These activities are aimed at strengthening the performance of the company as well as expanding to other geographical areas, and this will help in acquiring more customers. In addition, the cash flow hypothesis helps in understanding the leverage buy-outs since those company that do not have sufficient funds are likely to be sold out to other investor companies.
The leverage buy-outs will make the firms, which are in big debts to have sufficient funds for settling their outstanding debts. Under the leverage buy out arrangement, the acquiring company would use collateral from the company that it is intending to purchase so as to secure loan. Though, this often comes with some interests, it is beneficial in the sense that the company is able to get cash from the secured loans so as to carry out some of its intended activities. Basing the arguments on the empirical evidence, the acquiring group of company is likely to benefit more than the acquired group in the mergers and acquisition arrangements. This is because the assets of the company, including its customers and the goodwill are transferred to the acquiring company.
Under many arrangements, the debts of the company are just partially settled by the acquiring firm, thus much of the profitability and gains are transferred to the firm that acquiring the other. Indeed, debt can always be regarded as a cheaper option since the equity is more expensive than it. This is so because equity involves partnership with the shareholders who share the company’s profitability. However, in case of losses the business bears it alone since the investors are only involved in sharing the returns, which are given in the form of dividends. These groups of the investors do not offer some technical expertise and knowledge in running the business since their work is to contribute capital to the business alone. Therefore, this can be regarded as a cost to the company.
Focusing on the debts, it is evidenced that the interest paid on the money borrowed is always periodic and has a time limit to complete the loan repayments. However, the dividends paid on the equity do not have the time limit since they are paid to the shareholders once the business is still in operation, and making profits. This compels the board of directors to declare dividends to the investors. Bankruptcy costs play crucial roles on the firm’s capital structure since they are the basic foundation upon which the financing policies of the firm are based. These bankruptcy costs act as the counterweight to those taxes that have been deducted on the interest payments.
Therefore, bankruptcy costs are very relevant in determining the optimal capital structure of the firm. The costs associated with the bankruptcy such as the reorganization costs, and tax credit losses directly impact on the capital structure of the firm since they are borne by the failing company. The agency cost impacts directly on the optimal debt ratio of the firm since the equity holders often have the incentives that make them to under-invest in those projects that have negative net present value (NPV), in situations whereby the leverage of the company is on the upward trend. This happens due to the fact that the equity holders are mainly interested in the net benefits of the project, when they bear the investment costs. The rests of the cots are passed on to the bond holders. On the other hand, the debt holders are aware of this incentive enjoyed by the equity holders of shifting the risks as well as under-investing.
As a result of this, the debt holders price their debts accordingly as well as demanding for the higher rates of return. This agency cost problem puts much pressure on the optimal debt ratio of the firm. The capital structure theories have several uses that facilitate the understanding of the capital structure of various companies, as outlined in the following discussion. Capital structure is the way corporations finances its own assets through combining equity, debt, or through hybrid securities. A company assets structure is the composition or the structure of its liabilities. For example, a company that sells twenty billion dollars in equity has $80 billion in debt, is alleged to be 20% equity financed and is 80% debt financed.
The company debt ratio total financing, 80% in this case, is described to as the company’s gearing (leverage) level. Moreover, the theory of the Pecking Order attempts to capture costs of the asymmetric information. It states that companies prioritize their own sources of financing right from financing to equity internally. According the least effort law and that of least resistance that is preferred to raise equity as means of financing and as the last resort”. Therefore internal financing is firstly used first; and when depleted, the debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains the fact that businesses stick to pecking order of financing sources and prefers internal financing if available, sometimes the debt is preferred over equity if external financing is a requirement and equity would imply issuing of shares bringing about external ownership’ inside the company.
