-Question -
INSTRUCTION TO CANDIDATES
1. You are given three questions below and you are required to answer all.
2. Kindly note that all references are to be clearly stated.
3. Candidates can write the assignment either in Bahasa Malaysia or English.
ASSIGNMENT QUESTION
Question 1
The utmost goal of Board of Directors and Managers of any corporation is to maximize the wealth of the stockholders. Even so, there will be undoubtedly be times when management goals are pursued at the expense of the stockholders. In such cases, there is a possibility of conflict of interest between the principal (stockholders) and the agents (the Management). This problem is common in corporate management, where the principal is shareholders and the agent is managers. It is also common in government, where the principal is the public and the agent is elected leaders.
Describe and discuss main reasons that agency problems arise in corporate form of organization. How do you think agency problems can be controlled and reduced?
Question 2
In the era of competitive and complex business environment, understanding the financial statements is becoming an integral part of most non financial managers of many corporations. Statement of cash flows is one of the most important financial statements that indicate the actual cash position of a corporation at any given period. From your understanding, explain:
- What is Statement of Cash Flows and how do you determine the sources and uses of cash?
- What are some of the problems associated with financial statement analysis?
Note : You may choose to use your own sample of financial statements to explain the above.
Question 3
Suppose you save RM2,500 per year for five years, beginning one year from today. At the end of year 5, you left the balance for another 10 years without adding anymore savings. Given that your savings pays you 8% interest per year, how much would you have at the end of 15 years?
Please state clearly the formulas and explain the results as necessary
Prepared By
MR. BALAMURUGAN SUBRAMANIAM
Executive Summary
This paper’s main objective is to give an in-depth view of corporate financial management and decision making theory, emerging issues in conflict of interest between the Agency and the organizations’ competitive advantage or more known as agency problem.
Furthermore, financial statement analysis and the problem associated with it is being analyzed and described in this paper. Thereafter, a financial calculation shows hows future value being calculated.
In conclusion, corporate financial management and decision making is important in all industry and the knowledge of it is beneficial for both financial and non-financial managers.
Table of Content
Table of Content
No
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Description
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Page
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Assignment Question
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2
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Executive Summary
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3
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1.0
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Introduction
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5
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2.0
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Agency problem
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5
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2.1
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Agency problem in local corporate firm
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5
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2.2
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Agency problem in local Islamic Bank
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6
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2.3
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Control and reduce agency problem
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7
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3.0
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Statement of cash flow
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10
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3.1
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Problems associated with financial statement analysis
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10
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4.0
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Future value
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12
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5.0
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Conclusion
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12
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6.0
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Reference
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13
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1.0 Introduction
Corporate finance is the broad heading given to the process of transacting and managing certain activities of companies, including the raising of funds and the realization of value through a sale or listing. These include raising funds for the purpose of financing existing activities, developing new activities or investing in new fixed assets, buying other companies or businesses and selling the whole part of companies, or even selling certain specific assets.
At its most basic level, it could be arranging a simple loan for the purchase of a piece of machinery, or agreeing an overdraft facility to meet cash needs during a seasonal slowdown. Alternatively, it could be a hugely complex deal involving the issue of complex instruments to financial institutions and the public
Question 1
The utmost goal of Board of Directors and Managers of any corporation is to maximize the wealth of the stockholders. Even so, there will be undoubtedly be times when management goals are pursued at the expense of the stockholders. In such cases, there is a possibility of conflict of interest between the principal (stockholders) and the agents (the Management). This problem is common in corporate management, where the principal is shareholders and the agent is managers. It is also common in government, where the principal is the public and the agent is elected leaders.
Describe and discuss main reasons that agency problems arise in corporate form of organization. How do you think agency problems can be controlled and reduced?
2.0 Agency Problem
Agency problem means a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The problem is that the agent who is supposed to make the decisions that would best serve the principal is naturally motivated by self-interest, and the agent's own best interests may differ from the principal's best interests. The agency problem is also known as the "principal–agent problem."
