The Role of Principles and Practices of Financial Management - Assignment Example

Student Name: Student No: Tutor: Date: Question 1 Agency Relationships Agency relationships exist when one party (the principal) depends on another party (the agent) to undertake legal action or make decisions. It is important to note that any employment relationship is an agency relationship. In this case, the hiring firm, or a human resources manger representing the owner’s interests, is referred to as the principal and the employee has the agent. Similar examples of agency relationships include powers of attorney, real estate agents and lawyers and many more. When in an agency relationship, the following are some of the problems that are bound to occur. In most cases, the principal and agent have divergent goals and interests. For large and publically traded corporations shareholders lack direct control and most agents may make decisions that result in the pursuit of goals that conflict with those of the principal. It also becomes difficult and expensive for the principal to confirm and verify whether agents behave appropriately. On the other hand, the agent falls prey to managerial opportunism. Advantages agency relationships This permits you to delegate authority to another person, the agent, and this allows you to be two places at the same time. Since your agent has authority to make legal decisions and contracts on your behalf, he can be your representative in many activities as you attend others. This particularly becomes useful when you hire an agent that has specialized in a particular subject and has more knowledge than you do. Classification of Agents They are classified according to the extent of work they undertake. These classes include; general agents who are of a company authorized by the principal to transact all affairs in a specific business; special agents are the third parties hired under an agreement by the principal to carry out a specific act or authorized by the principal to transact a well defined business affair. Therefore, an agency relationship is legally created through appointment or by principal's conduct authorization. Question 1b Agency costs These are internal costs that arise as a result of inefficiency relationship between an agent and a principal, or conflict of interest between shareholders and management. There are two types of costs linked with the agency problems, and they include direct agency costs and indirect agency costs. Direct agency costs are due to loss in shareholder wealth as a result of the managerial misconduct. The indirect agency costs are the costs incurred while avoiding the agency problem. These costs must be paid to an agent acting on behalf of the principal. Agency costs are inevitable inside an organization if the principals are not completely in charge. These can be reduced by providing suitable incentives to align both the interest of agents and principals. Question 2 Throughout history, the advent of economic crisis has fostered concern that a strict focus on shareholder interests can be destructive. Moreover, this has encouraged some to advocate a broader view of the goal of the firm that incorporates multiple stakeholders. For example, following the stock market crash of 1929 Dodd (1932) argued that if the corporation can be viewed as an entity that is separate from its shareholders (as is implied by court rulings that granted corporations constitutional protections similar to those guaranteed citizens), then that entity had citizenship responsibilities. Social responsibility refers to a corporate objective whereby business organizations are asked to consider the interests of society in their actions. They do this by taking responsibility for the impact of their activities on customers, suppliers, employees, shareholders, communities and the environment in all aspects of their operations. It distinguishes itself from the basic concept of good citizenship in that it asks businesses to go beyond its legal commitment to comply with the law and voluntarily take steps to improve the quality of life of their employees and their families, the local community and society at large. The social responsibility program is based on the notion that public corporations have the necessary discretion to sacrifice profits for the sake of social goals. These activities undertaken by firms in the guise of social responsibility most often lead to lower costs and improved profits are not acts of social conscious but simply good management practice. These practices are aimed at increasing acceptance and performance of the company. The economic argument for maximizing shareholder value rests on the belief that by adhering to this goal, the interests of society as a whole are maximized. According to the words of Adam Smith, every individual strives to use his capital to ensure that the produce are of great value. Also, he neither intends