What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.

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Question 1

At year-end 2018, Marvel Company total assets were $4.5 million, and its accounts payable were $850,000. Sales, which in 2018 were $5.5 million, are expected to increase by 25% in 2019. Total assets and accounts payable are proportional to sales, and that relationship will be maintained. Marvel typically uses no current liabilities other than accounts payable. Common stock amounted to $ 2.25 million in 2018, and retained earnings were $150,000. Marvel has arranged to sell $25,000 of new common stock in 2019 to meet some of its financing needs. The remainder of its financing needs will be met by issuing new long-term debt at the end of 2019. (Because the debt is added at the end of the year, there will be no additional interest expense due to the new debt.) Its net profit margin on sales is 2.5%, and 55% of earnings will be paid out as dividends.

a. What were Marvel’s total long-term debt and total liabilities in 2018?

b. How much new long-term debt financing will be needed in 2019? (Hint: AFN – New stock = New long-term debt.)

Question 2

Suppose you decide (as did Steve Jobs and Mark Zuckerberg) to start a company.

Your product is a software platform that integrates a wide range of media devices, including laptop computers, desktop computers, digital video recorders, and cell phones. Your initial market is the student body at your university. Once you have established your company and set up procedures for operating it, you plan to expand to other colleges in the area and eventually to go nationwide. At some point, hopefully sooner rather than later, you plan to go public with an IPO and then to buy a yacht and take off for the South Pacific to indulge in your passion for underwater photography. With these issues in mind, you need to answer for yourself, and potential investors, the following questions.

  1. What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.
  2. If you expanded and hired additional people to help you, might that give rise to agency problems? Explain your answer
  3. Suppose you need additional capital to expand, and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur?
  4. Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs?
  5. Suppose your company is very successful, and you cash out most of your stock and turn the company over to an elected board of directors. Neither you nor any other stockholders own a controlling interest (this is the situation at most public companies). List six potential managerial behaviors that can harm a firm’s value.
  6. What is corporate governance? List five corporate governance provisions that are internal to a firm and under its control. What characteristics of the board of directors usually lead to effective corporate governance?
  7. List three provisions in the corporate charter that affect takeovers.
  8. Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as a form of compensation?
  9. What is block ownership? How does it affect corporate governance?
  10. Briefly explain how regulatory agencies and legal systems affect corporate governance.

Submit your answers in a Word document.

Text book

Title: Corporate Finance

 

ISBN: 9781337909747

Authors: Ehrhardt

Publisher: Cengage

 

Edition: 7TH 20

 

