Financial Performance Analysis
Instructions:-
Prepare a 10-12 page paper analyzing the financial performance of Fastenal and W.W. Grainger in recent years, along the outline and questions that I distributed in class. ( Prepare comparisons include average sales of growth, Gross Profit Margin, Operating Profit margin, Interest expense /sales ( between 2014-2016), ,Interest Expense /sales 2016, TIE( use net income) in 2016, EPS growth between 2014-2016, P/E ratio end of 2015, ROAE in 2016. Which company performed better in the last three years? Which company is in stronger financial condition? Which company communicates better with their shareholders? How did the stock market performance of the shares of these two companies (symbols are FAST and GWW) square up with your fundamental analysis?
Chapter 4 ( fundamentals of corporate Finance) will be helpful here.
b) Prepare a 10-12 page paper describing the eight mechanisms we discussed that have been developed to manage issues associated with agency costs arising from the separation of and control. In addition to describing these mechanisms, tell me which of them you think qualify as the three most productive, and tell me why you think so.
Solution
Financial Performance Analysis
Public companies have various stakeholders; employees, shareholders, customers and bondholders among others, who have a keen interest in the performance of the company in order to determine the degree to which their interests are being served by the company while undertaking its business operations. The stakeholders rely on the financial statements of the company to determine whether or not the firm is profitable. Financial statements can, therefore, be used to analyze the general performance of a firm and at the same time assess its financial standing at a particular time (Epstein, Buhovac & Yuthas, 2015). Financial statements also help a company to determine some of the areas where it is performing well in regards to outdoing the major competitors in the market as well as those areas that the company is realizing the desired outcomes and such focus on improving the process for better organizational outcomes.
The paper will analyze the financial performance of two companies, Fastenal Company and W. W. Grainger Company. Fastenal Company was founded in 1967 by Bob Kierlin and his four friends in Winona, MN, which is his hometown and also the headquarters of the company. On the other hand, W. W. Grainger Company was founded in 1927 in Chicago. The two firms operate in the related markets and industry as their business activities mainly involve the supply of products and services that are needed by manufacturers to undertake their manufacturing activities. These include products and services required for the processes of manufacturing, building and construction, safety and protective equipment and facility maintenance among many others. In simple terms, these two companies achieve their business goals and objectives by helping other businesses realize their own goals and objectives (Siedlecki, 2014).
The Average Sales of Growth
On average, Fastenal Company has realized an average sales growth of 6.8% in the last quarter of the year 2016. This is an improvement from the value recorded in the period 2012-2016 which was 2.4% (Morningstar, 2017). Looking back in the previous years, it is clear that the growth sales of the company have been has been on a decline. Year over year, for the period 2007-2012, the company realized a sales growth of 13.95% which has been declining over the years to the current period (Morningstar, 2017). There are various reasons that may have contributed to the decline in the sales growth of the company. One possibility is that the company may have reduced its marketing efforts and capacity and as such declining sales due to a decreasing customer base. Also, the customer satisfaction may have reduced resulting in a reduced demand and preference for the company’s products and services (Siedlecki, 2014).
The average sales growth for W. W. Grainger Company, as reported in the last quarter was 1.38%. When one focuses on the company’s sales growth trend from 2007 to the current period, it is clear that the rate has been on the decline with the current period being the second least recorded growth rate for the company. The least recorded sales growth rate was in 2012-2015 where the company recorded a sales growth rate of 0.08%. Also, the highest sale growth was recorded in 2011-2012 where the company realized a 12.48% sale growth rate. The drop in sales may be associated with various factors both internal as well as external which have a profound effect on the customers’ decision to buy the products and services being offered by the company.
Gross Profit Margin
The gross profit margin reveals the amount of money that remains from the revenues after all the deductions relating to the cost of goods sold have been taken into consideration. The general formula for obtaining the gross profit margin is by dividing the gross profits by the revenues. Over a period of 10 years, Fastenal Company has been able to maintain a steady gross profit margin. From 2007-2015 the company has been able to realize a gross profit margin of 51.4%. However, for the period 2012-2016, the gross profit margin for was recorded at 49.59%. From this information, it is clear that the company has been able to maintain a steady gross profit margin. This is an indication of the ability of the company to overcome not only some of the major changes being faced in the industry but also competitions from the other players in the market.
