May 12, 2011

Financial Management\Individual Assignment

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May 12, 2011

Financial Management\Individual Assignment

Table of Contents
I. II. III. IV. V. VI. VII. VIII. IX. X. XI. Q1..................................................................................................................................................... 3 Part (A) ............................................................................................................................................ 3 Part (B)............................................................................................................................................. 4 Q2..................................................................................................................................................... 5 Agency problem theoretical background ........................................................................................ 5 Why Disciplinary Mechanisms Do Not Work? ................................................................................. 6 The Most Effective Methods to Control Managers ......................................................................... 7 Agency Problem Practices................................................................................................................ 8 Conclusion and Recommendations ............................................................................................... 10 Surveys on agency problems ......................................................................................................... 11 References ..................................................................................................................................... 12

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Financial Management\Individual Assignment

Q1 Part (A)
E(r) Boom = 0.24(0.4) + 0.36(0.4) + 0.55(0.2) = 0.35 = 35% E(r) Normal = 0.17(0.4) + 0.13(0.4) + 0.09(0.2) = 0.138 = 13.8% E(r) Bust = 0.00(0.4) + (-0.280.4) + (-0.450.2) = - 0.202 = - 20.2% E(r) Portfolio = 0.35(0.35) + 0.50(0.138) - (0.2020.15) = 0.1612 = 16.12% Variance = 0.35 ( ) ( ) ( )

= 0.012475904 + 0.00029612 + 0.019787136 = 0.03253216 = 3.25% Standard deviation = = = 0.180366737 = 18.04 %

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Financial Management\Individual Assignment

Part (B)
Krf = 8%, Km =16%, KCAPM = Krf + (Km- Krf )
=0.08+0.7(0.16-0.08) =0.136 =13.6% IF KCAPM = 24%, would be as follows

=0.7, KCAPM =?

= = =2

Generally, is the Measures of the stocks market risk, and it express how the stocks volatility is being relative to the market. Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond into swings in the market where a beta of 1 indicates that the security's price will move with the market. In the question, we are noticing that when the expected return has risen from 13.6% to 24%, the ; the risk also increased from 0.7 into 2 in the market. Therefore, a beta of less than 1 means that the security will be less volatile than the market whereby, on the other hand, a beta of more than 1 indicates that the security's price will be more volatile than the market. To summarize, a higher-beta stock tends to be more volatile and therefore riskier, but in providing the potential for higher returns whereby the lower-beta stock poses less risk but generally offer lower returns.

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Financial Management\Individual Assignment

Q2
Agency problem theoretical background
American Business Organization ABO1 (2011), highlighting that the agency theory is a management and economic theory that attempts to explain the relationships and self-interest in business organizations. In agency theory, principals make a contract with agents to initiate the tasks for the benefit of the principals. At the end of contracting with agents, the principals delegate their authority regarding how a task is to be achieved, holding the agent responsible for attaining a certain outcome but not dictating the methods used to achieve the outcome. Therefore, Agency theory or agency relationship is the theory which looks at the relationship between the owners of the company in the form of shareholders and those have been given responsibility to take charge of the management of the company in the form of directors. Hence, the available theory and evidence are consistent with the view that stockholders control the firm and stockholder wealth maximization is the relevant goal of the corporation.

Online website: http://american-business.org/176-conflict-of-interest.html

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Financial Management\Individual Assignment

Why Disciplinary Mechanisms Do Not Work?

The main reason is totally hinges on the devices of these mechanisms. Firstly, the shareholders have no enough time to control and observe the top of management members during the whole year where it affects totally in applying the disciplinary mechanisms properly and efficiently. The second point, the minority of shareholders have less portion to vote and give the right opinion since the right of voting only for those who have the most shares in the company however, their vote only acceptable even they have a wrong controlling decisions whereby this will affect completely the compliance of the disciplinary mechanisms over controlling the top management. In addition, the disciplinary mechanism also is related to the contribution of managers that helps completely if it is being treated positively. On the other hand, if the treatment of managers is considered negative they can oppose the process of disciplinary mechanisms to make it under working whereby the agency problem will arise in front of the shareholders. Therefore, there are many methods that can be used by shareholders to overcome the agency problems. The first mechanism would be the profit pay techniques. This means that the managers' earnings are paid with accordance to the level of profit hence the managers will then try hard to meet the targeted profit so that they can be rewarded more. Besides, the managers should also be rewarded with shares by inviting them to subscribe the shares at lower price when public companies go to public whereby the managers with shares in the companies will go for projects that would raise the share value of the business and also the profitable projects that would give the managers more dividends since they are having investment in the company as well. The third mechanism would be the direct intervention by the shareholders in company when The shareholders may actively checking the performance of the company and if they suspect any poor performance that can result to poor profit level or any kind of fraud by the managers, they can quickly take initiative to encourage all other shareholders to remove the managers from the management team or take a strong action against them. Moreover, the threat of firing is also one of the mechanisms that the shareholders may take in order to discipline the managers and stop the agency problem to be occurred.