The agency problem arises due to the separation of ownership and control of business firms. In theory the shareholders, being the owners of the firm, control its activities. In practice, however, due to a diffuse and fragmented set of shareholders, the latter appoints a board of directors to direct the affairs of the company. The board would similarly delegate the duty of day to day running of the organization to managers. In terms of this arrangement therefore, managers are the agents of the board whereas board members are also agents of the shareholders.
2.1 Agency problem in local corporate firm
Inherent in any principal-agent relationship is the understanding that the agent will act for and on behalf of the principal. The agent assumes an obligation of loyalty to the principal that he will follow the principal’s instructions and will neither intentionally nor negligently act improperly in the performance of the act. An agent cannot take personal advantage of the business opportunities the agency position uncovers. A principal, in turn, reposes trust and confidence in the agent. These obligations bring forth a fiduciary relationship of trust and confidence between principal and agent. However, the principal-agent relationship that subsists between the shareholder and the directors on one hand and between the directors and managers on the other is fraught with some problems. The agency problem is compounded by the conditions of incomplete and asymmetric information as between the principal and the agent. Shareholders (as principals), expect directors/board members (as agents), to make decisions that will lead to the maximization of the value of their equity. In the same vein, directors (as principals) expects management (as agents) to pursue strategies and operations that contributes to the bottom-line and are in tune with the board’s expectations. This scenario means that the shareholders who should stand to benefit from the profitability of the company do not have direct control over what management (who generate that profitability) does. This dilemma, which is a consequence of the separation of ownership and control, raises worries that the management team may pursue objectives attractive to them, but which are not necessarily beneficial to the share holders.The distance that is created between the shareholder and management team therefore breeds the problem of a serious lack of goal-congruence – where there is no alignment of the actions of senior management with the interests of shareholders.
Related to this issue, firms whose CEOs are also part of the firm’s founding family tend to have higher agency costs and monitoring needs than firms with unrelated CEOs. For example, Dergahayu Sdn Bhd, a property developer firm finds that family management is inferior to professional management. They show that these CEOs have less control over the agency problem than CEOs who are not founders (or founder’s heirs) of the firm. Research has focused on the theory that a strong board of directors is one that is able to effectively monitor management and alleviate agency problems. Effective directors are typically those that make the board more independent from the internal workings and individuals of the firm.
2.2 Agency Problem in local Islamic Banks
Islamic banking, which became established in the 1970s, currently consists of a variety of financial instruments or products. These include mudarabah (trust financing), musharakah (equity financing), ijarah (lease financing), murabahah (trade financing), qard al-hassan (welfare loan), and istisna` (progressive payments).
Musharakah is essentially a joint venture profit-sharing business of two or more parties in which the Islamic bank is an important partner or shareholder. Under musharakah, the bank relies on the other partner(s) to manage the business and make the day-to-day decisions. Even though the bank could monitor the management of the business by hiring
external auditors and consultants, such measures would incur additional costs. Therefore, the bank must rely on professional managers or other partners to manage the businesses, even though these managers may have an incentive to maximize their own utility at the business owner’s expense.
Mudarabah financing is really a hybrid. It is neither equity nor debt, because it
has important features of both. This type of financing has elements of equity financing, since the Islamic bank receives no fixed annual return. In fact, such a return from the business is similar to a dividend, which the business pays only if it earns a profit.
On the other hand, mudarabah has elements of conventional debt financing, because in the event of dissolution, the bank has a “fixed” claim on the venture equal to the initial capital provided, plus its share of any profits.