to promote the public interest, nor knows how much he is promoting it, for his objective is to be assured of his security. The business promotes the society interest as it strives to promote its own interest. The business corporation is organized and carried on primarily for the profit of shareholders. The operations of the management should be geared towards attainment of this objective. The discretion of management should be exercised such that the aims of the shareholders, as well as all stakeholders, are upheld (Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668; 1919).1 Therefore, operation within this margin means that the business remains relevant and is in a position of making and maximizing profit. In some instances, social responsibility has been legalized as a way of maximizing business operations acceptance in the society. For instance Minnesota passed a statute in 1987 that allowed firms to consider the interests of the corporation’s employees, customers, suppliers and creditors, the economy of the state and the nation, community and the society (Statute 302A.251 (5), (Supplement 1988). Pennsylvania leads all states with eight anti-takeover laws).2 Question 3 (a) Present Value (T0) =, and the Future value (T13) =, where C is the cash flow per period, i is the interest rate, and n is the number of payments.  = $ 736.01 This means that if one invested $ 100 every year for 10 annual cash flows and at 6% rate, the Present value (T0) today would be worth $ 736.01 The future value (T13) will be =this means that the total cash at the end of the series will be $ 1, 318.08 One year from today the present value (To) will be;  and the future value (T13) will be;  = $ 100.00 Four years from today the present value (To) will be; and the future value (T13) will be  Question 3 (b) (i). Monthly repayments can be calculated as  where, C is the monthly repayments, r is the rate, P is the amount borrowed (principal), and n is the total period. Therefore, monthly repayments ($ 5, 071.33 (ii). The balance to be paid out after the 36th month will be given as; , where A is the amount of mortgage, i monthly interest rate, P monthly repayments, n is the period, and B the payoff balance. Therefore, on the 36th month the payout figure will be $ 445, 623.70 (iii). The repayment period, N =  , where A, is the principal on 36th month ($ 445623.70), and p is $ 5, 071.33 -log (1 – 0.01*445623.68/5, 071.33)/ log (1 +0.01) = 17 years and 9 months Up to 36th month, period remaining was 12 years. Therefore, extra payment period is 17 years, 9 months – 12 years 5 years and 9 months. Question 4 i The monthly holding period returns (%) for Brisbane Broncos Limited (BBL) in the period starting 1 January 2010-31 December 2010 is given by 17.069 % Therefore for the Brisbane Broncos Limited (BBL) the % returns is 17.069%. The monthly holding period returns (%) for Foster’s Group Limited (FGL) in the period starting 1 January 2010-31 December 2010 is given by 11.84 % Therefore for the Foster’s Group Limited (FFGL) the % returns are 11.84 % The monthly holding period returns (%) for market (MKT) in the period starting 1 January 2010-31 December 2010 is given by Therefore for the Market (MKT) the % returns are 6.029% The graph showing % monthly returns holdings against time for the three companies Question 4 iii Average monthly holding period return  For BBL =  = 0.216032; therefore, the average monthly holdings for BBL is 0.2160. For FGL = 5.395823; therefore, the average monthly holdings for FGL is 5.3959. For MKT =  2845.701 Question 4 iii a). The annual holding period returns are; BBL is 482.40, FGL is 1219.81, MKT is 19530043. b). the standard deviation of the monthly holding period returns; BBL is 0.0889 FGL is 0.66588 MKT is 1411.242 Question 4 iv The risk/return graph is constructed by plotting the annual holdings returns from 4 iii, above against standard deviations. The standard deviation stands for the risk, while the annual holdings returns stands for the returns. Question 4 v I would invest in BBL because it has the lowest risk and the returns are almost risk free. This means that the potential for making losses in this investment are low. MKT has the highest return on the model but is the riskiest. This implies that it could also have high potential for making losses if the market trends changes. Therefore, BBL would be the best for one to invest in at a risk free rate of return. Factoring in the amount of risk one can take in any investment is important. In investment, risk refers to a chance that an investment’s actual return will deviate from the expected. This implies that one has the possibility of losing some, or even all, of the original investment. In statistics this is measured by standard deviations. