In this essay the meaning and importance of several crucial terms from financial economics will be discussed, namely: ‘information asymmetry’, ‘agency costs’, ‘dividend policy’, ‘signalling’ and ‘clientele effects’. Firstly, each one of these concepts will be defined and exemplified for better understanding. After having done this, the connection between these single concepts will be highlighted and shown as to how they may have reciprocal influence. To conclude, a short summary will highlight the implications for public quoted firms and their managers.
On the outset the term ‘ information asymmetry ’ will be defined. Neoclassical economics assumes ‘complete information’, this means that every market participant could observe every state of environment and every activity of its contracting party; therefore contracts are complete and information is available at no charge.
However the ‘new institutional economics’ assumes ‘bounded rationality’, meaning that information procurements creates transaction costs (Furubotn & Richter, 2005). It is practically necessary to divide management and ownership in large companies, because it is impossible for hundreds of thousand of shareholders to be directly involved in the business administration (Brealey et al., 2008). With respect to capital markets, information asymmetry arises from this separation and the fact that managers (insiders) have ‘monopolistic access’ to information of their company. This ‘private information’ can generally not be accessed by outsiders, the shareholders. It is assumed that management can predict the future development of their entity and the cash flows they can expect. If it cannot been assured that this information can be passed to the outside then the stockholders will assume the current value of the company as the expected value of its payouts (Copeland & Weston, 1992). This means that in the investors’ eyes, a firm will probably not fulfil its main target, maximising its and hence the shareholders’ value. This could result in a declining share price and therefore it should be the managers’ task to reduce these information asymmetries.
Asymmetric distributed information is one type of market imperfection and is the cause of the ‘agency problem’ and creates ‘ agency costs ’ for market participants, especially for the shareholders (Wigger, 2006). “The agency theory is an hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationship between principals such as shareholders and agents such as company managers” (Davies et al., 2008, 77). Agency costs arise due to the management and shareholders having contrary objectives. It is assumed that managers are primarily led by ‘self-interest’ and that they do not always act in the best interest of the owners. Shareholders can only observe the actions of their agents with reservation and managers can use their information advantage to the shareholders’ disadvantage to trade on their principals. Agency costs arise from the instance that either managers do not attempt maximising firm value or shareholders incur costs preventing this instance (Davies et al., 2008). For example, both parties have different views about risk and return: shareholders are interested in long-term sustainable investments like R&D projects, whereas managers’ rewards are based on short-term performance figures (e.g. earnings per share) and for them R&D expenses decrease these earnings.
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- Thorsten Wenke (Author), 2009, Meaning and importance of key terms of Financial Economics , Munich, GRIN Verlag, https://www.grin.com/document/137221