Under mudarabah, the Islamic bank does not participate directly in management decisions. Rather, it relies completely on the business venture’s trustee or entrepreneur. This trustee is clearly an agent of the Islamic bank and, therefore, is inherently subject to the agency conflict of interest. Thus, under both musharakah and mudarabah, the Islamic bank experiences the agency problem with its associated costs. Islamic banks operate
primarily in developing countries, where there is a high degree of financial market imperfection and a prevailing presence of inefficiency and corruption. The agency problem becomes more acute when banks have little access to dependable accounting information, due to a lack of standardized financial reporting requirements and procedures. The difficulties presented by this agency problem, together with the lack of verifiable financial data, complicate the profit-sharing characteristics of these forms of Islamic financing and actually encourage debt financing (e.g., murabahah and
ijarah) over equity financing (e.g., musharakah and mudarabah).
To some extent, the agency problem in musharakah and mudarabah can be reduced by carefully specifying the sharing of profit and performance bonuses between the entrepreneur and the bank. Also, in the case of musharakah, the bank participates in the election of the company’s board and officers, a factor that should further reduce the agency problem.
2.3 Control and reduce agency problem
In order to control and reduce the agency problem, principal or shareholders of accompany should incorporated a standard operating procedure (SOP) to be followed by their appointed agents/managers. Besides SOPs, employment act should be adhered properly to all managers and their subordinates when it comes to terms and regulation of servicing the company.
On the other hand shareholders of a firm should give incentives such as bonuses or profit sharing scheme to their agents in order to make the agents to imitate the shareholders point of view and carry their mission diligently.
Alternatively managers should be disciplined in order to mitigate agency problem by these four steps;
A) The legal system
A firm operating in a country whose legal system affords investors little protection from mismanagement can adopt the legal environment of a country that is more protective of investors by being acquired by another firm that already operates in such an environment.
Example
Iliad Corp. is managed by Homer, the founder of the company, who also owns 60% of the shares. The annual profit is $1000 of which Homer is entitled to $600. Not all of the $400 to which the outside shareholders are entitled reaches them. They get only $100, because Homer diverts $300 of their share to himself. However, the diverted funds are used to buy luxury boxes at a baseball stadium. In term’s of Homer’s utility, these box seats are equivalent to only $120 in cash. If Virgil purchased the firm for the equivalent of an annual payment of $900, with $760 of that going to Homer and $140 going to the incumbent outside owners then everyone gains. Virgil pays $900 for something worth $1000. The outside owners get $140 instead of $100, and Homer gets $760 instead of $720.
B) Product markets
How does competition in product markets can discipline top executives? The manager will lose his or her job if the firm suffers losses year after year, and this gives the manager incentive to avoid losses. This is a long way from claiming that the manager will make every effort to maximize profit, but it will prevent extreme abuse. Moreover, the more intense is the firm’s competitive environment the more efficient the management team has to be for the firm to stay afloat. This suggests that product market competition has substantial impact. But note that even if competition in the product market does prevent profit from declining, it doesn’t stop the top executives from adopting strategies that transfer profit from the owners to management.
In the United States, not only are CEOs paid twice as much on average as their counterparts in other countries, but they also receive a much higher fraction of that pay in the form of performance bonuses—50% in the United States. Other countries are slowly approaching U.S. practice, however (Murphy, 1999).
It is important to understand that a performance bonus doesn’t necessarily provide an incentive to perform. When the CEO or the board announces, “We had a great year so everyone gets a big bonus,” it is past performance—or perhaps good luck—that is being rewarded, and that is not necessarily an inducement to do well in the future. A contract that permanently ties senior executives’ pay to profit is a much better incentive device.
For example, the Walt Disney Corporation was run by family members for several years after the death of the founder, and the family members did a poor job. Profits were dismal, and the managers even used $31 million of the owners’ wealth to repurchase the shares of a financier attempting to buy a controlling interest in the company in hopes of being able to turn it around. (They paid $31 million more than the shares were worth on the stock market.) When Michael J. Eisner was hired to run the company in 1984 he was given a bonus of 2% of all profits in excess of a 9% return on equity. Under Eisner’s leadership, the return on equity soared to 25%. (It was well below 9% when he was hired.) Over a five-year period, Eisner received about $10 million a year in performance bonuses, a tiny fraction of what he delivered to the company’s owners (Milgrom and Roberts, 1992).