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return. Question 4 vi Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return and is used in the pricing of risky securities. The expected rate return r is given by rf + βa (rm – rf ); whereby, Rf is the risk free rate, βa is the Beta of the security and rm is the expected market return. For BBL the expected rate return = 4.75% + 1.08 (5 – 4.75) = 4.75% + 1.08 × 0.25 = 5.02% For FGL the expected rate return = 4.75% + 0.84 (5 – 4.75) = 4.75% + 0.84 × 0.25 = 4.96% For MKT, both beta vales are combined and the expected rate return = 4.75% + 1.92(5 –4.75) = 4.75% + 1.92 × 0.25 = 5.23% Question 4 vii The Security Market Line (SML) is graphed by plotting the results from CAPM model against the risk (beta). The SML graph is shown below. The equation of the line above is Y (Expected return) = 0.25× (risk) + 4.75. The slope is 0.25, and it represents the market premium. Question ix The Capital Asset Pricing Model (CAPM) is unable to predict the past and the future, due to many assumptions (Kurschner, 2008), since it relies on making optimal investment decisions by considering returns over the next period (single period model). The model should only be based on forward-looking data such as, the expected rate of return and the expected beta. These cannot be estimated with precision and are therefore often historically based (Kurschner, 2008). Other assumptions do not comply with reality are the lack of free and instantly available information (information with efficiency), the exclusion of taxes and transaction costs. In reality a risk-free asset does not exist; even the government bonds, which play this role in the practical usage of the CAPM, actually contain risk as well (Kurschner, 2008). Question 5 (i) a). Incremental cash flows are cash flows that occur if and only if some definite event occurs or they are the positive and negative cash flows associated with a project. If a project is rejected by a firm they do not occur. Cash flow statement will include interest expenses because it is a negative cash flow associated with the project. b). $200,000 that was spent to rehabilitate the plant will not be included in the analysis because it is not an incremental cash flow instead it is a sunk cost, and whether or not the project is accepted or rejected this amount must be paid out. c). If another wine maker had expressed interest in leasing the wine production site for $10,000 a year, it would be incorporated into the analysis as an opportunity costs. Question 5 ii Depreciation schedule Year Depreciation. Allowance Depreciation Expense End-of-year Book value 1 33% $198000 $402000 2 45% $270000 $132000 3 15% $90000 $42000 4 7% $42000 $0 Cash flow projections Year 0 Year 1 Year 2 Year 3 Year 4 Unit price 4 4 4 4 Unit sales 200,000 200,000 200,000 200,000 Net investment outlay Price 500,000 Freight 40,000 Installation 60,000 Change in NWC 20,000 Operating cash flows Revenues 800,000 800,000 800,000 800,000 Operating cost (600,000) (600,000) (600,000) (600,000) Depreciation (198,000) (270,000) (90,000) (42,000) Other project effects (20,000) (20,000) (20,000) (20,000) Before – tax income (18,000) (90,000) 90,000 138,000 Tax @ 40% 48,000 Net income (18,000) (90,000) 90,000 90,000 Plus depreciation 198,000 270,000 90,000 42,000 Net operating cash flow 180,000 180,000 180,000 132,000 Salvage value 50,000 Salvage value tax 20,000 Recovery of NWC 20,000 Project net c/f 620,000 180,000 180,000 180,000 182,000 a. Net Present Value (NPV) Year Cash flow D.F (10%) NPV 0 $620,000 1 (620,000) 1 – 3 $180,000 2.4869 447,642 4 $182,000 0.6830 124306 (48,052) b. Internal Rate Of Return (IRR) IRR = Lower rate + NPV of lower rate * difference between rates Absolute sum Since NPV obtained above is negative, recalculate NPV of the project using a lower trial discounting rate in order to obtain a positive NPV. e.g. 5 % Year Cash flow D.F (5%) NPV 0 $620,000 1 (620,000) 1-3 $180,000 2.7232 490,176 4 $182,000 0.8227 149,731 19,907 Therefore: IRR = 0.05 + 19.907/ (19,907+48,052) × (0.1- 0.05) =0.05+ 19,907/67, 95*0.05 =6.47% c. Mirr ( Modified Internal Rate Of Return) Year CIFt(1+r)n-t 1 180,000(1+0.1)4-1=239,580 2 180,000(1+0.1)4-2=217,800 3 180,000(1+0.1)4-3=198,000 4 182,000(1+0.1)4-4=182,000 837,380 620,000=837,380/(1+MIRR)4 620,000(1+MIRR)4=837,380 (1+MIRR)4=1.35061 1+MIRR= 1.0780 MIRR=7.8% d. PBP (payback period) Year Cash flow Cumulative cash flow 1 180,000 180,000 2 180,000 360,000 3 180,000 540,000 4 182,000 722,000 PBP = Year before full recovery + Cash balance to pay back/Cash received the following year = 3+ (620,000-540,000)/182,000 = 3(80,000/182,000) = 3(40/91) years Conclusion Capital budgeting in investment appraisal is the planning process used to determine whether a firm’s long term investment is worth pursuing. To evaluate whether or not to invest in the project, the chief financial officer of Archer wineries used NPV, IRR, MIRR and payback period methods of project Question 5 (iii) Before the management decides to embark on a capital expenditure programme, it should clearly justify the