Corporate Finance Essay
Most corporate financing decisions in practice reduce to a choice between debt and equity. The finance manager wishing to fund a new project, but reluctant to cut dividends or to make a rights issue, which leads to the decision of borrowing options. The issue with regards to shareholder objectives being met by the management in making financing decisions has come to become a major issue of recent times. This relates to understanding the concept of the agency problem. It deals with the separation of ownership and control of an organisation within a financial context. The financial manager can raise long-term funds internally, from the company’s cash flow, or externally, via the capital market, the market for funds of more than a year to maturity. This exists to channel finance from persons and organisations with temporary cash surpluses to those with, or expecting to have, cash deficits, i.e. the shareholders.
The agency problem on a firm’s capital structure decisions
Potential conflict arises where ownership is separated from management. The ownership of larger companies is widely spread, while the day-to-day control of an organisation’s business interests rests in the hands of a few managers who usually have a relatively small proportion of the total shares issued. This can give rise to the problem of managerial incentives. Examples of this include pursuing more perquisites (splendid offices and company cars, etc.) and adopting low-risk survival strategies and satisficing behaviour. This conflict has been explored by Jensen and Meckling (1976), who developed a theory of the firm under agency arrangements. Managers are, in effect, agents for the shareholders and are required to act in their best interest. However, they have operational control of the business and the shareholders receive little information on whether the managers are acting in their best interest. According to Jensen and Meckling (1976), if a wholly-owned firm is...
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