Critically evaluate and analyse the differing ways in which the shareholders of a company can encourage its managers to act in a way that is consistent with the objective of maximization of shareholder wealth.
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In this section students should demonstrate knowledge, understanding, and an ability to critically evaluate the importance of agency theory, and the role it plays within financial management. The response should draw upon the differing techniques that can be used by shareholders to reduce the agency problem that is faced within many businesses. A critical evaluation of relevant academic literature should be performed, providing clear evidence of wider reading within this topical area of research, rather than simply describing the core concepts. Attempting to evaluate within the context of real-life examples where shareholders have actively attempted to address agency problems would assist in developing the depth of response offered.
In practice financial managers use a variety of differing investment appraisal techniques upon assessing the viability of potential capital investment projects. Critically compare and contrast two investment appraisal techniques, one of which must be a discounted cash flow technique that would assist within the financial management decision-making process.
In this section students should demonstrate knowledge and understanding of two investment appraisal techniques used by financial managers, how they can inform future projects, what limits their ability to guide investment, and which technique you would prefer (with reasons). The response should demonstrate evidence of wider reading and application of the chosen techniques within a real-life business context, supported through relevant empirical research. Real-life examples can be drawn from differing countries, industries and individual businesses, clearly identifying whether the investment appraisal techniques chosen are applied in practice. The inclusion of relevant numerical examples to develop the response further would be advantageous although should not form the main thrust of the work.
Shareholders are the owners of the company. They contributed a significant part of the capital by which a company can operate its business. They take all the risks associated with the company. So it is the duty of the company to provide them adequate rewards. On the other hand investors can only willing to invest in a company’s share from which he can able to get a good return. The following study is based on these two objectives where it is shown how the wealth maximization goal is achieved and how the project appraisal techniques can be used to evaluate the returns of the shareholders (Shim, Siegel and Dauber 2008).
Wealth maximization is an important term used in financial management. The term wealth means the value of the shareholders, so its does not only consider the profit earned by the company. We know shareholders are the owner of the company and they get dividends at the end of the year depending on the performance and profit of the company. The problem is that the profit which have earned today by the company have no certainty that it will be earn tomorrow also so the main concern of the shareholder is always to maximize the value of his share so that he is able to sell his share and will have a capital gain. This process is called wealth maximization. It can be better described by a simple example. Say a shareholder purchased a share of company at $ 4 in 2006 and was getting continuous dividend. In the year 2015 the value of that share rise to $18 and the shareholder sell the share at that price. So he will have a capital gain of $ 14 which arises because of his wealth maximizes from $ 4 to $ 14. Wealth maximization occurs when shareholders have confidence about the rising of the price of the shares (Welch, 2010).
As per the entity concept of accounting it is said that the company and its owner have separate legal entity (Heracleous and Lan, 2011). It was also decided in a famous case study Salamon Vs Salamon Co that the existence of Salamon Company as a sole trader and later as a partnership business is separate. So in case of company also the entity of managers and owners are separate and from this relationship between owner and manager the agency theory is evolved (Agency Theory, Information, and Incentives, 2015). This theory says that the relationship between managers and owners is like the principal and agent and as per the law an agent means ‘a person used to affect a contract between their principal and a third party. This theory is based on the following assumptions (Forbes-Pitt, 2011) -
- In agency relationship persons have rational behavior and they are always willing to maximize their personal utility. This implies that the persons are only concerned about how their individual goal can be satisfied.
- The utility gaining by the principal for providing services, information is same as or equal to the utility achieved by the agents in receiving benefits.
- The company creates a link between contracts and the activities must be conducted as per of those contracts.
Problems with the agency theory
The agency theory has several problems which are discussed as follows-
- In this theory the main importance is given on the individual interest by ignoring the collective interest (Brammer, 2005).
- As we know that an organization should have such objectives which will help it to achieving the organizational goals. For this purpose all the parties in the organization must have proper communication and same level of interest. In practical situation it is often observed that the interest of these two parties namely management and owner are separate. Management are only concentrating in decision making activities which may increase their profit but they may be less bothered about the wealth maximization goal as they have no share in dividends (Levante, 2007).
- Again the problem can arise when the risk taking attitude of the parties are different. The owners might have an opinion that the company should invest in high risky project in order to get higher return but the management may reluctant to do so as they will be accountable for taking extra risk and with the addition they will not get any reward for this. On the other hand owner can prefer debt financing as it will increase their return but management may not agree with this decision as this will increase their fixed financial obligations (Dickinson and Villeval, 2008).
Techniques for resolving agency problems
For resolving agency problems mentioned above several techniques are suggested. One of the most important techniques among this is the effective corporate governance. Hermes, an institutional fund manager had developed 12 principles which can be applied to any company for reconcile the profit maximization and wealth maximization objectives (Jiraporn et al., 2008) ; (Yahanpath and Joseph, 2011).
