agency problems: shareholders, directors and management

Why is maximization of shareholder wealth a better measure of a firm’s goal?

Answer: Control of the firm. Control of the firm ultimately rest with stockholders. They elect the board of directors, who, in turn, hire and fire management. An important mechanism by which unhappy stockholders can replace existing management is called a proxy fight. A proxy fight develops when a group solicits proxies in order to replace the existing board and thereby replace existing management. Example in 2002. The proposed merger between HP and Compaq triggered one of the most widely followed, bitterly contested, and expensive proxy fights in history over $100 million. The available theory and evidence are consistent with the view that stockholders control the firm and that stockholder wealth maximization is the relevant goal of the corporation.

What are the mechanisms to control for agency problems?

Answer: Regulation , example – disclosure all relevant information by corporation to investor and potential investor will put all investors on a level information playing field and thereby to reduce conflicts of interest.

Agency problems. Who owns a corporation? Describe the process whereby the owner control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise?

Answer: the corporation comprises three sets of distinct interest: the shareholders (the owners), the directors and the corporation officer (the top management). The shareholders elect a board of directors, who in turn select top management. Members of top management serve as corporate officers and manage the operations of the corporation in the best interest of the shareholders.

The relationship between stockholders and management is called an agency relationships. Such a relationships exists whenever someone (principal) hires another (the agents) to represent his or her interest. The conflict of interest between the principal and the agents is called agency problem.

Goal of the firm. Evaluate the following statement: managers should not focus on the current stock value because doing so will lead to an overemphasis on short term profits at the expense of long – term profits.

Possible goals of firm:

Survive

Avoid financial distress and bankruptcy

Beat the competition

Maximize sales or market share

Minimize costs

Maximize profits

Maintain steady earnings growth.

The goal of maximizing profits may refer to some sort “long run” or “average” profits. The two classes of goals, first is relate to profitability: involving sales, market share, and cost of control. Second goal: involving bankruptcy avoidance, stability and safety.

Agency problem.  Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company’s management immediately begin fighting of this hostile bid. Is management acting in the shareholder’s best interest? Why or why not?

Answer: yes, because avoiding a takeover by another firm gives management another incentive to act in the stockholder’s interest. 

My attempt answering some questions number 1, 3, 6, 7 page 18 -19 of corporate finance book, Stephen A Ross, Randolph W.Westerfield and Jeffrey Jaffe. Ninth edition.

net present value (NPV)

Example:

The Alpha Corporation is considering investing in a riskless project costing $100. The project receives $107 in one year and has no other cash flows. The discount rate is 6 percent.

The NPV of the project:

$ 0.94 = -$100 +( $107 / 1.06)

The project should be accepted because its NPV is positive.

The basic investment rule can be generalized to:

• Accept a project if the NPV is greater than zero
• Reject a project if NPV is less than zero.

Why does the NPV rule lead to good decision? Considering the following two strategies available to the managers of Alpha Corporation:

• Use $ 100 of corporate cash to invest in the project. The $107 will be paid as a dividend in one year.
• Forgo the project and pay the $100 of corporate cash as dividend today.

If strategy 2 is employed, the stakeholder might deposit the dividend in a bank for one year. With an interest rate of 6 percent, strategy 2 would produce cash of $106 = ($100 x1.06) at the end of the year. The stockholder would prefer strategy 1 because strategy 2 produces less than $107 at the end of the year.

Accepting positive NPV projects benefit the stockholders.

How do we interpret the exact NPV of $0.94? this is the increase in the value of the firm from the project. For example, imagine that the firm today has productive assets worth $V and has $ 100 of cash. If  the firm forgoes the project, the value of the firm  today would simply be:

$V + $100

If the firm accept the project, the firm will receive $107 in one year but will have no cash today. Thus, the firm’s value today would be:

$V + ($107 / 1.06)

The difference between these equations is just $0.94, the Net Present Value of Equation:

The value of the firm rises by the NPV of the project.

