That means it is the theory between the shareholders & the company managers. This term includes the expense of solving the potential conflicts between the two relevant groups. According to this theory, because of incomplete information & uncertainty, two types of problem can arise. Such as-
A potential agency problem arises whenever the manager of a firm owns less than 100% of the firm's common stocks. However, if the owner-manager incorporates & then sells some of the stocks to the outsiders, a potential conflict of interests immediately arises. In most large listed companies, potential conflicts of interests are important, as those firm's managers generally own only a small percentage of the stocks. In this situation, shareholder wealth maximization could take a back seat to any number of conflicting managerial goals.
In addition to the conflict between stockholders & managers, there can also be conflicts between creditors & stockholders. Creditors have a claim on the part of the firm's earning stream of payment of interest & principle on the debt, & they have a claim on the firm's assets in the event of bankruptcy. Stockholders have a control of decisions that affect the profitability & risk of the firm. Creditors lend the firm on the base of -
1) Capital Structure: A firm's capital structure is that mix of debt & equity that maximizes the stock price. At any point of time, management has a specific target capital structure. Capital structure policy involves a trade-off between risk & return:-
Using more debt raises the risk born by stockholders.
Using more debt generally leads to a higher expected rate of return on equity.
Four primary factors influence capital structure decisions-
Business risk or the risk inherent in the firm's operations if it used to debt. The greater the firm's business risk, the lower its optimal debt ratio.
The firm's tax position which is a major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt.
Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions. The greater the