What kind of performance bonus would induce a manager to maximize profit? A substantial bonus that is paid only if the manager realizes maximum profit would provide the appropriate incentive. However, if the shareholders know how much profit the firm is capable of generating they can simply write a contract so the manager’s continued employment is conditional on the firm reaching its potential. How can the owners induce profit maximization when they don’t know what the maximum profit is?
When the price of the company’s shares is used to connect the manager’s pay to managerial performance—whether or not a stock option is used—the manager can profit from an economy-wide increase in share price levels. This happened during the bull market of the 1990s. The median pay of the CEOs of the top 500 firms (the Standard and Poor’s 500) increased by about 150% from 1992 to 1998 (Perry and Zenner, 2000). Tying the manager’s performance to the differential between the firm’s share price and a general stock market price index might be a more effective incentive device.
D) Capital markets
How do capital markets discipline top executives?
If the firm’s performance had been poor, then the price of its shares will be low. If the new owners replace the management team with a more effective one, and there is a big increase in the flow of profits as a result, the share price will increase. The new owners will have realized a handsome return, justifying the takeover. The possibility of dismissal may provide an incentive for managers to maximize profit in the first place.
Takeovers are not inevitable when the management team does a bad job. Easterbrook (1984) estimates that it takes an anticipated 20% increase in the value of shares to trigger a takeover. In that case, the threat of a takeover does little to discourage management from diverting profit away from the owners. Howeover managers often restrict the flow of information concerning the internal operation of the firm, making it even harder to determine its potential. Moreover, it often happens that dismissed managers have contracts with the original owners that provide them with multimillion-dollar parting gifts (a golden parachute) in case they are fired as a result of a takeover. The fact that boards of directors offer this sort of compensation may point to the unwillingness of directors to properly monitor managers.
Some acquisitions serve the managers’ interests by entrenching their positions. Shleifer and Vishny (1988) report that managers sometimes initiate takeovers. If some managers have strong reputations in the railroad industry, say, and their firm acquires a railroad, then they will be much more valuable to the shareholders. They have strengthened their positions at the head of the firm, even if the acquisition diminishes the present value of shareholder wealth.
There is a free rider problem that could undermine takeovers as a device to discipline managers. Existing shareholders stand to benefit from any improvement in profitability that a takeover would bring. This could make them reluctant to sell to the takeover group at the current market price or at a price low enough to render the takeover profitable to the new owners. Consequently, it could become difficult or impossible to find enough current shareholders willing to sell their shares (Grossman and Hart, 1980). That is why the constitutions of many firms include a dilution provision. This allows the new owner to sell part of the firm’s assets to another company belonging to the new owner at terms that are beneficial to takeover group and disadvantageous to the firm’s minority shareholders.
Question 2
In the era of competitive and complex business environment, understanding the financial statements is becoming an integral part of most non financial managers of many corporations. Statement of cash flows is one of the most important financial statements that indicate the actual cash position of a corporation at any given period. From your understanding, explain:
- What is Statement of Cash Flows and how do you determine the sources and uses of cash?
- What are some of the problems associated with financial statement analysis?
Note : You may choose to use your own sample of financial statements to explain the above.
3.0 Statement of Cash Flow
Statement of cash flows shows the detail how a firm’s cash position has changed over a given period of time. Cash flow is the change in a firm’s cash position over a given amount of time. Cash flow differs from earnings because earnings includes noncash items, such as depreciation and accruals. Earnings also ignores some cash items, such as large expenditures for plant and equipment. Cash flow measures only changes in cash.