Note that the value of the firm is merely the sum of the values of the different projects, divicion, or other entities within the firm. This property, called value additivity, is quite important. It implies that the contributor is quite important. It implies that the contribution of any project to a firm’s value is simply the NPV of the project.

The key to NPV is its three attributes:

• NPV uses cash flows
• NPV uses all the cash flows of the project.
• NPV discounts the cash flows properly.

Source: Source: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition.

sensitivity analysis and scenario analysis

Sensitivity analysis – examines how sensitive a particular NPV calculation is to changes in underlying assumptions. Sensitivity analysis is also known as what – if analysis and BOP (Best, Optimistic and Pessimistic) analysis.

Example – Solar Electronics Corporation (SEC) has recently developed a solar – powered jet engine and wants to go ahead with full- scale production. The initial (year 1) investment is $ 1,500 million, followed by production and sales over the next five years. The preliminary cash flow projection appears in table 1.

Table 1 – Cash flow forecasts for Solar Electronics Corporation’s jet engine

	year 1	years 2 - 6
Revenues		$           6.000
Variable costs		3.000
Fixed costs		1.791
Depreciation		300
pretax profit		909
tax (tc = 0.34)		309
Net profit		600
cash flow		900
initial investment costs	$           1.500

Should SEC go ahead with investment in and production of jet engine, the NPV at a discount rate of 15 percent is (in millions):

NPV = -$ 1,500 +

= - $ 1,500 + $900 x

= $ 1,517

Because the NPV is positive, basic financial theory implies that SEC should accept the project. However, is this all there is to say about the venture? Before actual funding,  we ought to check out the project’s underlying assumptions about revenues and cost.

Revenues – let’s assume that the marketing department has projected annual sales to be:

Number of jet engines sold per year = market share x size of jet engine market per year

3,000 = 0,30 x 10,000

Annual sales revenues = number of jet engines sold x price per engine

$ 6,000 = 3,000 x $ 2 million

Thus, it turns out that the revenue estimated depend on three assumptions:

·         Market share

·         Size of jet engine market

·         Price per engine

Cost – Financial analyst frequently divide costs into two types : variable cost and fixed cost. Variable cost change as the output changes, and they are zero when production is zero. Cost of direct labor and raw materials are usually variable. It is common to assume that a variable cost is constant per unit of output, implying that total variable costs are proportional to the level of production. Example – if direct labor is variable and one unit of final output requires $10 of direct labor, then 100 units of final output should require $ 1000 of direct labor. Fixed costs are usually measured as cost per unit of time, such as rent per month or salaries per year. Naturally, fixed costs are not fixed forever, they are fixed only over a predetermined time period.

Table 2 – different estimates for solar electronics’ solar plane engine

variable	pessimistic	expected or best	optimistic
Market size (per year)	5000	10000	20000
Market share	20%	30%	50%
Price	$ 1,9 million	$ 2 million	$ 2,2 million
Variable cost (per plane)	$ 1,2 million	$ 1 million	$ 0,8 million
Fixed cost (per year)	$ 1,891 million	$ 1,791 million	$ 1,741 million
Investment	$ 1,900 million	$ 1,500 million	$ 1,000 million

The engineering department has estimated variable costs to be $ 1 million per engine. Fixed cost are $ 1,791 million per year. The cost breakdowns are:

Variable cost per year = variable cost per unit x number of jet engine sold per year

$ 3,000 million = $ 1 million x 3000

Total cost before taxes per year = variable cost per year + fixed cost per year

$ 4,791 million = $ 3,000 million + $ 1,791 million

These estimates for market size, market share, price, variable cost, and fixed cost as well as the estimate of initial investment. Table 2 represent the firm’s expectations or best estimates of the different parameters. For comparison, the firm’s analyst also prepared both optimistic and pessimistic forecasts for each of the different variables.

Standard sensitivity analysis calls for an NPV calculation for all three possibilities of a single variable, along with the expected forecast for all other variables. This procedure is illustrated in Table 3.

