Question

1. AGENCY PROBLEMS Who owns a corporation? Describe the process whereby the owners control the firm’s management. Describe the main reason why an agency relationship exists in the corporate form of organization. In this context, describe the types of problems that can arise.

2. ENTERPRISE VALUE A firm’s enterprise value is equal to the market value of its debt and equity, less the firm’s holdings of cash and cash equivalents. This figure is particularly of interest to potential purchasers of the firm. Why?

3. CURRENT RATIO Explain what it means for a firm to have a current ratio of .50. Would the firm be better off with a current ratio of 1.50? What if it were 15.0? Explain your answers.

4. SALES FORECASTS Why do you think most long term financial planning begins with sales forecasts? Stated differently, why are future sales the key input?

Answer 1

1. Agency Problem:

The shareholders jointly own the corporation.

The process in which the owners take decisions and the financial managers of the company act on behalf of the owners in order to create wealth for the shareholders describes the way in which the owners control the firm’s management.

Agency relationship exists because the financial managers are the agents of the shareholders and the shareholders or owners are the principal. Hence there is a principal -agent relationship between the financial managers and the shareholders.

There can be a problem when the financial managers of the corporation act for their own benefit rather than the benefit of the shareholders. There may be project that may not be profitable for the shareholders, but the financial managers may want o pursue it for for getting a pay raise. So this can cause a conflict in the agent-principal relationship.

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