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Corporate Finance: Principles Of Corporate Finance Add in library

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Question:

Describe about the Principles of Corporate Finance?

 

Answer:

Conflict between management’s goals and maximizing shareholders wealth

Shareholders are the owners of the company by buying the shares. The profits of the company are distributed among the shareholders according to proportion of holding the shares. The managers of the company engage in maximizing the wealth of the company. But, shareholders are interested in increasing the stock price of the company (Brealey, Myers and Allen, 2009). The rising of stock price, the value of the company increases.  As well as, net worth of shareholders can increase. The conflict arises between the shareholders and managers for the different objectives (Brealey, Myers and Marcus, 2009). It is also denoted as agency problem.

It can be thought by the people that the managers own the company. It may be true for small scale business organization. The owner of small business firm is one and he also may act as a manager. But, in a big business organization, there are various levels of management and employees. They are not the owners of the company in actual. In general, the profits are not distributed to the managers of the organization except their salaries. If they hold the share of the company, the profits are distributed. Sometimes company provides bonus share or share at discount price to the employees.

The managers of the company are controlled and regulated by Board of Directors. The numbers of shareholders in large organization are so high may be 100, 1000 or more. It is not possible to involve actively by the all shareholders in management. So, the responsibility and authority are delegated to the managers. Managers are called agents of the company. They have the managerial ability to run the business with their own interest except of the best interest of the organization. This is because of asymmetric information between managers and shareholders (McGuigan et al., 2009). Managers have the better knowledge than the owners of the company whether they are able to meet the objectives of owners. Another reason of agency problem is uncertainty. There are large numbers of factors which has impact on the contribution to final outcomes and there are no direct evident that agent has positive and negative impact on the given outcome.  Evidence regarding the own interest of managerial behavior involves the utilization of corporate assets in such way which may create extra benefit avoiding the optimal position of risk. Some managers who like avoid the risk can diverse from the profitable opportunities where the owners may have the interest to invest. It is recognized by the external investors that company will take decision opposite to interest of them.

Managers may be motivated and pressurized to act as the interest of the owners through incentives, hard rules & regulation and punishment. These can be applied effectively if the shareholders do observation all actions of the managers. The moral hazard problem is that it is difficult to monitor and control all the actions of the managers by the shareholders and agency cost is incurred to reduce that problem (Parrino and Kidwell, 2009).        

There are two major actions through which the agency problem can be mitigated. It can be mitigated by compensating the managers of the organization on the basis of changes in stock price. By applying this action, agency can be decreased because the managers get attracted through incentives for maximizing the shareholders’ wealth. But, it is difficult for hiring the talented managers under this condition because the earnings of the firm depend on the economic events which are not under control of management. The second action is to control and monitor the managerial actions. But it is very costly and inefficient. To overcome the above situations, the followings steps can be taken to motivate the managers to operate the business according to the interest o shareholders:

1. Providing incentive to the managers according to their performance.

2. Making direct intervention and interaction by the shareholders with the managers.

Fearing of getting fired. The threat of getting fired can encourage the managers to act.

Fearing of takeover can also encourage the managers.

There are two employees Loren and Dale who work in Sports Product Ltd. They work in the shipping department. One day, at the time of lunch break, they started to discuss regarding the company. According Dale, the share price of the company had decreased over last few months though he had worked efficiently without wasting materials of packaging. She was also frustrated because the profits of the firm had been increasing. Then Loren said to her regarding the profit distribution plan of the company. The company distributed its profits partially to the manager for compensation. She told that the profit may also important to the management. According to Dale, it had no sense as the shareholders own the company. So, this case describes the agency problem in well. The company is distributing its profits to the managers without paying any dividend. Therefore, the managers should encourage for the interest of shareholders to raise the stock price.

 

Evaluation of Companies

AGL Energy Ltd.

AGL Energy is an Australian company of energy supplier. It provides gas and electricity service to larger than 6 million in Australia. AGL is making great effort to become a renowned integrated company of energy in the world investing majorly in supply of gas and electricity. The company is listed in Australian Security Exchange. The code is AGK. It is also an S&P/ASX 50 company which has market capitalization of A$5.2 billion. It is operating for 170 years in Australia.

AGK has faced several challenges in past few years. The demand of the electricity has also decreases and there is tough completion in energy retail sector. The company has faced with bad weather effects and poor regulatory outcomes on pricing of energy. These have created impact on the earnings and stock price of AGK. The company fell under pressure regarding its earnings and share price. Though the company is facing with several risks and challenges, it is noted some improvement of trading environment. But, it is not enough for trading. The report of FY 2015 also describe that growth is in difficult situation. The current share price is near A$15.00 which comes under tiny stock. So, it is not better for the current investment. But, it is expected that the price would improve in future.

Atlas Iron Ltd.

Atlas is an iron ore company in Australia. It is an independent company in mining and exporting Direct Shipping Ore. It operates in the region of Northern Pilbara in Australia (Western). It is listed in Australian Security Exchange from 2004. The company is growing rapidly in terms of iron ore mining.

The market performance of Atlas Iron Ltd is not good. The current price of share is very low i.e. A$0.16. There is expectation of raising its price from the past analysis. The price of share is declining over the period. According to the report of 2014, the paid dividend was A$0.02. It has decreased 33.33% from the last year. It is expected that the company may not able to pay any dividend in upcoming financial year. The EPS was also very low in last year and the growth is more negative. The profitability position of the company is not also good. So, it is not better both for current and future investment because the share is underperforming.

Amp Ltd.

Amp Ltd. provides financial services in Australia and New Zealand. In current scenario, it is a leading company of wealth management (Ngoc Huy, 2013). The company is operating it services from than 160 years. The present customers of the company are more than 4 million. It provides various financial services such as financial advice, income plan for retirement and other investment products for individuals, etc.

From the past history, it is expected that the share price may grow. The price has grown 30% from the last year. The company has paid dividend of A$0.26 in 2014 which has increased 13% from the last year and it is expected that it would pay dividend of A$0.29 in upcoming year. The average EPS growth rate is positive. It is the better option to buy the share of Amp Ltd. and should hold it for future gain.

 

References  

Books:

Brealey, R., Myers, S. and Allen, F. (2009). Principles of corporate finance. Boston: McGraw-Hill Irwin.

Brealey, R., Myers, S. and Marcus, A. (2009). Fundamentals of corporate finance. Boston: McGraw-Hill Irwin.

McGuigan, J., Kretlow, W., Moyer, R. and McGuigan, J. (2009). Contemporary corporate finance. [Mason, Ohio]: South-Western.              

Parrino, R. and Kidwell, D. (2009). Fundamentals of corporate finance. Hoboken, NJ: John Wiley & Sons.  

Journal:

Faff, R. and Mittoo, U. (n.d.). Capital Market Integration and Industrial Structure: The Case of Australia, Canada and The United States. SSRN Journal.

Ngoc Huy, D. (2013). The Volatility of Market Risk In Viet Nam Listed Banking, Insurance and Financial Services Company Groups after the Financial Crisis

2009-2011. Journal of Risk Analysis and Crisis Response, 3(3), p.127.

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