The financial statements of the W.W. Grainger Company show that the gross profit margin of the company has not exceeded 43.76% from 2007 to the current period. The lowest recorded gross profit margin is 40.57% which was for the period 2007-2012. The value gradually increased from 2007 to 2012 where a maximum of 43.83% was recorded in 2013 (Morningstar, 2017). This means is that the firm has been able to maintain or lower its prices based on the market prices as a means of attracting new customers as well as maintaining those who are already its customer base. Maintaining the lower prices means that the company is able to make its products and services more attractive to its customers because they are do not only have the will but also the ability to pay for the products and services at the prices offered by the company.
Operating Profit Margin
The operating profit margin plays a major role in the determination of the operating efficiency of a company as well as the effectiveness of its pricing strategy. It is a measure of the proportion of a company’s revenue that remains after all the variable costs related to production have been catered for. The information presented in the ratio shows the degree to which a company can meet the needs of its creditors while at the same time creating value for the shareholders through cash flow generation. A company, therefore, needs to have a healthy operating profit margin to pay for its fixed costs such as debts and interests on the loans. With that said, a company with a higher operating profit margin will experience less financial risks which enable the management to invest in its growth and development.
The operating profit margin for Fastenal has increased steadily from 2007 to 2016 except in 2009-2012. The highest operating profit margin was recorded in 2013 with the company recording a value of 21.43%. On the other hand, the lowest recorded operating profit margin for the company was recorded in 2009 where the company realized a record of 15.32% (Morningstar, 2017). In the last financial year, the company recorded a 20.09% operating profit margin. One the other hand, the W.W. Grainger Inc recorded has recorded lower operating profit margins compared to that of Fastenal over the years. The company realized its highest operating profit margin in 2013 where is recorded a value of 13.74%. The lowest margin was recorded 2007 where the company realized a 10.45% operating profit margin. The highest margin by the company was in 2013 where it recorded a margin of 13.74% (Morningstar, 2017).
Company Sales 2014-2016
Fastenal Company has been able to realize increased sales from 2014-2016. In 2014, the company recorded total sales worth $3,734 million which increased to $3,839 million in 2015 and finally $3,962 million in 2016 (Morningstar, 2017). What this means from 2014 to 2016, the management of the company has been able to realize a sales growth worth $123 million. Various factors may have contributed to increased sale realized by the firm. First and foremost, the company may have changed its business strategy to focus more on the customers and their specific needs. As a result, the customers were more interested in the products and services offered by the company, and as such, they had to buy more of the products and services being offered. It is also possible that that company improve its business processes over the years and as such it was in a better position to eliminate time wasting process that hindered the delivery of its products and services.
Likewise, W.W. Grainger Inc. has also been able to achieve increased sales from 2014-2016. The company recorded total sales of $9,965 million in 2014 and $9,975 million in 2015 and finally $10,137 million in 2016 (Morningstar, 2017). It is clear that the company has higher sales compared to that of Fastenal. One of how the company may have achieved this is through the improvement of its business processes resulting in the improvement of the overall efficiency and productivity of the employees. For instance, the company may have improved its business processes by ensuring that the right individual is given the right duties and responsibilities within the organization. This can be achieved by providing the necessary knowledge and skills to the employees through the employment of effective training programs (Siedlecki, 2014).
Interest rates
According to a report in the annual financial report of the Fastenal Company, 2016, it was stated that the company, both in the present as well as in the past, has never hedged the interest swap arrangement with the variable interest rates under its credit facility. In 2015, the company had a long-term debt of $302,950. The figure increased to $379, 518 in 2016 (NASDAQ, 2017). The interest periods selected by the company has enabled the management of the company to obtain a weighted per annum interest rate of 1.7% as at 31st December 2016. Moreover, the company also pays a commitment fee for the portion of the Credit Facility that has not been spent. Based on how the Credit Facility has been used, the commitment fee may be 0.10% or 0.125% per annum (Fastenal 2016 annual report, 2017). It is also imperative to state that the company’s management is actively involved in the process of selecting the most suitable interest periods.