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Financial Management\Individual Assignment

The Most Effective Methods to Control Managers

There are many control mechanisms of the agency problem that are considered necessary to reduce the divergence between the agents interests and the principals interests. Rewarding method is probably the widest control mechanism used for efficient utilization that can be more beneficial to the shareholders. A managers compensation plan should be structured to maximize the companys profitability where, at the same time, the pay plan should reward and incentivize management for reaching goals of the shareholders(Clausen, 2010).this is applied vigorously by giving a specified rate of the annual profits as remunerations to the board of directors which it would be more courageous to explicit the power of managers to perform efficiently and carefully. Another element that is being related to the rewarding method of managers is to give them an opportunity to become partial shareholders where it is being an active idea to give the shareholders a remote controlling of the managers. According to Johnson (1987)on his research, he found that the most effective compensating method to managers is the stock options gift that is given to managers by the real owners of the shares in the firm.Therefore, this would enhance the manager consideration among their duties performance as they work for their own business where they will struggle till chieving the aimed goals through the increasing of the profitiabiltiy and also rising up the value of each share. Another important mechanism by which unhappy stockholderscan can replace the existing management is called a proxy fight whereby it develops when agroup solicits proxies in order to replace the existing board and thereby replace existing management(Megginson and Smart, 2006).For example,the propesed merger between HP and Compaq triggered on of the most widely followed and exppensive proxy fights in history.hence, this would be as amotivatg element that will encourage the managers to do a better job in order to fulfill the need of shareholders and also to avoid the replace of the managemt.

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Financial Management\Individual Assignment

Agency Problem Practices

The concepts of agency theory has become a lot more important now than ever before, especially with the corporate collapses of major multinational companies such as Enron in 2001, WorldCom in 2001, Lehman brothers 2008, and the nationalization of many financial institutions in recent months as a result of the global financial crisis(Armah, 2010). Corporate managers and shareholders can sometimes find themselves in a conflict of interest that is being harmful to the flow of business where the Conflict of interest happens when both parties want to maximize each benefit(KennUjsme, 2007). Accordingly to Angioni (2007) we can see many issues has arisen such as the shareholders is likely to have higher profits as more dividends can be yield from it whilst the directors are focusing more in higher revenue because it holds on more expenses that can be made some benefits to them. Thus, Managers may wish to hold more cash in order to receive more remuneration that would be hold in as expenses of the company and this may reduce the profit. Thus, the biggest conflict between managers and shareholders is starting from the disagreements of disseminating the occurred profits. Here is the most common example; there is Enron in 2001 which achieved more profits than expected. Therefore, the corporation has a cash surplus whereby the managers want this money to be recorded as a financial bonus and the shareholders would want this money as a stock dividend, however, the mangers will argue that without their leadership and managerial ability, the corporation would not have been as profitable and the shareholders will argue that without their money, the corporation would not have been able to invest in its growth. Thus, the collapse of this company is occurred after this kind of agency problem happened. Another situation highlights that when the managers are also being the shareholders (Evans and Weir, 1995). This may lead the particular managers to push the opposite way of their position. For example, if a shareholder manager would get more money from a stock dividend than from a bonus, this shareholder manager might vote in favor of a stock dividend, not because he/she believes that stockholders should be rewarded for their investment, but because it will mean more money for that particular manager and he or she desires to prevent other mangers that have no shares in the firm from getting more bonuses.

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Financial Management\Individual Assignment

In addition, the biggest conflict between managers and shareholders is going to be money where, In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards (Angioni, 2007). For example, the best-paid executive in 2005 was Terry Semel, the CEO of Yahoo Corporation; according to Forbes1 magazine, he made about $231 million. By way of comparison, Semel made quite a bit more than George Lucas ($180 million), but only slightly more than Oprah Winfrey ($225 million), and a way more than Judge Judy ($28 million). Over the period 20012005, Oracle CEO Larry Ellison was the highest-paid executive of earning about $868 million where he was the best from the whole managers in Yahoo Corporation. There are also many issues that emerge from the disagreement of the compensation of the managers. According to Bloomberg2 (2011) magazine, Beazer Homes directors were sued this year by shareholders who contend the homebuilders executive compensation plan shortchanges investors by rewarding managers for shoddy performance. Beazers board didnt act in shareholders best interests when it approved pay raises last year for Chief Executive Officer Ian McCarthy and other executives while the company had $34 million in losses.