- Transparency and Communication
Each and every company should disclose accurate and timely information to all its parties, owners and management so that any miscommunication between these parties can be avoided. Feedback from all the concerned parties is equally acceptable.
A strong internal culture should be established which will help in value creation of the members. Here the employees can be trained to get accustomed with the organization and arrangements can be made for delegating responsibilities and evaluation of the performance should be made (Chuang, 2014).
The company should developed effective corporate strategies for each of their business units and by keeping in mind their target customers.
The company should maximize its sustainable operating performance which is in their existing business. A proper acquisition should be incorporated before some new acquisition decisions can be taken.
All companies should ensure that the investment plans must passed through feasibility studies and only that kind of investments are given preference which maximizes the long term wealth of the shareholders.
When a company is taking a long project for long term benefit of the shareholders then it is obvious that the management should have assessed the risk properly. The Board of Directors must have effective risk management tools.
The company should have a capital structure which will reduce the long term cost of capital. Debt financing is cheaper than the equity financing but involves higher obligations so it is the decision which can be taken on the basis of the financial ability of the company. If the capital structure is not as per the requirements then it should be reconsidered.
- Environment, Stakeholders and Social issues
Company should build effective relationship with all the parties who have an interest on the company like suppliers, customers, government, employees etc.
For long term sustainability of the business the company should manage the environmental and social factors which give an impact on the business. A business is the part of the large society so it is the primary responsibility of a company to do some betterment for the society.
A company has a large number of shareholders. Though they are the owner of the company but it is not possible for all of them to participate in the management of the organization so a Board of directors is nominated by them who manage the affairs of the business but when the company is taking some decisions for restructuring of capital structure or acquisition etc teen it must allow the shareholders before taking the decisions.
The Board of Directors should guide the company with diverse range of competencies, experience and enable the company to carry its duties, responsibilities. Sometimes there are different approaches are used, a proper explanation for that should be given by the management to its shareholders.
The company should design its remuneration structure and remuneration policies adequately and implement those timely.
Real life examples on agency problems
Barclays bank plc
In this company the main conflict arises between the management and the shareholders because
- The company declared a £ 2.4 billion bonus shares in spite of 34% fall in profit.
- The company plan to cut 12000 jobs in year 2014.
- Management makes an argument with the shareholders that the bonus increase is necessary.
- The shareholders are afraid about this bonus issue because the company had a poor financial history.
This company has also faces some agency problem recently which affects their value of the shares (Hargreaves Lansdown, 2015).
- Tesco’s market share fall from 29.9% to 29.1% in 2014.
- In late 2014 Tesco admitted that they were making a misstatement of their profits by £263 million as a result of which the shareholders get disappointed.
- The company failed to give information to the suppliers timely and they were cancelling their deals.
- While the investigation is going on eight executives were suspended with pay and the cost of the company increased.
- The share price again falls by 44% and the shareholders wealth getting affected very badly.
- They closed down their 43 shops and thousands of job cut occurred.
But the shareholders do not lose their hopes fully. They again began to start believing the company and it is reflected by the recent share price movements as it is again started to increase.
Contrast and Comparison between Payback period and Net present value
Net present value and Payback period
A contrast and comparison of the discounted cash flow technique and another technique of investment appraisal has been made. The discounted cash flow technique that has been used for the study is the net present value. The other cash flow technique that has been used for the study is the payback period (Bragg, 2011).
The discounted cash flow technique is one of the investment appraisal techniques that evaluate the attractiveness of the investment opportunity. The future free cash flow projections are analyzed in the technique of discounted cash flow and they are discounted in order to arrive at the present value (Connor, 2006). This is done for the evaluation of the potential investment opportunity. On analysis of the projects via the discounted cash flow technique the value of the project where the DCF analysis is higher than the current cost of the investment is chosen.
Net present value calculation is one of the major discounted cash flow techniques. It calculates the sum of the present value of the cash flows. The inflows and the outflows of the project are discounted at the present value. The process of calculation of the net present value is a very simple technique and it is straight forward in nature (Goel, 2015).
On the other hand payback period is one of the capital budgeting techniques that refers to the time period that is required to recoup the funds that has been invested. This is necessary technique to achieve the breakeven point. However, the payback period does not take into consideration the time value of money (Heysel and Filion, 2014).