In the case of Grainger Inc., the debt and liquidity ratio which is maintained by the company helps the management to achieve flexibility in the funding of the needs which are associated with the long-term cash requirements as well as the working capital. Moreover, the company has also created internal funding systems which provide additional funding during an imminent financial need. Under lines of credit, the company can borrow money from banks and other financial institutions. As at December 31st, 2016, the total interest bearing debt of the company, the current plus the long term, was 54.1% which was expressed as a percentage of the total capitalization of the company. The company also issued a $400 million long-term debt in 2016 which is to be repaid over a period of 30 years at an interest rate of 3.75% which is payable on a 6 months basis (Morningstar, 2017).
Net Income
Net income is also be called the total earnings of a company. The value is obtained by subtracting the costs of doing business from the revenue generated. These costs include taxes, depreciation, expenses and interests among others. The net income of a company is important to all the stakeholders of the company because it reveals the profitability of a firm over time. A company with a higher net income is in a better position to offer its shareholder higher dividends compared to that with a lower net income when all factors are held constant. This, therefore, makes the net income susceptible to manipulation in an attempt to earn higher net income that is attractive to investors as well as all the other stakeholders of the company. The quality of the numbers should, therefore, be reviewed by the potential investors to ensure that they value provided in the correct one.
In 2016 Fastenal Company recorded a net income of $499 million. From 2007 to the current period, the general trend is that the company has gradually increased its net income from $233 million to the above figure which was recorded in 2016 (Morningstar, 2017). From the perspective of stakeholders, the fact that the company has been able to earn increasing net income means that they are bound to receive more dividends for their shares and as such invest more in the company. On the other hand, in 2016, Grainger Inc. recorded a net income of $606 million (NASDAQ, 2017). Just like the Fastenal Company, Grainger has also been able to increase its net income over the year to the current high. Between 2007 and 2016, the lowest net income, $420, was recorded in 2007 which has increased to the current value (NASDAQ, 2017)
Earnings per Share Growth
The earning per share growth refers to a part of the profit of a company that is allocated to the share stock which is outstanding. The profitability of a company can be determined by focusing on the value of the earnings per share. The capital which is required to generate the earnings is normally ignored. However, it happens to be a very important aspect of earnings per share. This is so because even though two companies may have the same earnings per share value, one may have done so with less equity making the company more efficient regarding generating revenue for the capital investment. These, among other financial ratios, are some of the key issues that investors look for when they are choosing which companies to invest in.
Over the last decade, Fastenal Company has been able to obtain a steady increase on it earning per share. According to the 2016 financial report of the company, the earning per share was $1.73 (Morningstar, 2017). When compared to the previous year, the earning per share of 2016 was less than that of 2015 by $0.04. Over the last ten years, the shareholders of the company have been able to get an increase in their share earnings. On the other hand, Grainger Inc has also been able to get a steady increase in its earnings per share for the last ten years except for the year2016. According to the financial report of the company for the year ended 2016, the earning per share of the company was $9.87 (Morningstar, 2017). This was a drop from the previous were where the value was $11.58. This may have been greatly influenced by the reduction in the net income from $769 million in 2015 to $606 million in 2016 (Morningstar, 2017).
Price-Earnings Ratio
Price earnings ratio refers to the ratio that measures the current price of a company’s share as it relates to its per-share earnings. A company with a higher price-earnings ratio would be in a better position to offer its investors higher earnings growth compared to that with a lower price earning ratio. For Fastenal Company, for the year ended 2015, the price-earnings ratio was 61.2%. Compared to the previous year, 2014, one recognizes that in 2014 the company recorded a higher ratio of 62.5 %. On the other hand, in 2015, Grainger Inc. had a price earning ratio of 39.5%. The value was higher compared to that obtained in the previous year which was 34.9% (Morningstar, 2017). It is also crucial to point out that Grainger Inc. has been able to obtain a steady increase its price-earnings ratio for the past decade.