1 2

Online : http://blogs.forbes.com/richardlevick/2011/04/25.html Online : http://preview.bloomberg.com/news/2011-03-16/beazer-homes-directors-sued-by-teamsters-fundsover-executive-compensation.html

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Financial Management\Individual Assignment

Conclusion and Recommendations

Generally, the principal-agent problem that could happen between the shareholders and managers are totally is considered very hurdle issue that can paralyze the business growth of the shareholders. This problem has many various solutions that might overcome this problem such as direct control by shareholders and threat of firing but the most effective mechanism is the rewards method by giving more profits and also the pitons of shares criteria. To recommend, the shareholders and managers are advised to build up their relationships strongly on the trust, ethics and loyalty. This is applied to the contribution from each one of them to fulfill or to maintain the flow life of business, where each of them they must understand the due diligence and mutual understanding practices in order to apply it throughout the real business area. This would create a prosperous understanding of duties from the shareholders to managers and vice versa, However, the clue to build up this relationship is hinging on the shareholders desire to commence this relationship with managers by initiating to be more trustful with them and giving them the acceptance to be more close to each other specially in business. Lastly, we conclude that the more trustful relationship between managers and shareholders the higher the opportunity to dispose the agency problem away from road of business. This is happening expressly by the rewards given by shareholders to managers in order to make them more active and motivated to do the best among their duties through the shareholders business.

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Surveys on agency problems

1. Russ Webster in 2002 has done a survey in USA where his survey was titled Corruption on the private sector where he stated that agency problem especially the managers who fail in their duties and also the mistakes that come from the shareholders with managers is considered as 40% of main corruption on the private entities. 2. This survey has done by Bryan Armstrong and took place for 24 companies in Chicago in 2005, and the final thoughts that found as follow: Shareholder activism often highlights differences in strategy or poor communication. Inconsistency in messaging and lack of information breed investor discontent, and ultimately shareholder activism. If ignored long enough, the situation comes to a breaking point where activist investors choose a drastic approach. The underpinning to nearly all shareholder activism campaigns is to increase shareholder value. Through a collaborative relationship, management can turn an activist hedge fund into an attractive long-term investor. While in the past management has viewed the relationship as adversarial and has been suggested that the potential exists for a mutually beneficial relationship where the activists and management striving for the same objective to increase shareholder value.

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References
1. ANGIONI, M. 2007. Conflict of interest between managers and shareholders [Online]. Available: http://www.helium.com/items/497796-conflict-of-interest-between-managers-andshareholders [Accessed 31 April 2011]. 2. ARMAH, W. 2010. Agency theory [Online]. Available: www.warmah.com/articles/Agency%20theory.pdf [Accessed 7 May 2011]. 3. ARMSTRONG, B. 2005. The New Crisis: Shareholder Activism [Online]. Available: www.chin.client.shareholder.com/.../download.cfm?...Shareholder...pdf [Accessed 10 May 2011]. 4. CLAUSEN, J. 2010. Management Pay and Compensation Plan [Online]. Available: http://www.suite101.com/content/management-pay-and-compensation-plan-a190082 [Accessed 8 May 2010 ]. 5. EVANS., J. & WEIR., C. 1995. Decision processes, monitoring, incentives and large firm performance in the UK. Management Decision journal, vol.33, PP:32-38. 6. JOHNSON, W. B. 1987. Discussion of Management Compensation Contracts and Merger-Induced Abnormal Returns. Journal of Accounting Research, 25, 77-84. 7. KENNUJSME. 2007. Conflict of interest between managers and shareholders [Online]. Available: http://www.helium.com/items/361088-conflict-of-interest-between-managers-andshareholders [Accessed 30 April 2011]. 8. MEGGINSON, W. L. & SMART, S. B. 2006. Introduction to corporate finance, Mason, OH, USA, Thomson/South-Western. 9. WEBSTER, R. 2002. Corruption and the private sector [Online]. USA. Available: www.usaid.gov/our_work/democracy_and.../privatesector.doc [Accessed 10 May 2011].

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