Therefore, the type of debt choice of a company chooses be a signal for external finance. This theory is made popular by Myers (1984) when he argued that equity not a preferred method of raising capital, this is because when managers who are understood to have a better knowledge of the true condition of the company than investors floats new equity, investors supposedly think that managers are of the opinion the company is overvalued, and that managers are taking benefiting from the of this over-valuation. Consequently, investors will set a lower value for issuance the new equity. The Study of capital structure is a significant part of a typical introduction to a finance course. The same unit amplifies the importance of, also it provides a strong theoretical base for, economic analysis students are most likely to encounter in later courses like Business Policy and Strategic Management.
The traditional approach got in most introductory books presents Modigliani plus Miller’s capital structure inappropriate hypothesis build in the effects of taxes, financial distress, and agency overheads up to when the conventional form of optimal capital structure appears. It is an organized approach which is known as the “Trade-Off form which simply understood under the basic primary perception of optimizing worth and therefore shareholder wealth by choosing a capital organization combination which has the lowest probable cost of capital for the company. Once the firm finds this best mixture of monetary sources, which is a mix of debt plus equity sources which equates the profit of tax guard provided by debt of bigger expenses produced by company’s financial distress equity holders. The assumption is that new dollars of financing is raised proportion of debt and equity financing. There are two separate surveys of tentative capital structure choices showed similar findings. In each of the surveys, question were put forward to financial managers of two major criteria they used to determine their financing decisions, maintaining a mark capital structure or using a hierarchical of financing.
Furthermore, the ones who followed the hierarchy were requested to grade the order which they could use different internal plus external sources of financing. The first survey was of riches 500 companies while second were of the 500 biggest Over The-Counter companies. The study observed three world real phenomena difficult to explain using the agency cost and tax shield trade-off form. These are: in various industries the most profitable companies habitually do have the smallest debt ratios completely opposite what trade-off model would predict. Huge positive and abnormal returns for a company’s stockholders are linked with leverage-increasing actions like stock repurchases and debt-for-equity interactions other leverage-decreasing events like issuing stock. Finally, very few companies in America issue new stock once in a decade.
Therefore, while trade-off model is useful in explaining how financial managers make financing decisions, it appears to have small explanatory value of the number of financial managers actually come up these decisions in the real world. Bearing this in mind, a case of making introducing students to pecking order theory in harmonizing with the theory trade-off reached. Furthermore, the theory of pecking order of capital structure explains that companies do have a favorite hierarchy for financing decisions. The highest prediction is by the use internal financing kept income and the results of depreciation before sourcing for external funds. Internal funds earn no flotation expenses and require no extra disclosure of first hand financial information leading to more strict market discipline and a possible failure of competitive advantage.
If a company is forced to use it must use external funds, the choice is to use the next system of financing sources: debt of convertible securities sand preferred stock, and ordinary stock. While the trade-off form indicates a fixed approach in connection to financing decisions that are based on a target capital structure pecking order theory permits for the dynamics of the company to speak on a better capital structure for particular company at any given point. A company’s capital structure basically is a function brought about by its internal currency flows and the sum of positive NPV asset opportunities present. A company that is very profitable in an industry registering slow growth in terms of little investment opportunities doesn’t have any reason to issue debt and will most likely have a low debt-to-equity ratio. A less profitable firm in the same industry will likely have an elevated debt-to-equity ratio. Financial slack is described company’s liquefied assets which are money and profitable securities plus any idle debt capacity companies with adequate financial slack will have the ability to fund almost, all, of their investment chances internally and will not be required to issue debt and equity securities.
Failure to give out new securities allows the company to escape the flotation costs linked with external grant and the monitoring and market discipline that happens when accessing capital markets in the Asarco oil and gas, the Coca Cola and the The company computer companies most of the money is liquidities. This explains the reason for their continued expansion globally and their financial stability. In sum, the practical monetary managers will try to retain financial flexibility while making sure the long-term survival of their companies. When profitable companies keep their income as equity and build up cash coffers, they can create the financial slack which gives room for financial flexibility and, eventual lasting survival.
Pecking order theory examines plains these observed and reported managerial dealings while the trade-off model cannot. It also explains stock market responses to leverage-increasing and leverage-decreasing event, while trade-off model is not able.