Dissimilarities between the net present value technique and payback period
The net present value method is a dynamic technique of investment appraisal. It is a discounted cash flow technique. The technique is calculated using the technique of time value of money. The profitability from the project will be assessed on calculation of the return from the capital that has been invested. It is achieved under the assumption of the discount rate. The investment proposals whose net present value is zero will have the same return as that of the alternative investment. The investment with net present value greater than zero than the alternative techniques of investment will achieve an increase in the capital. The investment with net present value less than zero will have worse return than the alternative techniques of investment and the investment may not be able to achieve the capital expenses. The net present value method is considered as a process for the assessment of the investment techniques. It is also used as a tool for the assessment of the investment technique by comparing it with the alternative techniques. The capital value can be interpreted in terms of monetary units by using the net present value technique (Holland and Torregrosa, 2008). The major advantage of this method is that it uses the discounted rates.
On the other hand the payback period can be considered as the static investment appraisal method. The period is determined that is required to get back the capital that has been invested. This is achieved via the repayments. The investment that has the shortest period of pack back is considered as the best investment decision and it is the most advantageous decision. The payback decision is an important technique for comparison between the various alternatives. The comparison between the various alternatives can be done using the technique of payback period. The absolute risk from the investment can be determined by using the technique of payback period (Kalyebara and Islam, 2013). There are large organizations where there is specific target that is set for the investment to get recouped. The payback period can be calculated using the average method or it can be calculated using the cumulative method. However the investment decision entirely on the basis of the payback period can lead to results that are misleading in nature. The cash flows that are considered during the amortization period are considered in the calculation of the payback period. Thus there are various discrepancies associated with the technique of payback period. Thus it must not be considered as the sole technique for the calculation of the payback period (Kimmel, Weygandt and Kieso, 2011).
Limitation of the Net present value and Payback period technique
The net present value technique takes into consideration, the cash flows which are both positive and negative for conducting the project at present and in the future. The future cash flows that will be generated are discounted in order to reflect that the future inflows of cash are worth for the present day. The future cash flows are adjusted using the discount rate that takes into consideration the inflation rate. The cost of capital is taken into consideration. The present values of the cash flows that are negative and positive in nature are added to calculate the net present value. The project will be accepted when the net present value is positive while it is rejected when the net present value is negative. While making decisions between various projects, the project with high net present value is selected (McSweeney, 2006).
The payback period does not taken into consideration the inflation rate and the cost of capital. The purchasing power of money declines with time. This is not considered by the payback period. On the other hand the major drawback of the net present value method is that it is based on assumptions. The estimation of the discount rate is based on assumptions. Thus the calculation may not be accurate.
The analysis of the investment decision using the net present value technique is accurate than the payback period. Thus it is more feasible technique than the payback period (Naumov, 2013).
Practical examples of application of net present value and payback period
Net present value
In the year 2012, Kotak Mahindra Bank had acquired the non performing portfolio of the Barclays bank in India. The credit card business was acquired by the organization. The decision taken by Kotak Mahindra Bank to acquire the assets of Barclays Bank was a result of analysis of the profitability from the project. In such situation, the discounted cash flow technique plays a major role. The portfolio that has been acquired by Kotak has an estimation of around Rs 300 crore and the acquisition is of 200,000 cards. The present value of the inflow over the years has been considered. The outflows that will occur as a result of this acquisition have been taken into consideration. The three possibilities that can arise as a result of the investment decision have been discussed. The three possibilities can be either zero, positive or negative. The acquisition has been possible as it has produced positive results. If the present value of the inflow of cash is less than the present value of the outflow of cash then the project would have been rejected (Park, 2013).
Another example can be cited to show the application of net present value.
Fine Electonics Company is considering purchasing equipment that will be attached with the main manufacturing machine of the company. The cost of the equipment will be $6000 and there will be an increase in the annual cash flow by $2200. The life of the project will be 6 years. However the machine will have no salvage value. A 20% return on the investments in expected. The net present value of the investment project has been computed. The feasibility of the investment decision has been analyzed.
Amount of cash flow
20% cost of capital
Present value of the cash inflow
Annual inflow of cash
Net present value
Since in this case the net present value is $1317, the project will be accepted.
Payback period for different projects can be analyzed for the selection of the project which will give the highest return. For example, among two projects B and C that have identical inflow of cash, the project C is considered as the cash inflow from this project is $60,000. The project C is able to recoup the invested capital within shorter period of time than the project B. The payback period is sophisticated tool for making investment decisions in the organization. The investment opportunities can be analyzed by using this tool (Peterson Drake and Fabozzi, 2002).
The paper has analyzed the importance of the agency theory and the role played by the theory in taking major decisions of financial management. The ways in which the agency problem can be reduced significantly has been discussed. The agency problem of Tesco and Barclay’s Bank has been analyzed and the feasible solution to the problems has been studied. The various investment appraisal techniques have been studied. A comparison and contrast between the net present value method and the payback period technique has been studied. Among the two investment appraisal technique the net present value method is a better investment appraisal technique as it analyses the projects using time value of money. On the other hand the payback period does not consider the time value of money which is one of the major discrepancies of the technique.
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