Tutorial 1 Answers PDF

Tutorial 1 Questions 1. What is corporate finance? What are some of the key questions that need to be answered in corporate finance? Corporate finance is the branch of finance that is focused on issues of financing, capital structuring, and investment decisions of the company. With the...

Tutorial 1 Questions 1. What is corporate finance? What are some of the key questions that need to be answered in corporate finance? Corporate finance is the branch of finance that is focused on issues of financing, capital structuring, and investment decisions of the company. With the ultimate purpose of maximizing shareholder value, corporate financiers actively develop and implement short- and long-term strategies that are a combination of various disciplines including but not limited to finance, economics, marketing, and management. Specifically, corporate finance seeks to answer questions such as “What investments should a firm make?”, “What is the best source of financing for these investments?”, and “What is the role of the management team in managing the financial activities of the firm?”. To answer these questions, the finance manager or CFO will have to have a good understanding of how his/her firm operates at all levels – from the frontline to the board of directors – and changes at each level will affect the firm’s performance. 2. What is the role of finance manager? What are some of the key issues finance managers face in performing their role? The finance manager’s primary role is to serve as the bridge between the company and the wider (financial) markets. In performing this role, s/he will have to develop strategies for the achievement of the organizational goals in line with its agreed policy framework; recommend strategies for the management of the financial resources of the organization to ensure that they are utilized in an efficient, effective and transparent way, and to advise the BOD / management in setting the financial goals of the business as well as financial policy development. In performing this role, the finance manager has to contend/deal with a number of issues including optimal investment selection and capital allocation, distribution (i.e. dividend) and retention policy, and risk (financial & non-financial) management. 3. What are the agency problems? Explain (with examples) the 3 parties to the agency problem and how each party is related to the other. The agency problem refers to the conflict of interest that exists in any relationship where one party is expected to act in the best interests of the other party or parties. In corporate finance, agency problems normally refer to conflict of interest between the management, shareholders, and bondholders. Between Management & Shareholders Because managers are often remunerated based on company performance, managers may be tempted to make reckless investment decisions that can generate quick profits which can be reported in the shortest time possible (preferably within a year) so that the positive outcomes will be reflected in their performance appraisals and bonuses. Since shareholders do not have access to managerial decisions, they may unknowingly assume that the managers have performed well and reward them accordingly. However, because the investments were not properly appraised, its short-term performance may fizzle out quickly and soon cost more to maintain than whatever amount of income it generates for the firm. When that time comes, the manager(s) responsible may have already left the firm, leaving it in a lurch which ultimately destroys firm value. Between Controlling Shareholders & Minority Shareholders Normally, the interests of both shareholder groups are aligned i.e. they are seeking capital appreciation and positive returns. However, controlling shareholders – sometimes known as blockholders – are often high net-worth individuals or large investment institutions such as the Ministry of Finance, Khazanah Nasional or Permodalan Nasional Berhad. As a result, blockholders have the ability to influence and place pressure on the board of directors or top management teams to make inefficient decisions. This is often done in the form of appointing the blockholder’s favoured candidate as directors or top managers (i.e. cronyism, nepotism). Other forms of inefficient decisions may also be made such as unnecessary capital expenditure on dead projects, loans to struggling companies owned by the blockholder, or even money laundering. Blockholders can also unfairly overrule minority shareholders during the AGM to pass/reject any motions that potentially jeopardise their influence in the company. Between Shareholders & Bondholders The position of shareholders and bondholders reflect the order of priority between equity and debt in the event of liquidation. If a company is liquidated, its creditors (i.e. debt) have first claim over the company’s (sale of) assets to settle the debts owed. Only after all creditors are paid will the owners (i.e. equity) be paid. In a large corporation, the shareholders play the role of equity/owners while bondholders are the creditors/debt. During an economic downturn, company performance will suffer, reducing the amount of cash it has to pay for all its obligations. However, if the company is