Agency issue

Goal of the finance manager is the maximisation

of the wealth of the owners of the firm Management can be viewed as agents of the owners
Owners hires the management Gives the decision making authority to manage the firm for owners benefits

In practice, managers concerned with their own

benefits
E.g. personal wealth, job security, lifestyle, fringe narain@fms.edu benefits, etc.

Agency issue
Managers personal goals may make managers

reluctant or unwilling to take more than moderate risk if they perceive it to be in conflict with their personal goals The result of such a satisfying approach is
A compromise between satisfaction & maximisation less than the maximum return & potential loss of wealth for the owners

The resolution isA. Market Forces B. Agency costs

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A: Market Forces
1. Institutional Investors: E.g. Insurance companies, Mutual Funds, Pension Funds, etc. Holds large blocks of a firms stocks They actively uses their votes to oust under performing managers and replace them with more competent managers Also communicate with the companies and exert pressure on management to perform or be fired narain@fms.edu

A: Market Forces
2. Hostile Takeovers Acquisition of a firm (the target) by another firm or group (the acquirer) that is not supported by management Typically occurs when the acquirer feels that the target firm is being poorly managed, and as a result, is undervalued in the market place Attempt techniques available to defend against hostile takeovers, its constant threat motivates mgt. to act in the best interest of firms owners narain@fms.edu

B: Agency Costs
Incurred to respond to potential market

forces by preventing or minimising agency problems and contributing to the maximisation of owners wealth

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Types of Agency Costs

1. Monitoring expenditures-

Payment for audit & control 2. Bonding expenditures Payment to third party to obtain a fidelity bond 3. Opportunity costs Loss of profit due to the longer response time of the complex organisational structure 4. Structuring expenditures Results from structuring managerial compensation to correspond with stock price maximisation
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Types of structuring expenses

1. Incentive Plans To tie management compensation with share price E.g. Stock Options- allow manager to purchase stock Is been criticised as positive effort may be accompanied by the negative market 2. Performance Plansa. Cash bonuses narain@fms.edu b. Performance shares

Capital Budgeting Decisions

Accepting projects that yields a return higher than the hurdle rate

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Capital Budgeting Decisions

Capital budgeting decisions relate to selection of a long-term asset or investment proposal or course of action that generally involves use of funds today but generate regular and recurring benefits in future.

Benefit may be in the form of increased revenue or reduced cost Capital budgeting decisions could relate to: Additions Modifications Replacements Disposals

Capital Budgeting Decision Process

While evaluating projects, an attempt is made to:1. Reduce costs and benefits to a single figure 2. Compare this against a predetermined amount, rate or time period 3. Make a choice

Assumptions in Capital Budgeting

1.

2.

3. 4.

5.

6. 7.

All cash flows take place at the end of the time period No change in the risk i.e. size and timing of cash flow are known with certainty Perfect capital markets Projects are infinitely divisible but exhibit decreasing return to scale Cash flows are in independent of each other overtime and other investment decisions Rational decision parties It is a well-behaved project or conventional cash flow projects

Problems involved in Capital Budgeting

1.

2. 3.

4.

5.

Estimating future costs both initial and operating Forecasting of benefits Determination of cost of capital or required rate of return Treatment of time element economic life of project Treatment of risk element