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Bbm 414 financial management

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Running head: BBM 414-FINANCIAL MANAGEMENT 1
Financial Management
Course Code
BBM 414
Institutional affiliation
MOI UNIVERSITY

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BBM 414-FINANCIAL MANAGEMENT 2
QUESTION ONE
Discuss agency theory, relationships, problem and resolutions, with respect to corporate
business organizations (10 marks)
Agency theory is a concept used to explain the important relationships between principals
and their relative agent. In the most basic sense, the principal is someone who heavily relies on an
agent to execute specific financial decisions and transactions that can result in fluctuating
outcomes. Because the principal relies so heavily on the agent to make the right decision, there
may be an assortment of conflicts or disagreements. Agency theory dives into such relationships.
In terms of business, the principal is considered to be a shareholder, while the agent is considered
to be a company executive. Although it may not seem like it, shareholders and company executives
are tightly connected. Each of their actions greatly affects the position of one another.
Agency Relationship Agency
The Agency Relationship Agency theory was developed by Jensen and Meckling (1976). They
suggested a theory of how the governance of a company is based on the conflicts of interest
between the company’s owners (shareholders), its managers and major providers of debt finance.
Each of these groups has different interests and objectives.
i. The shareholders want to increase their income and wealth. Their interest is with the returns that
the company will provide in the form of dividends, and also in the value of their shares. The value
of their shares depends on the long-term financial prospects for the company. Shareholders are
therefore concerned about dividends, but they are even more concerned about long-term
profitability and financial prospects, because these affect the value of their shares.
ii. The managers are employed to run the company on behalf of the shareholders. However, if the
managers do not own shares in the company, they have no direct interest in future returns for
shareholders, or in the value of the shares. Managers have an employment contract and earn a
salary. Unless they own shares, or unless their remuneration is linked to profits or share values,
their main interests are likely to be the size of their remuneration package and their status as
company managers.
iii. The major providers of debt have an interest in sound financial management by the company’s
managers, so that the company will be able to pay its debts in full and on time. Jensen and Meckling
defined the agency relationship as a form of contract between a company’s owners and its
managers, where the owners (as principal) appoint an agent (the managers) to manage the company

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