Return on Average Equity
Return on average equity refers to the adjusted value of the return on equity which is also used as a measure of the profitability of a company or business. The adjusted value is the shareholder equity which is changed to the average equity of the shareholders. When a company has a higher return on the average equity, what that means is that the firm can create more income for each dollar in the shareholders’ equity. The Return on average equity for the Fastenal in 2016 was 191.9 (Morningstar, 2017). The average stakeholder equity was obtained by finding the average of the current and the previous shareholder equity which was then divided by the net income of the company. In the case of Grainger Company, the return on average equity was calculated using the same formula and was found to be 104.1.
There above financial analysis can be used to provide insight on which company is performing better than the other. Even though it appears as if Grainger Inc. has a higher revenue compared to the Fastenal Company, the Fastenal Company is the performing better. One of the most effective means of determining the performance of a company is by focusing on the return on the asset. Looking at the two companies, Fastenal Company has a higher return on assets, 19.21% in 2016 (“Growth, Profitability, and Financial Ratios for Fastenal Co (FAST) from Morningstar.com”, 2017). Also from the information presented above, the company that would be in a stronger financial position would be Fastenal Company because of its long-term profitability trend which is higher compared to that of Grainger Inc.
Fastenal
Company also communicates better with its shareholders. It has gone an extra
mile to offer its shareholders the critical information they need to now about
their investment in the company as well as the returns that they expected from
their investment. In addition to that, it is also clear that the company offers
its shareholders more value for their investment. This is shown by the price
earning ratio where Fastenal recorded a value of 61.2 % for the year 2015
whereas that of Grainger Company was 39.5% (“Growth, Profitability, and
Financial Ratios for Fastenal Co (FAST) from Morningstar.com”, 2017) in
the same year. Moreover, this is information that is also helpful to those
individuals who are not yet shareholders of the company but are interested in
knowing more about investing in the company (Kassicieh, Ahluwalia &
Majadillas, 2015). This is in line with the information from the stock market
which shows a decline in the Fastenal share value by 0.43% while that of
Grainger Company in declined by 2.0%.
Mechanisms for Solving Agency Costs Associated with Agency Problems
The conflict of interest between the management and stockholders of a company creates an agency problem that requires effective and immediate attention to prevent an impact on the profit efficiency and the financial performance of the company. The management of the company acts as the representative or an agent of the shareholders and makes critical decisions, mainly targeting the creation of shareholder-wealth regardless of the interests of the manager or the management. The continued creation of shareholder value requires the management or corporate governance of a company to prioritize measures or implement strategies that guarantee enhanced profit efficiency through profit maximization and wealth maximization. However, agency problems and, as a result, agency costs are inevitable mainly in the face of separation of ownership and control. The effective management and leadership of business entities is critical for the minimization of agency costs and holding-up problems related to the separation of ownership and control.
According to the agency theory, agency costs are a representation of important problems in the governance of a corporation. Separating ownership and control in major companies may sometimes result in the inefficacy of the managers who choose to exert minimal or insufficient effort in work, indulge in perquisites, and make decisions that suit their interests and preferences, or fail to place the supposed emphasis on the maximization of the company’s value. Stepanov and Suvorov (2017) suggest the enhancement of the effectiveness of corporate governance for the mitigation of agency costs. Of the critical solutions to the agency problems, the board of directors, specialist monitors, management and equity ownership, legal and regulatory requirements, compensations plans, control value, shareholder activism, and hostile takeovers are fundamental. The integration of strategies and measures directed towards minimizing the costs and resolving problems set up organizations towards success in dealing with issues facing them.
