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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
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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
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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