Agency Problems and Corporate Ownership - Essay Example

?CHAPTER Questions Agency problems and Corporate Ownership )Corporate ownership varies around the world. Historically , Individuals have owned the majority of shares in public corporation in the united states , in Germany and Japan , however , Banks , other large financial institution s , and other companies own most of the stock in public corporations . Do you think agency problems are likely to be more or less severe in Germany and Japan than in United States?? Agency problem is less severe in Germany and Japan and the reason for the same is the insider ownership transaction that takes place in US corporations. The Enron scandal and Arthur Anderson case has been the witness of this testimony. If the interest of organisation and individuals are not aligned then there are classical cases like Arthur Anderson and Enron comes up in the public world. This case tries to highlight how a corporation like Arthur Anderson came to such demise. 80 years of legendary innovative history in Corporate America that was created by Arthur Anderson was washed up in a matter of 8 years. Internal divisions came up in the company and the world started to look at Corporate America with shame. To align the principal agent theory in practice, Sarbanes Oxley came into operation in 2002. The act tried to align the best interest of the shareholders and the agent i.e. Management in the same mould. The objective of the act was to reduce the ever growing gap between the two of the main functions of the organisation. There are two main functions of any organisation which decide the fate of the organisation as a whole. The first one of them is the shareholders (Principals) who elect the Management (agent) to represent them as the owner of the company. The objective of the principal is to maximise shareholders wealth while that of Management can be the same or it can be different also. If the objectives are aligned by using good compensation strategy and urging responsibilities over the management then agency cost of the company will be reduced. If that is not the case agency cost will always increase. With this background let us have a look at the classic case of Arthur Anderson. Management of the company which was looking after the AA division of the company was less compensated compared to their counterparts in AC. This is itself a contradiction to the principal agent theory. Arthur Anderson has grown from the roots as a major auditor and the consulting division came into picture very late when they started automating the book keeping systems. AC was very successful and the compensation was not in alignment with the kind of success they achieved. Hence the companies were separated and consulting division was now separate from auditing division. After the separation AC kept growing fast with their own set of compensation strategy while AA started facing challenges. This challenges are advent from the number of lawsuits AA faced during 1990s and 2000. Employees at AA were resenting and finding other ways to get paid and rope in extra money for the organisation and themselves. This is when they started realigning shareholders interest with theirs. This was visible in the biggest corporate scandal of America- Enron. Enron was the worst corporate scandal which shook American Corporation. Auditors at Arthur Anderson signed the financial statements of Enron without cross checking the stated facts. This was done just to rope in extra money from this big ticket client. Somewhere this is an also a case where organizational structure should be questioned. The reason for this is because for a big ticket client like Enron, Arthur Anderson compromised its corporate hierarchy. They allowed their premier groups to go and reside at the client’s headquarter. There was no proper check on what was happening within employees and the client. 2- (Goal of financial Management )Why is the goal of financial management to maximize the current share price of the company‘s stock? In other words, why isn’t the goal to maximize the future share price? The goal is to maximize the share price in any possible way so that best return can be generated for the shareholder and investor at any moment of time. Future expected health of the company is discounted in current share price of the share. Principal agent theory can be used to understand the situation. If a shareholder tries to give management major go ahead with all the decisions it needs to compromise authority. Now if the same owner tries to keep a check on Managements work policies and decision, it needs to inculcate huge agency cost. Before 2002 this was all trust based system. After Arthur Anderson and Enron Scandal which shook America, Corporations started looking into aligning the compensation strategy in a manner which will make sure that management works in the best interest of the shareholder CHAPTER ( 2) Questions : 1- (Accounting and cash flow ) Why might the revenue and cost figures shown on a standard income statement not present the actual cash inflows and outflows that occurred during a period? Some revenue figures are part of receivables and are not realized in cash flow and some figure like noncash charges are included in cost and hence are not visible in cash flows of the company. These charges are just part of income statement and are utilized there. Hence this charges never become part of the cash flow. 2- ( Book Values versus Market Values ) Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets. When this occurs, the owners equity negative. Can this happen with market values? Why or why not? Yes it is possible for liabilities to exceed the value of assets when the market value of loan increases manifold at times. 