Board of Directors
The board of directors (BOD) plays a fundamental role in the prevention or control of agency problems and the minimization of the costs upon the occurrence of the problems. Some of the main objectives and responsibilities of the BOD include keeping the management in check, ensuring that the corporation remains focused on the mission and vision of the company, representation of shareholder interests, selection of the executive, and ascertain adequate resources and effective management of the resources. Yegon, Sang, and Kirui (2014) state that small boards are more effective and less powerful as compared to large boards. While citing Singh and Davidson (2003) and Pearce and Zahra (1991), Yegon, Sang, and Kirui (2014) assert that small boards show a positive asset utilization ratio thus lower agency cost as the ratio increases. Larger boards are less efficient and, therefore, higher agency costs. Moreover, the independence of the board is critical in influencing the process of handling, limiting or controlling, the agency problem (Yegon, Sang, & Kirui, 2014). In cases where there is no separation of ownership, mainly where the manager is the sole equity owner, there is no agency problem since the owner and the manager are unified. The board of directors operates and monitors the operations of the manager and the corporation where there is the diffusion of residual claims to equity by different outside investors (Kolbjørnsrud, 2017).
Kolbjørnsrud (2017) and Stepanov and Suvorov (2017) term the BOD as the ultimate internal monitor of the operations of the company to protect the interests of the company and ensure shareholder wealth creation through company value improvement. Among other internal monitoring mechanisms such as mutual monitoring and the naturally set monitoring of all levels of management, the board serves a fundamental role in scrutinizing managerial decision-making and influencing the decision control systems in the corporation. The effectiveness of the BOD is enhanced through the inclusion of external members in the board. External members have the incentive and show impartiality in protecting the interests of the shareholders and ensuring the promotion of the firm value (Kolbjørnsrud, 2017; Yegon, Sang, & Kirui, 2014).
Legal, Regulatory Requirements (SEC)
Agency relationship is guided and controlled by specific laws and regulations. In cases of separation of ownership and control, the management must meet legal and regulatory requirements to avoid legal liability. The SEC plays an important role in protecting investors from fraudulent practices from the management in cases where managers may make decisions that favor their preferences or interests (SEC, 2017). The laws and regulations focus on enabling an effective ground that brings the managers and investors through their agents together in a financially profitable business operation. Megginson, Smart, and Lucey (2008) state that the US SEC has a mission of maintaining fairness in business practice, protecting investors, and promoting orderliness, and creating efficient markets for the improvement and development of capital. To protect the shareholders, the SEC enforces regulations that require companies to submit financial reports (quarterly and annual reports) to ascertain transparency in operations, accuracy of the reports, and fair practices. The regulations ensure that public companies report accurate financial figures and in the process ensure that the investors receive their fair shares. The legal and regulatory requirements are critical in resolving conflicts of interest that may cause agency problem and agency costs. Through the guidance of the regulatory requirements, the manager(s) uphold the interest of all the parties that co-own the business through their investments and ensure that each party receives a fair share of the returns on investment (Megginson, Smart, & Lucey, 2008).
Control value / large blocks of stock
The separation of ownership and control may sometimes cause agency costs that require immediate attention including effective measures to ensure the prosperity of a company. Megginson, Lucey, and Smart (2008) point out that reliance on market incentives, incurring monitoring and bonding costs, and the use of executive compensation contracts that align with and prioritize the shareholders’ and managers’ interests are some of the effective ways of reducing the agency costs. The separation of ownership and control means that some shareholders have greater control depending on the percentage of shares they hold or the amount invested in the company. Bodenhorn (2013) states that large shareholders influence corporate decision-making and governance significantly. Large-block shareholders are capable of determining the course of the company in the case of an agency problem. Securities and Exchange Act 1934 has set regulations that define blockholders and set out the relationship with the management of public corporations. Large-block shareholders resolve agency problems by pushing for the creation of shareholder wealth and firm value. However, according to Aldrighi (2003), they may influence decision-making through their power over the board to ensure that decisions align with their personal interest. Major shareholding gives them a greater control over the corporation, its management, and the board (Bodenhorn, 2013).
Compensation Plans
The adoption of compensation plans is essential for the resolution of agency problem and addressing the agency costs. The use of compensation contracts is an effective method of controlling agency costs arising from agency problems. Executive remuneration plans or compensation contracts is the most popular and expensive way of overcoming agency costs through the alignment of managerial and stakeholder interests (Megginson, Smart, & Lucey, 2008; Aldrighi, 2003). A company experiencing agency issues from conflicting interests between the management and the shareholders may consider the application of the technique. The compensation plans give the managers the incentives to perform their roles diligently while acting in the best interest of the shareholders and the firm. The implementation of the method ensures the choice of the most effective managers and allows the competition and hiring of the best managers. The effectiveness of the compensation plans such as the remuneration contracts is assured by tying the managerial wealth to the firm’s share price as an incentive remuneration plan.
