Agency Theory and Dividend Policy Quiz

Agency Theory

• Explores principal-agent relationships, focusing on conflicts of interest when a principal delegates work to an agent.
• Key issues include information asymmetry and ensuring agents act in principals' best interest.
• Eisenhardt emphasizes balancing outcome-based incentives with behavior-based monitoring to mitigate agency problems, considering the costs and benefits of each.
• Integrates economic, organizational, and sociological perspectives to understand how contracts and governance mechanisms shape relationships.
• Aligning goals and reducing information asymmetry are crucial for effective organizational structures and incentives.

Dividend Policy

• Defines how firms distribute profits to shareholders, with three typical policies: Residual, Stable, and Hybrid.
• Residual Policy: Dividends paid only after funding investments; promotes growth, but unpredictable payouts deter income-focused investors.
• Stable Policy: Consistent or gradually increasing dividends; attracts long-term investors, but potentially strains finances during low earnings.
• Hybrid Policy: Maintains a baseline dividend with occasional extras during profitable periods; offers stability and flexibility, but needs careful management to meet shareholder expectations.

Time Value of Money (TVM)

• A dollar today is worth more than a dollar in the future due to its earning potential.
• Uses present value (PV) and future value (FV) calculations to assess investments, loans, savings.
• PV of future cash flows evaluates project viability.
• FV calculations show investment growth with compound interest.
• Applicable to comparing investments, planning retirement, or structuring loan repayments.

Capital Markets

• Financial systems where individuals, institutions, and governments trade securities (stocks, bonds) to raise or invest capital.
• Primary Markets: New securities sold directly to investors (IPOs).
• Secondary Markets: Existing securities traded among investors (stock exchanges).
• Fund flow from investors seeking returns to entities needing funds for growth.
• Efficient capital markets allocate resources effectively.

Financial Ratio Analysis

• Evaluates company performance and health by comparing key metrics across liquidity, profitability, leverage, and efficiency.
• Ratios like the current ratio assess short-term solvency, while ROE measures profitability.
• Identifies trends, industry benchmarks, supports decision-making.
• Pros: Simplicity, versatility, insights into operational strengths/weaknesses.
• Cons: Reliance on historical data, potential for misleading results, lack of context without industry/temporal comparisons.

Risk and Return

• Higher potential returns typically require acceptance of greater risk.
• Earnings Volatility Determinants: firm's revenue variability, operating leverage, and financial leverage.
• Risk categorized into systematic (market-wide, cannot be diversified) and unsystematic (firm-specific, can be diversified).
• Understanding these concepts balances risk tolerance with optimal returns.

Capital Budgeting Techniques

• Evaluates investment projects to maximize value using four techniques.
• Net Present Value (NPV): Measures added value—positive NPV favored.
• Internal Rate of Return (IRR): Discount rate where NPV=0; prioritizes projects above required return.
• Payback Period: How quickly investment is recovered (focuses on liquidity, ignores long-term gains).
• Profitability Index (PI): Ratio of inflows to outflows, useful for constrained budgets.
• Ranking challenges include size, time, unequal life, and complex decision-making.

Financial Statements

• Income Statement: Profitability over time (revenues, expenses, net income).
• Balance Sheet: Financial position at a point in time (assets, liabilities, equity).
• Cash Flow Statement: Cash inflows/outflows (operating, investing, financing activities)—liquidity.
• Statement of Shareholders' Equity: Changes in equity (retained earnings, stock).

Ratio Analysis based on Financial Statements

• Uses financial statement data to evaluate company performance and health.
• Liquidity, profitability, and leverage ratios provide insights.
• Comparing ratios over time or against industry benchmarks helps identify strengths/weaknesses.

Expected Returns and Portfolios

• Expected return is the weighted average of possible returns.
• Standard deviation measures return volatility.
• Portfolio expected return: weighted average of individual stock expected returns.
• Portfolio standard deviation considers individual volatilities and correlations; diversification can reduce overall risk.

Bond Valuation

• Calculates the present value of future bond cash flows (coupon payments, face value).
• Bond price is sum of discounted cash flows.
• Discount rate reflects required return or market interest rate.
• Higher coupon rate than market rate = premium; lower coupon rate = discount.

Stock Valuation (with Dividends)

• Determines intrinsic value based on future cash flows (dividends, growth).
• Dividend Discount Model (DDM): Stock value as the present value of expected future dividends, discounted at a required rate of return.
• Accounts for constant growth in dividends if applicable.
• Aids in assessing whether stocks are overvalued, undervalued, or fairly priced.

This quiz covers the fundamental concepts of Agency Theory, exploring principal-agent relationships and how conflicts of interest arise when delegating tasks. It also examines different Dividend Policies such as Residual, Stable, and Hybrid, and their implications for firms and investors. Test your knowledge on how these theories impact organizational structures and profit distribution.