3- ( Building a Balance Sheet )Culligan ,Inc , has currnt assets of $ 5,300, net fixed assets of $ 26,000, current liabilities of $ 3,900, and long-term debt of $ 14,200. What is the value of the shareholders’ equity account for this firm ?how much is net working capital ? Assets Current Assets- 5300 Net Fixed Assets- 26000 Total Assets=31300 Liabilities Current Liabilities- 3900 Long term Debt- 14200 Shareholders Equity- 31300-18100=13200 4- (Building an Income Statement )Ragsdale , Inc. , has sales of $ 493,000, costs of $ 210,000, depreciation expense of $ 35,000, intrest expense of $ 19,000, and tax rate of 35 percent . what is the net income for the firm ? suppose the company paid out $ 50,000 in cash dividends . what is the addition to retained earnings ? Sales- 493000 COGS-210000 EBITDA-283000 Depreciation- 35000 Interest Expense- 19000 PBT-229000 Tax= 35% of 229000(80150) PAT- 148850 5- ( Market values and Book values ) Klingon Cruisers , Inc. , purchased new cloaking machinery three years ago for $ 9.5 million . The machinery can be sold to the Romulans today for $ 6.3 million. Klingon’s current balance sheet shows net fixed assets of $ 5 million. Current liabilities of $ 2.1 million , and net working capital of $ 800,000. If all the current assets were liquidated today , the company would receive $ 2.8 million cash . What is the book value of Klingon’s assets today ? What is the market value ? Current assets= 2.1+0.8= 2.9 million Total Assets= 2.9+5=7.9 million Value of liquidated current assets= 2.8 million Market value of assets= 6.3-(7.9-2.8)= 1.2 million 6- ( Calculating Taxes ) The Herrera Co. had $ 246,000 in taxable income .using the rates from table 2.3 in the chapter 2, calculate the company’s income taxes. What is the average tax rate? What is the marginal tax rate? Average Tax Rate= 35% Tax= 35% *246000 Tax= 86100 7- ( Building a Balance Sheet ) The following table presents the long – term liabilities and stockholders’ equity of information Control Corp. one year ago : Long term debt $ 72,000,000 Preferred stock $ 9,000,000 Common stock ( $ 1 per value ) 20,000,000 Accumulated retained earnings 97,000,000 Capital surplus 43,000,000 During the past year , Information Control issued 10 million shares of new stock at total price of $ 43 million, and issued $ 10 million in new long-term debt. The company generated $ 9 million in net income and paid $ 2 million in dividends. Construct the current balance sheet reflecting the changes that occurred at Information Control Corp. During the year. Long term debt $ 72,000,000 + 10 million= 82 million Preferred stock $ 9,000,000=9 million Common stock ( $ 1 per value ) 20,000,000+ 10 million= 30 million Accumulated retained earnings= 104 million (dividend and net income included) CHAPTER ( 3) Questions : 1- ( Common – Size Financials ) One tool of financial analysis is common – size financial statements . Why do you think common- size income statements and balance sheets are used ? Note that the accounting statement of cash flows is not converted into a common-size statement. Why do you think is this ? It helps in determining the line items more correctly as all items are scaled down to the same value. 2- ( Comparing ROE and ROA ) both ROA and ROE measure profitability . Which one is more useful for companies? Why ? ROA is for companies for whom capital expenditure is huge while ROE is for general companies which have returns directly correlated to the equity infused. 3- (Ratio Analysis ) Consider the ratio EBITD/Assets. What does this ratio tell us ? Why might it be more usefull than ROA in comparing two companies ? It tells us at operating level how assets are generating returns. It is better than ROA because it does not discount depreciation. 4- ( Return on Equity ) Firm A and Firm B have debt- total asset ratios of 40 percent and 30 percent and returns on total assets of 12 percent and 15 percent , respectively . Which firm has a greater return on equity ? Firm B has greater return on equity. CHAPTER ( 4) Questions : 1- ( Compounding and Period ) As you increase the length of time involved , what happens to future values ? what happens to present values ? The future values go on increasing while the present value get reduced as per the time frame. 2- ( Interest Rate ) What happens to the future value of an annuity if you increase the rate r ? What happens to the present value ? Future value will increase as the returns is increasing while present value will reduce as the discounting factor is making a huge impact now. 3- ( Present Value ) Suppose two athlets sign 10 – year contracts for $ 80 million . In one case , we’re told that the $ 80 million will paid in 10 equal installments . In the other case , we’re told that the $ 80 million will be paid in 10 installments , but the installments will increase by 5 percent per year . Who got the better deal ? The first payment is better since huge money will be available in the initial part of the payment schedule, hence time value of money will have a lesser impact. 4- ( Time Value of Money ) Would you be willing to pay $ 24 ,099 today in exchange for $ 100 ,000 in 30 years ? What would be the key consideration in answering yes or no ? Would your answer depend on who is making the promise to repay ? My answer is sole dependent on the discounting rate. 5- ( Length of Investment ) The TMCC security is bought and sold on the New York Stock Exchange . If you looked at the price today , do you think the price would exceed the $ 24,099 original price ? Why ? If you looked in the year 2019 , do you think the price would be higher or lower than today’s price ? Why ? Yes it will increase as the cash flow is expected in future. 6- ( Calculating Future Values ) Compute the future value of $1,000 compounded annually for : a. 10 years at 6 percent -$1790.84 b. 10 years at 9 percent -$2367.36 c. 20 years at 6 percent - $3207.35 d. Why is the interest earned in part © not twice the amount earned in part (a) ? The reason for this is the effect of compounding and the interest earned from the already compounded interest. 7- ( Calculating present value ) For each of the following compute the present value : Years 6 interest rate 7% Future value $ 15,451-$10295.65 Years 9 interest rate 15% Future value $ 51,557-$14655 years 18 interest rate 11% Future value $ 886,073- $135411 Years 23 interest rate 18% Future value $ 550,164- $12223.21 8- ( Calculating interest rate ) Solve for the unknown interest rate in each of the following : Present value $ 242 years 2 interest rate 8% Future value $ 307 Present value $ 410 years 9 interest rate 9% Future value $ 896 Present value $ 51,700 years 15 interest rate 11% Future value $ 162,181 Present value $ 18,750 years 30 interest rate 10% Future value $ 483,500 9- ( Calculating the number of Periods ) Solve for the unknown number of years in each of the following : Present value $ 625 years 10 interest rate 6 % Future value $ 1,284 Present value $ 810 years 23 interest rate 13 % Future value $ 4,341 Present value $ 18,400 years 20 interest rate 32 % Future value $ 402,662 Present value $ 21,500 years 15 interest rate 16 % Future value $ 173,439 Read More