In the implementation of the solution, Megginson, Smart, and Lucey (2008) advise the inclusion of outright grants of shares to the management or offering managers share options thus allowing them to purchase stock at the market price. The options translate to greater efficiency, better decision-making, and a focus towards the creation of shareholder wealth. Apart from the reduction of agency problems and the minimization of agency costs, the method improves the company’s financial performance and boosts profit efficiency. The options ensure that the growth of the share prices ascertains wealth for the management and the other shareholders. Additionally, the link motivates the management and improves its effectiveness considerably. However, critics terms the strategy expensive and unnecessary questioning the wisdom of using millions as packages to the executives of sometimes poorly performing companies (Megginson, Smart, & Lucey, 2008).
Hostile Takeovers
The threat of a hostile takeover keeps the management in control and ensures that they prioritize the concerns of the firm in the quest to increase shareholder wealth. According to Megginson, Smart, and Lucey (2008), a hostile takeover of a corporation involves its calculated acquisition by another company through the shareholders or the replacement of the management and influencing the approval of its acquisition. The threat of a takeover plays a crucial role in monitoring the actions of the management. Actions taken by the management that threaten the future earnings of the shareholders but affecting shareholder value influence the threat of a takeover if effective measures are not implemented for the resolution of the agency problems. Decreasing the value of the firm and its shares affects shareholder wealth considerably. Conflict between the company management and the shareholders makes the company a possible target for takeover. The replacement of the company’s management may sometimes benefit the shareholders by enhancing efficiency in the company’s operations thus boosting shareholder wealth (Megginson, Smart, & Lucey, 2008; Kolbjørnsrud, 2017).
As an external control mechanism, the threat of a hostile takeover serves an important role in monitoring the manager(s) and the management. The management must work diligently, make informed and beneficial decisions, and focus on the creation and maximization of shareholder wealth. The threat of a takeover ensures a solution to agency problems by keeping the management on check and ensuring the prioritization of the company’s financial performance. While pushing for a hostile takeover, the acquirer promises the shareholders of the ability to boost the company’s financial performance and guarantees better returns on equity/investment (Megginson, Smart, & Lucey, 2008).
Specialist Monitors – Analysts, Media, Ratings Firms
Specialist monitors are important in enabling effective control of agency costs and the resolution of agency problems. The monitors include financial analysists, the media, and rating firms among others that influence corporate decision-making through a keen analysis and discussion of issues pertaining a specific company. The analysis of the financial position of a company by the media, financial analysis, and rating firms helps build the shareholders understanding of the company’s progress. As specialist monitors, these different groups are objective and offer articulate and accurate information. Shareholders use the information to determine the direction off the corporation. For example, media’s financial analysists analyze the financial status of a company, the value of the firm and its share prices and putt the information out for public consumption. The management works effectively to minimize the possibility of constant negative financial reports that would otherwise affect the shareholder wealth. Additionally, rating firms analyze the financial status of companies to determine the prices of their shares/stocks thus affecting the public’s choice to purchase their shares or not. The impact of the special monitors on the company and agency relationship pushes managers to perform and work towards the improvement of the financial performance of the company for the creation of shareholder wealth. The effect resolves agency costs and prevents the development of agency problems (Megginson, Smart, & Lucey, 2008).
Shareholder Activism
The legal requirements for the formation of companies sets out the responsibilities, rights, and the power each arty in the agreement holds. A breach of the terms of agreements or any other operational requirements may result in legal liability. Most importantly, shareholders are given specifically outlined rights that if exercised efficiently may influence company and management’s behavior. The separation of ownership and control through shareholding means that no specific manager or shareholder can make decisions singly without the possibility of criticism. Eisenhofer and Barry (2006) defines shareholder activism as the process where the shareholders apply their rights to influence change. The activism focuses on achieving different goals. In the case of agency problem or costs, shareholder activism focuses on changing the governance, policies, and managerial practices for the improvement of the financial performance of the company. Other grounds for pushing shareholder activism may include a change of the compensation plans, oversight of the company’s functions, and a change of the company’s corporate behavior among others (Cooperman, 2016).