3.1 Problems associated with financial statement analysis
a) Lack of an Underlying Theory
The basic problem in financial statement analysis is that there is no theory that tells which numbers to look at and how to interpret them. In the absence of an underlying theory financial statement analysis appears to be ad hoc informal and subjective. From a negative viewpoint, the most striking aspect of ratio analysis is the absence of an explicit theoretical structure.
As a result the subject of ratio analysis is replete with untested assertions about which ratios should be used and what their proper levels should be.
b) Conglomerate Firms
Many firms, particularly the large ones, have operations spanning a wide range of industries. Given the diversity of their product lines, it is difficult to find suitable benchmarks for evaluating their financial performance and condition. Hence, it appears that meaningful benchmarks may be available only for firms which have a well defined industry classification.
c) Window Dressing
Firms may resort to window dressing to project a favorable financial picture. For example, a firm may prepare its balance sheet at a point when its inventory level is very low. As a result, it may appear that the firm has a very comfortable liquidity position and a high turnover of inventories. When window dressing of this kind is suspected, the financial analyst should look at the average level of inventory over a period of time and not the level of inventory at just one point of time.
d) Variations in Accounting Policies
Business firms have some latitude in the accounting treatment of items like depreciation, valuation of stocks, research and development expenses, foreign exchange transactions, installment sales, preliminary and pre-operative expenses, provision of reserves, and revaluation of assets. Due to diversity of accounting policies found in practice, comparative financial statement analysis may be vitiated.
e) Interpretation of Results
Though industry average and other yardsticks are commonly used in financial ratios, it is somewhat difficult to judge whether a certain ratio is good or bad. A high current ratio, for example may indicate a strong liquidity position (something good) or excessive inventories (something bad). Likewise a high turnover of fixed asset may mean efficient utilization of plant and machinery or continued flogging of more or less fully depreciated worn, out and inefficient plant and machinery.
Another problem in interpretation arises when a firm has some favorable ratios and some unfavorable ratios and this is rather common. In such a situation, it may be somewhat difficult to form an overall judgment about its financial strength or weakness. Multiple discriminated analysis, a statistical tool, may be employed to sort out the net effect of several ratios pointing in different directions.
f) Correlation among ratios
Notwithstanding the previous observation, financial ratios of a firm often show a high degree of correlation. This is because several ratios have some common element (sales for example, is used in various turnover ratios) and several items tend to move in harmony because of some common underlying factor. In view of ratio correlations, it is redundant and often confusing to employ a large number of ratios in financial statement analysis. Hence it is necessary to choose a small group of ratios from a large set of ratios. Such a selection requires a good understanding of the meaning and limitations of various ratios and an insight into the economies of the business.
Question 3
Suppose you save RM2,500 per year for five years, beginning one year from today. At the end of year 5, you left the balance for another 10 years without adding anymore savings. Given that your savings pays you 8% interest per year, how much would you have at the end of 15 years?
Please state clearly the formulas and explain the results as necessary
4.0 Future Value
FV = PV(1+r)t
FV = (2,500 x 5)(1+r)t
FV = 12,500(1+0.08)15
FV = 12,500(3.1722)
FV = RM39,652.11
FV = future value
PV = present value
r = period interest rate, expressed as a decimal
t = number of periods
5.0 Conclusion
Corporate finance is like the backbone of a business and often when the bone is stronger, the businesses rise high. Agency problem is unavoidable in all type of businesses and with correct and proper corporate governance, the problem can be mitigated for an extend. Meanwhile understanding financial statements are crucial to both finance and non-finance oriented people as it is what enabling them to see the exact situation of the business at a certain period of time.
THE END
5.0 Reference
a) Financial statement analysis retrieved from
b) Agency problem retrieved from
c) corporate finance handbook 3rd edition by Kogan Page Staff(CB)
d) Agency problem retrieved from
e) Islamic Banking retrieved from
f) Scientific calculator
g) Incentives: Motivation and the Economics of Information, Second Edition
Chapter 4 – Corporate Governance
Cambridge University Press © 2006 (605 pages) Citation
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