financial management notes narain

7/30/2019 Financial management notes narain

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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

benefits, [email protected]


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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 goalsThe 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 is-

A. Market Forces

B. Agency [email protected]


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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 [email protected]


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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 [email protected]


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B: Agency Costs

Incurred to respond to potential market

forces by preventing or minimising agency

problems and contributing to themaximisation ofowners wealth

[email protected]


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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 [email protected]


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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 market2. Performance Plans-

a. Cash bonuses

b. Performance [email protected]


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Capital Budgeting

DecisionsAccepting projects that yields a return higher

than the hurdle rate

[email protected]


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Capital Budgeting Decisions

Capital budgeting decisions relate to selection ofa long-term asset or investment proposal orcourse of action that generally involves use of

funds today but generate regular andrecurring benefits in future.

Benefit may be in the form of increased revenue orreduced cost

Capital budgeting decisions could relate to: Additions

Modifications

Replacements

Disposals


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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 predeterminedamount, rate or time period

3. Make a choice


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Assumptions in Capital Budgeting

1. All cash flows take place at the end of the timeperiod

2. No change in the risk i.e. size and timing of cash flow

are known with certainty3. Perfect capital markets

4. Projects are infinitely divisible but exhibit decreasingreturn to scale

5. Cash flows are in independent of each other overtimeand other investment decisions

6. Rational decision parties

7. It is a well-behaved project or conventional cash flow

projects


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Problems involved in Capital Budgeting

1. Estimating future costs both initialand operating

2. Forecasting of benefits3. Determination of cost of capital or

required rate of return

4. Treatment of time element

economiclife of project

5. Treatment of risk element

financial management notes narain

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