Table 3 – NPV calculations for Solar Plane Engine Using Sensitivity Analysis.

variable	pessimistic	expected or best	optimistic
Market size (per year)	- $ 1,802	$1,5717	$ 8,154
Market share	-696	$1,5717	5,942
Price	853	$1,5717	2,844
Variable cost (per plane)	189	$1,5727	2,844
Fixed cost (per year)	1,295	$1,5727	1,628
Investment	1,208	$1,5727	1,903

Under sensitivity analysis, one input is varied while all other inputs are assumed to meet their expectation. For example, an NPV of - $ 1,802 occurs when the pessimistic forecast of 5,000 is used for market size. While all other variable are set at their expected forecast from table 2.

Table 3 can be used for a number of purposes. First, taken as a whole, the table can indicate whether NPV analysis should be trusted. Managers viewing the table will likely consider NPV analysis to be useful for the solar – powered jet engine.

Second, sensitivity analysis shows where more information is needed. Example – an error in the estimate of investment appears to be relatively unimportant because even under the pessimistic scenario, the NPVof $1,208 million is still highly positive. By contrast, the pessimistic forecast for market share leads to a negative NPV of - $696 million, and a pessimistic forecast for market size leads to a negative NPV of - $1,802. Because the effect of incorrect revenues is so much greater than the effect of incorrect estimates costs, more information about the factors determining revenues might be needed. Because of these advantages, sensitivity analysis is widely used in practice. 

Unfortunately, sensitivity analysis also suffer from some drawbacks. Example – sensitivity analysis may unwitting increase the false sense of security among managers. Suppose all pessimistic forecasts yield positive NPVs, A manager might feel that there is no way the project can lose money.

Manager frequently perform scenario analysis, a variant of sensitivity analysis, to minimize this problem. Example, consider the effect of a few airlines crashes. These crashes are likely to reduce flying in total, thereby limiting the demand for any new engines. Furthermore, even if  the crashes do not involve solar – powered aircraft, the public could become more averse to any innovative and controversial technologies. A series of scenarios like this might illuminate issues concerning the project better than the standard application of sensitivity analysis would.

Source: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition.

multiple choices - 1

The excess return required from a risky asset over that required from a risk-free asset is called the: variance. excess return. geometric premium. average return. risk premium. You bought 100 shares of stock at $20 each. At the end of the year, you received a total of $400 in dividends, and your stock was worth $2,500 total. What was your total return? 20% 45% 50% 90% None of the above     The risk premium is computed by ______ the average return for the investment. adding the inflation rate to subtracting the average return on the U.S. Treasury bill from subtracting the average return on long-term government bonds from subtracting the inflation rate from adding the average return on the U.S. Treasury bill to Which of the following statements are correct concerning the variance of the annual returns on an investment? I. The larger the variance, the more the actual returns tend to differ from the average return. II. The larger the variance, the larger the standard deviation. III. The larger the variance, the greater the risk of the investment. IV. The larger the variance, the higher the expected return. I, II, III, and IV I, III, and IV only II, III, and IV only I and III only I, II, and III only  The capital gains yield plus the dividend yield on a security is called the: current yield. total return. variance of returns. geometric return. average period return.    Which one of the following is a correct ranking of securities based on their volatility over the period of 1926 to 2008? Rank from highest to lowest. large company stocks, U.S. Treasury bills, long-term government bonds small company stocks, long-term corporate bonds, large company stocks long-term corporate bonds, large company stocks, U.S. Treasury bills small company stocks, large company stocks, long-term corporate bonds long-term government bonds, long-term corporate bonds, small company stocks The average squared difference between the actual return and the average return is called the: variance. risk premium. excess return. volatility return. standard deviation. Capital market history shows us that the average return relationship from lowest to highest between securities is: There is no ordering. Treasury bills, government bonds, corporate bonds, large common stocks, small company stocks. Treasury bills, corporate bonds, government bonds, large common stocks, small company stocks. Inflation, corporate bonds, Treasuries, small company stocks, large company stocks. Treasury bills, inflation, small company stocks, large company stocks.