highly leveraged (i.e. high debt), its debt expenses will consume most of its free cash available, resulting in liquidity problems. In this situation, the bondholders are unaffected because they have to be paid, regardless of the company’s performance. Shareholders, meanwhile, may feel short-changed as they are already experiencing negative returns and now face the possibility of no payouts due to insufficient cash. 4. Explain some of the measures that can be taken to reduce agency problems in a firm. Firstly, internal control systems should be in place to ensure that important financial decisions are not made only by one person. For example, some companies prohibit the CEO/CFO from signing cheques above a certain amount and will require the approval of one or more senior officers before the cheque can be issued. Secondly, good management practices and compliance with a Corporate Governance code should be enforced. For example, various industry practitioners and studies have recommended that the position of Chairperson of the Board and the CEO or any other influential position should not be held by the same person to avoid a concentration of power that can overrule other directors / senior officers of the company. This is so that every significant decision is made in the best interest of the firm, and not the individual. Thirdly, the appointment of independent non-executive directors ensures that the interests of the shareholders are taken care of as they play a monitoring role in the operations of the firm. That is, they are neutral third parties that have access to the decisions made in the board of directors and can ensure that the decisions made are beneficial to shareholders. They also ensure that the audits performed by internal and/or external auditors are fair and transparent and can hold the board/management accountable if there are any discrepancies. 5. Are zero agency problems/costs possible? Why/why not? How about in a sole proprietorship? Unfortunately, despite the best internal control systems and governance mechanisms in place, agency problems still exist due to human factors. Greedy, and power-hungry individuals always find a way to circumvent rules and regulations directly or indirectly to benefit themselves at the expense of others. Even if the organization was a sole proprietorship where the owner and manager of the business is the same person, agency problems may still exist. For example, should s/he use the profits for themselves (e.g. shopping, holidays) or for business (e.g. expansion, investment, inventory)? 6. What is Fintech? How will it affect the role of the finance manager? Fintech or financial technology is the use of technology to innovate and improve existing financial products / services or to create new financial products / services. Fintech opens a variety of opportunities and alternatives for the finance manager to consider, especially in answering the question of what sources of financing is best for the firm. Responsible finance managers should actively pay attention to and educate themselves on the possibilities Fintech offers so that they may formulate the most efficient and profitable strategy for the firm. Problems Problem 1 Brealy, Myers, Allen Chapter 1, Q5 In most large corporations, ownership and management are separated (separation of duty). Why is this separation necessary? What are the main implications of this separation? The separation of ownership and management in large corporations is necessary simply because too many cooks spoil the soup. In a modern corporation, there can be thousands of owners (i.e. shareholders). If each of them wishes to actively manage (or interfere!) in the operations of the company, the company may soon go bankrupt as there is no cohesion and strategic direction for the company the employees to follow. By keeping shareholders out of the managing of the business, the company is able to recruit highly qualified individuals to run the business on behalf of the shareholders so as to maximise value for them. Separating ownership and management, however, introduces agency problems, where managers prefer to consume private perks or make other decisions for their private benefit—rather than maximize shareholder wealth. To overcome this possibility, shareholders can appoint a representative i.e. a director to the board who indirectly oversees the operations of the business on behalf of the shareholders and reports to them periodically. Problem 2 Brealy, Myers, Allen Chapter 1, Q12 Why might one expect managers to act in shareholders’ interest? Give some reasons Managers would act in shareholders’ interests because they have a legal duty to act in their interests. Managers may also receive compensation, either bonuses or stock and option payouts whose value is tied (roughly) to firm performance. Managers may fear personal reputational damage that would result from not acting in shareholders’ interests. And managers can be fired by the board of directors, which in turn is elected by shareholders. If managers still fail to act in shareholders’ interests, shareholders may sell their shares, lowering the stock price and potentially creating the possibility of a takeover, which can again lead to changes in the board of directors and senior management.