project technically and financially. The justification should include the reasons for undertaking the project such as a replacement of an existing worn-out asset or modernization to keep business with the changing needs, and the economic considerations or commercial feasibility. In recording and reporting of the replacement project, capital sheet should be serialized and be maintained. It should have details of the project, including all expenditures and this should not be more than the sanctioned cost. In the replacement analysis, a decision is made whether to replace an existing asset with a new asset. It is important to provide the project’s net present value (NPV) with the cash flow timeline that follows. All companies make replacement decisions to determine when older and worn out assets should be replaced with new assets to continue normal operations. The analysis relating to replacements is the same as that for expansion projects; identify the relevant cash flows and then find the net present value of the project (Brigham, 2010). However, identifying the incremental cash flows associated with a replacement project is more complicated than for an expansion project because cash flows from the new asset and from the old asset must be considered. Determining the relevant cash flows for a replacement decision is more involved than for an expansion decision because we need to consider the fact that the cash flows associated with the replaced asset will not continue after the new asset is purchased (Brigham, 2010)-that is, the cash flows associated with the new asset will take the place of cash flows associated with the old asset. Increase or decrease (changes) in cash flows that result from the replacement of the older asset need to be computed in order to evaluate how the acceptance of a capital budgeting project changes cash flow (Banerjee, 2008). Initial investment outlay includes the cash flows associated with the cost of the new project, and the change in net working capital (Brigham, 2010). When replacement project is initialized, the components of the old project are sold resulting to net cash flow from the sale of old asset to another firm. If the firm disposes of the older asset at a value different from its book value, its purchase price less accumulated depreciation, thus there is tax effect. Also the disposal of the old asset will generate a positive cash flow, thus reducing the amount of cash required to purchase the new asset, and thus the initial investment outlay. Therefore, any cash flows associated with disposing of the old asset must be included in the computation of the initial investment because they affect the net amount of cash required to purchase the asset. Then there is incremental operating cash flows, is determined by evaluating the change in cash flows with the acquisition of the new asset for the replacement project (Banerjee, 2008). This will result to less cash will have to be spent to operate the new machine. The replacement will result in an increase in sales in addition to the reduction in costs (Banerjee, 2008). If the annual savings changes over time, this should be built into the cash flow analysis. Also, the depreciation of the new machine will be used for the taxation purposes. In the replacement analysis, we compare two mutually exclusive projects; the expansion and replacement projects. Question 5 iv The project’s cash flow estimates are nominal because it grows at the compound product of the actual rate of inflation and the real rate of growth. Nominal discount rates are the compounded product of inflation and real return (Bruner, 2004). This valuation approach is the prevalent valuation method within global corporations. The 10% cost of capital reflects a real rate which is the actual economic activity, apart from illusions created by price changes. This is often considered as the “zero inflation” approach (Bruner, 2004). Question 5 v The project S NPV is $ 8, 264.46 and for the project L it is $12, 380.98. This is shown in the table below; Project S Project L The payback period 2 3 NPV 8, 264.46 12, 380.98 No. this is because one cannot use one tool (NPV) only to make a decision. To be able to make a decision one should look at the payback period. According to payback period, project S should be accepted. However, the NPV for project L indicates that if accepted the shareholders will maximize their wealth. References D. Andrew, T. A. (2007). Financial Management; Principles and Practice. United state of America: Freeload press. Banerjee, B. (2008). Fundamentals of Financial Management. Asoke K Gosh: New Delhi. Brigham, B. A. (2010). CFIN Student Edition. Mason Ohio: Joe Sabatino. Bruner, R. F. (2004). Applied Mergers and Acquisitions. New Jersey: John Wiley and Sons., Inc. Kurschner, M. (2008). Limitations of the Capital Asset Pricing Model (CAPM): Criticism and New. Norderstedt, Germany: Druk und Bindung. Read More