The fear of facing shareholder activism because of its possible impacts on the management and the company pushes managers to adopt and implement effective strategies for ensuring the protection of shareholder interests and the promotion of the firm’s value. A company is likely to become a target of shareholder activism if it records low market value as compared to its book value even when it remains profitable and a well-regarded brand. Additionally, if the management engages in malpractice depriving the shareholders of fair returns, the company is owned by institutional investors by a majority of the voting stock, or it does not meet the standard best practice expectations then there is a likelihood of a shareholder activism. Shareholder activism keep the management in check to avoid the prioritization of managerial interests with the disregard of the shareholder’s interests (Eisenhofer & Barry, 2006; Cooperman, 2016).
Equity Ownership for Managers
The ownership of a company is determined by the equity contribution towards the establishment of the business. According to (Megginson, Smart, & Lucey, 2008), equity ownership includes the contribution of equity capital that remain permanently within the business operations as investment. Equity ownership includes either the purchase of ordinary shares or preference shares. The ordinary shares form most of a company’s financial and business risks since returns accrue only after the full payment of the shareholders and preference shareholders. The preference shareholders receive a fixed annual payment on their investment like creditors. However, they differ from debt in that the shareholders of preference shares cannot push the corporation into bankruptcy if the payment of the dividends is missed. The utilization of equity ownership in the management of agency costs serves a fundamental goal in minimizing the costs and preventing recurrence or the new occurrence of the agency problems (Eisenhofer & Barry, 2006; Megginson, Smart, & Lucey, 2008).
Managing the agency costs requires the regulation of the managers’ ability to promote their interests and focus on a broader aspect of promoting the interests of the company or companies. Equity ownership for managers ensures that managers focus on creating wealth for the company’s shareholders. As a part of the shareholders, the managers must strive to acquire greater returns thus the ownership serves as an incentive. The mechanism reduces agency problem and costs by pushing the management to work towards the creation of wealth for the investors to reach and exceed the annual payment of returns on investment. To achieve success in meeting the needs of the equity owners requires a focused implementation of strategies in accordance with the set mission, vision, and organizational goals and objectives. The emphasis placed on the aforementioned reduces the possibility of agency problems and agency costs (Megginson, Smart, & Lucey, 2008; deSousaa & CaioGaldi, 2016).
Most Effective Mechanisms for Managing Agency Costs
After the description of the different mechanisms of managing agency costs, I think specialist monitors, the board of directors, and equity ownership for managers are the most productive mechanisms. The mechanisms are easy and cheaper to implement on the side of the company and encourage the promotion of the interests of the shareholders without costing the company any significant capital. The implementation of the equity ownership for managers requires the managers to purchase either preference or ordinary shares from the company resulting to the permanent contribution towards the equity capital of the company for annual dividends. This does not involve the organization’s finances or dig into the shareholders’ wealth but acts as an effective strategy and incentive for pushing managers to prioritize shareholder interest thus focusing on the creation of shareholder wealth in which they partake.
Similarly, the specialist monitors including
external financial analysts, the media, and rating firms influence consumer and
shareholder opinions and perception of the company affecting the purchase of
shares or damaging the reputation of the management. The possible threats
arising from exposing poor financial performance of a company to the general
public or the articulate and accurate presentation of the financial analysis
and reports to the shareholders leaves the management with an only one option
of focusing on creating value and wealth for the shareholders. Unlike most
mechanisms where the company further incurs cost of implementing the strategies
or mechanisms, this technique requires minimal financial input. In conclusion,
the creation of a small board, which is more effective than a large BOD
requires less capital but yields better outcomes due to the efficiency of the
mechanism in addressing concerns about decision making. The control of the BOD
over the management ensures the consideration and promotion of the interests of
the shareholders thus cutting agency costs resulting from the development of
agency problems associated with the separation of ownership and control.
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