UNFORMATTED ATTACHMENT PREVIEW

CHAPTER 13 Corporate Governance © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Topics in Chapter • Agency Conflicts • Corporate Governance © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Governance and Corporate Value © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What is an agency relationship? An agency relationship arises whenever one or more individuals, called principals, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision-making authority to that agent. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. If you are the only employee, and only your money is invested in the business, would any agency problems exist? No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock, or the firm borrows. You own 100 percent of the firm. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Would hiring additional people create agency problems? An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decisionmaking authority to them. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Owner/managers versus Outside Shareholders • Benefits of being an owner/manager: • Increase wealth due to owning company • Perquisites (perks): • Luxurious offices • Executive assistants • Expense accounts • Limousines and auto allowances • Country club memberships • Generous retirement plan © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Who bears the costs of the perks? • If the owner/manager owns all the stock, the owner/manager bears all costs. • If there are also outside shareholders, they bear some of the cost due to the owner/manager’s perks. • Therefore, minority shareholders will pay less for shares of stock—this is an agency cost. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Borrowers versus Lenders • After the loan is originated, borrowers can make decisions that affect the lender: • Invest in risky projects. • Who benefits most if there is a small payoff, medium payoff, or big payoff? • Who loses most if there is a small loss, medium loss, or big loss? • Take on additional debt © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Agency Cost of Debt • Creditors anticipate possible harmful actions by stockholders • Creditors charge higher interest rate. • Company’s cost of capital goes up. • Value of company goes down. • This is an agency cost. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What actions reduce agency cost of debt? • Securing the loan with company’s assets. • Placing restrictive covenants in debt agreements. The borrower must: • Maintain profitability ratios and retained earnings at a certain level before making any distributions to shareholders. • Maintain debt ratios at specified levels. • Not issue more debt. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Modern Corporation • Many shareholders, none who own a controlling interest in the company. • Decision-making delegated by shareholders to an elected board of directors. • Board delegates most decision-making to hired executives, who then hire other employees and delegate some decision-making. • Potential agency conflict between shareholders and managers. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Six Potential Problems with Managerial Behavior (1 of 2) • Expend too little time and effort. • Consume too many nonpecuniary benefits. • Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Six Problems with Managerial Behavior (2 of 2) • Reject risky positive NPV projects to avoid looking bad if project fails; take on risky negative NPV projects to try and hit a home run. • Avoid returning capital to investors by making excess investments in marketable securities or by paying too much for acquisitions. • Massage information releases or manage earnings to avoid revealing bad news. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Governance • The set of laws, rules, and procedures that influence a company’s operations and the decisions made by its managers. • Sticks (threat of removal) • Carrots (compensation) © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Governance Provisions Under a Firm’s Control • Board of directors • Charter provisions affecting takeovers • Compensation plans • Capital structure choices • Internal accounting control systems © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Effective Boards of Directors (1 of 4) • Election mechanisms make it easier for minority shareholders to gain seats: • Not a “classified” board (i.e., all board members elected each year, not just those with multi-year staggered terms) • Board elections allow cumulative voting © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Effective Boards of Directors (2 of 4) • CEO is not chairman of the board and does not have undue influence over the nominating committee. • Board has a majority of outside directors (i.e., those who do not have another position in the company) with business expertise. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Effective Boards of Directors (3 of 4) • Is not an interlocking board (CEO of company A sits on board of company B, CEO of B sits on board of A). • Board members are not unduly busy (i.e., set on too many other boards or have too many other business activities) © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Effective Boards of Directors (4 of 4) • Compensation for board directors is appropriate • Not so high that it encourages cronyism with CEO • Not all compensation is fixed salary (i.e., some compensation is linked to firm performance or stock performance) © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Anti-Takeover Provisions • Targeted share repurchases (i.e., greenmail) • Shareholder rights provisions (i.e., poison pills) • Restricted voting rights plans © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Options in Compensation Plans (1 of 2) • Gives owner of option the right to buy a share of the company’s stock at a specified price (called the strike price or exercise price) even if the actual stock price is higher. • Usually can’t exercise the option for several years (called the vesting period). © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Options in Compensation Plans (2 of 2) • Can’t exercise the option after a certain number of years (called the expiration, or maturity, date). © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Problems with Stock Options • Manager can underperform market or peer group, yet still reap rewards from options as long as the stock price increases to above the exercise cost. • Options sometimes encourage managers to falsify financial statements or take excessive risks. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Block Ownership • Outside investor owns large amount (i.e., block) of company’s shares • Institutional investors, such as CalPERS or TIAA-CREF • Blockholders often monitor managers and take active role, leading to better corporate governance © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Regulatory Systems and Laws • Companies in countries with strong protection for investors tend to have: • Better access to financial markets • A lower cost of equity • Increased market liquidity • Less noise in stock prices © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 12 Corporate Valuation and Financial Planning © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Topics in Chapter • Financial planning • Additional funds needed (AFN) equation • Forecasted financial statements • Operating input data • Financial policy issues • Changing ratios © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Intrinsic Value: Financial Forecasting © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Planning Process • Forecast financial statements under alternative operating plans. • Forecast the free cash flows to determine the estimated intrinsic stock price. • Determine amount of financing needed to support the plan. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Balance Sheet, Hatfield, 12/31/19Planning Process Assets Cash Accts. rec. Inventories Total CA Net fixed assets Total assets 2019 $90 1,260 1,440 $2,790 3,600 $6,390 Liab. & Equity Accts. pay. & accruals Line of credit Total CL Long-term debt Total liabilities Common stock Retained earnings Total common equ. Total liab. & equity 2019 $1,620 0 $1,620 1,800 $3,420 $2,100 870 $2,970 $6,390 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Income Statement, Hatfield, 2019 Income Statement Sales Op. costs (excl. depr.) Depreciation EBIT Interest Pretax earnings Taxes (40%) Net income 2019 $9,000.9 8,100.9 360.0 $540.0 144.0 $396.0 99.0 $297.0 Additional Data Dividends Add. to RE Common shares EPS DPS Ending stock price 2019 $100 $197 50 $5.94 $2.00 $41.00 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Selected Additional Data and Ratios Operating Data (Op. costs)/Sales Depr./FA Cash/Sales Receivables/Sales Inventories/Sales (Fixed assets/Sales (AP & accr.)/Sales Tax rate Hatfield 90% 10% 1% 14% 16% 40% 18% 25% Ind. Other Ratios 88% 12% 1% 11% 15% 32% 12% 25% Debt/TA TL/TA Times int. earned ROA Profit margin (M) Sales/Assets ROE P/E ratio OP ratio CR ratio ROIC Hatfield Ind. 28.2% 53.5% 3.8 4.6% 3.30% 1.41 10.0% 6.9 4.5% 53.0% 8.5% 16.9% 37.3% 10.2 9.4% 5.52% 1.69 7.1% 16.0 6.1% 47.0% 13.0% © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Hatfield to Industry: Operations • Hatfield has a lower operating profitability (OP) ratio: • 4.5% vs. 6.1% • Hatfield has a worse capital requirement CR ratio • 53% vs. 47% • Hatfield has a lower ROIC • 8.5% vs. 13% • Hatfield’s 8.5% ROIC is less than its 10% WACC • Conclusion: Hatfield’s overall operations are not as good as those of its competitors and Hatfield is not adding value for its investors. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Hatfield to Industry: Leverage and Risk • Its debt/TA ratio shows more leverage: • 28.2% vs. 16.9% • The TL/TA ratio also shows more leverage: • 53.5% vs. 37.3% • The combination of higher interest payments and lower operating profitability cause Hatfield’s times interest earned ratio to be much lower than the industry average. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Hatfield to Industry Using DuPont Equation (1 of 3) M = Profit margin = NI/Sales TAT = Total asset turnover = Sales/TA Equity multiplier = TA/Equity ROE = M × TAT × (Equity multiplier) © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Hatfield to Industry Using DuPont Equation (2 of 3) ROEHatfield = 3.30% × 1.41 × 2.15 = 10.0%. ROEIndustry = 5.60% × 1.69 × 1.59 = 15.05 = 15.1 with no rounding of inputs © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Hatfield to Industry Using DuPont Equation (3 of 3) • Profitability ratios lower because of lower operating profits and higher interest expense. • Lower asset management ratios due to high levels of receivables, inventory, and fixed assets. • Higher leverage than industry. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Additional Funds Needed (AFN) Equation • AFN equation forecasts the additional financing needed by the operating plan. • Basic idea: • Estimate new assets required • Subtract new spontaneous liabilities (i.e., accounts payable and accruals) • Subtract reinvested pr …
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