Finance Management - Assignment Example

Finance Management Name Institution Course Date Finance Management Explain the aggressive financing of working capital. Why this financing method is considered risky? Having enough working capital to finance business operations is important for the success of an organization. For this reason, finance managers have a responsibility to ensure attention is given to working capital financing because this is the money that keeps the business in operation every day. In the event that a company runs short of working capital, this might put a company into financial problems, thus affecting the smooth running of a business (Ogilvie 1999, p. 80). For instance, lack of enough working capital might result in a situation where a company defaults into paying off some of its obligations on time. At the same time, the adoption of inappropriate financing mode might result in a company losing interests, which might affect the profits of a company. Although there are a variety of financing methods commonly in use, such as hedging, aggressive and conservative approaches, aggressive financing is among the most commonly used working capital financing approach. Under this approach, a company tries to finance its current assets using the short-term sources credits. In aggressive financing, the finance managers focus on putting as much money that a company has to work as possible as a way of minimizing the time taken to produce products or deliver services (Khan & Jain 2013, p. 13). Accordingly, in aggressive financing, a company keeps very little money on hand as most cash is utilized to finance current asset requirements. Companies that adopt aggressive financing are not bothered about maintaining liquidity as the main focus is to save cost by taking greater risk. Aggressive financing is favored my companies for a variety of reasons, which include the fact that the approach is less costly and more profitable. Despite the benefits attached to aggressive capital financing approach, this method is considered a risky approach to financing working capital. In particular, aggressive financing approach puts a company at risk of falling into bankruptcy. The risk of bankruptcy is high under aggressive working capital financing because of low liquidity position maintained by a company (Ogilvie 1999, p. 81). To avoid falling into bankruptcy, a company needs to hold enough liquid assets so as to be able to service short-term obligations that might arise in a company. Unfortunately, in aggressive financing approach, a company utilizes most of its short-term sources of finance, such as cash and only maintain very little. The danger here is that, in the event that a sudden emergency arises, a company that adopts aggressive approach to financing working capital might not be able to finance those obligations, such as bond interest payments, thus putting the business at risk of bankruptcy. Aggressive working capital financing is also considered a risky approach because it can result in lost sales. For example, tight inventories can result in shortages because of the firm’s inability to acquire them, thus resulting in lost sales (Khan & Jain 2013, p. 14). Besides, aggressive financing is a risky financing approach as it scares vendors from extending credit to a company because of low liquidity position. When a company maintains low liquidity position by using aggressive financing method, this means that the company lacks enough liquid assets to meet its short-term debts, when they fall due, which is not good as far as vendors are concerned. Moreover, aggressive financing is considered risky because it makes investors adamant and less willing to purchase the business bonds, which may force a company to give away higher interest rates on long-term debts issued (Khan & Jain 2013, p. 16). a) Discuss how agency theory can be used to explain the payment of dividend Agency theory is one of the theoretical frameworks that are widely used in explaining dividend payment. Agency theory emerged in the 1960s and 70s and explain the relationship, whereby one party (principal) delegates work to another party (agent) to execute that duty. In other words, agency theory tries to explain the relationships between principals, such as shareholders and agents, such as company managers (Easterbrook 1984, p. 650). The theory seeks to address two critical problems that normally arise in principal-agent relationships. The problems addressed by this theory include attempting to align the principal’s goals with those of the agents that act on their behalf so as to ensure that there is no conflict. The theory also seeks to help the principal and agent reconcile differences between them that might arise in the course of conducting business to ensure a good working relationship. Franchising businesses are the examples of business operations, where an established business, called the franchisor, gives another company called the franchisee the rights to use either its trade name or business model to use in exchange for fee. In such a relationship, the franchisor assumes the principal position, while the franchisee assumes the agent position in the relationship (Jensen & Meckling 1976, p. 306). Like in all agency relationships, franchising businesses are often than not characterized by conflicts between the franchisor and franchisee. Agency theory is particularly of relevance in explaining the payment of dividend. To understand the relevance of the theory in explaining payment of dividends, it is important to begin by explaining why companies pay dividend (Easterbrook 1984, p. 652). One of the main reasons firms pay dividend is to help avoid agency problems. When a firm holds all the income generated and fails to distribute the earnings in the form of dividend, this create an agency problem that include incremental cost and the conflicts between the managers and the investors considering that retention of earnings gives the managers command over the investors. Agency theory, therefore, helps in explaining the reasons why firms need to pay dividends. According to agency theory, the retention of large amounts of earnings generated by a firm promotes the development of behaviors among managers that are not in the interest of the investors (Easterbrook 1984, p. 650). Because managers act as agents for investors in running an organization, they are expected to demonstrate behaviors that seek to maximize shareholder value, which is not promoted by large retention of earnings (Brav et al. 2005, p. 481). Therefore, agency theory maintains that dividends are used as financial tool by companies as it helps avoid the development of asset/capital structures that accord managers a lot of powers to make value-reducing investments. Agency theory also maintains that dividend payments are used as a tool for minimizing agency cost. Agency cost is one of the major problems that often emerge in a principal agency relationship. Agency cost refers to the amount that has to be paid to the agency for acting on the principal’s behalf (Easterbrook 1984, p. 651). Agency costs normally arise between of agency problems, such as conflict of interest between the management and the investors (Jensen & Meckling 1976, p. 306). Fortunately, according to agency theory, dividend payment acts as a useful financial tool for minimizing agency cost. For example, in some cases, managers may use company resources for use in issues that are in their own interest rather than in the interest of investors. This implies that, as the managers enjoy the benefits that come with the consumption of the company resources, the managers only have to deal with a small portion of the cost associated with the wasted of the firm’s resources (Brav et al. 2005, p. 483). This means that the remaining cost has to be borne by the investors. Therefore, paying dividends to shareholders help minimize the agency cost as it makes the managers and the investors to work in the interest of the company and not self. Additionally, agency theory helps in explaining dividend payment by explaining that companies pay dividends to investors as a matter of building reputation. It has been demonstrated that insiders, especially managers normally have an interest in creating reputation for good treatment of shareholders. Therefore, dividend payment is used as a tool for building reputation in the eyes of the minority shareholders in a company. Additionally, Jensen (1986) noted that dividends are paid to shareholders of a company by managers to minimize the amount of cash left in the hands of the managers that they might misuse by spending on projects that are in their won interest and not for the shareholders’ benefits. Allen and Michaely (1995) argue that the less discretionary cash managers has, the difficult it becomes for them to invest in projects with negative net present value. Therefore, one of the strategies used to remove unnecessary cash from a company is to increase the amount of dividend payouts to investors. In summary, agency theory is helps in understanding the relationship between shareholders (principals) and managers (agents). Franchising business is an example of a relationship that involves principal-agent relationships. However, as highlighted in the paper, agency theory particularly helps in understanding payment of dividend. According to the theory, firms need to pay dividend as it help minimize agency conflict and agency cost in an agent-principal relationship. References Brav, A., Graham, J. R., Harvey, C. R. & Michaely, R 2005, “Payout policy in the 21st century,” Journal of Financial Economics, vol. 77, no. 3, pp. 483-527. Easterbrook, F. H 1984, Two agency-cost explanations of dividends,” American Economic Review, vol. 74, no. 4, pp. 650-659. Khan & Jain 2013, Financial management. Tata McGraw-Hill Education, New York, NY. Jensen, M. C., & Meckling, W. H 1976, “Theory of the firm: Managerial behavior, agency costs and ownership structure,” Journal of Financial Economics, vol. 3, pp. 305-360. Ogilvie, J 1999, Treasury management: Tools and techniques for countering financial risks. 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