Agency Theory
Explain three causes of conflict of interest between shareholders and debt holders.
a) Disposal of assets used as collateral for the debt in this.
In this case the bondholder is exposed to more risk because he may not recover the loan
extended in case of liquidation of the firm.
b) Assets/investment substitution
In this case, the shareholders and bondholders will agree on a specific low risk project.
However, this project may be substituted with a high risk project whose cash flows have high
standard deviation. This exposes the bondholders because should the project collapse, they
may not recover all the amount of money advanced.
c) Borrowing more debt capital
A firm may borrow more debt using the same asset as a collateral for the new debt. The value
of the old bond or debt will be reduced if the new debt takes priority over the collateral in case
the firm is liquidated. This exposes the first bondholders/lenders to more risk.
Describe four ways that could be used to mitigate agency conflict between managers and
shareholders
i) Incentive Problem
Managers may have fixed salaries and they may have no incentive to work hard and maximize
shareholders' [Link] is because irrespective of the profits they make, their reward is
[Link] will therefore maximize leisure and work less which is against the interest of the
shareholders.
ii) Consumption of “Prerequisites”
Prerequisites refer to the high salaries and generous fringe benefits which the directors might
award [Link] will constitute directors remuneration which will reduce the dividends
paid to the ordinary [Link] the consumption of perquisites is against the
interest of shareholders since it reduces their wealth.
iii) Different Risk-profile
Shareholders will usually prefer high-risk-high return investments since they are diversified i.e
they have many investments and the collapse of one firm may have insignificant effects on their
overall wealth.
Managers on the other hand, will prefer low risk-low return investment since they have a
personal fear of losing their jobs if the projects collapse.(Human capital is not diversifiable).This
difference in risk profile is a source of conflict of interest since shareholders will forego some
profits when low-return projects are undertaken.
iv) Different Evaluation Horizons
Managers might undertake projects which are profitable in the [Link] on the
other hand evaluate investments in the long-run horizon which is consistent with the going
concern aspect of the [Link] conflict will therefore occur where management pursue
short-term profitability while shareholders prefer long term profitability.
v) Management Buy Out (MBO)
The board of directors may attempt to acquire the business of the [Link] is equivalent to
the agent buying the firm which belongs to the [Link] is inconsistent with the agency
relationship and contract between the shareholders and the managers.
vi) Pursuing power and self esteem goals
This is called “empire building” to enlarge the firm through mergers and acquisitions hence
increase in the rewards of managers.
vii) Creative Accounting
This involves the use of accounting policies to report high profits e.g stock valuation methods,
depreciation methods recognizing profits immediately in long term construction contracts etc.
Citing relevant examples in each case, distinguish between agency costs" and "financial
distress costs".
Agency costs are costs incurred by the owners of the company as a result of not being directly
involved in the management of the company. The shareholders appoint the directors to run the
company on their behalf. Examples of agency costs are:-
i. Costs of the incentives given to the management
ii. Costs of external audit
iii. Costs of installing systems of internal control
iv. Restructuring costs
Financial distress costs are costs associated with Bankruptcy of the company. Examples of
financial distress costs are:-
i. Selling of valuable assets at bargaining prices to raise cash
ii. Lawyers’ fees, court costs and huge administrative expenses
iii. Rust of machinery, vandalization of buildings, obsolescence of inventories all due to delay in
the liquidation of assets as bankruptcy cases take long to settle
iv. High borrowing costs
In relation to the financial objectives of a business entity, distinguish between the terms
"maximizing" and "satisficing"
Maximizing tendency is the effort to select the best option, and satisficing tendency is the
willingness to settle for a sufficient or “fairly good” option.
maximizing tendency is maladaptive while the satisficing tendency is adaptive
Brief notes on:
1) Role of finance manager.
a) Drive the continuous improvement of end-to-end accounting practices.
b) Prepare and post monthly accruals, prepayments and similar accounting entries.
c) Budgeting and forecasting.
d) Leading the analysis of monthly and quarterly numbers and presenting findings to the board.
e) Managing an end-to-end audit process of current systems – while acting as the first point of
contact for external auditors.
f) Continually identify risks to delivery, propose solutions where necessary and effectively
manage stakeholder expectations throughout.
g) Dealing with working capital management and production of cash flow forecasts.
h) Leading the team responsible for payroll, VAT and HMRC processes
2) Goals of a firm.
a) Profit maximization.
Usually, in economics, we assume firms are concerned with maximizing profit. Higher profit
means:
● Higher dividends for shareholders.
● More profit can be used to finance research and development.
● Higher profit makes the firm less vulnerable to takeover.
● Higher profit enables higher salaries for workers
b) Sales maximization
Firms often seek to increase their market share – even if it means less profit. This could occur
for various reasons:
● Increased market share increases monopoly power and may enable the firm to put up
prices and make more profit in the long run.
● Managers prefer to work for bigger companies as it leads to greater prestige and higher
salaries.
● Increasing market share may force rivals out of business. E.g. The growth of
supermarkets has led to the demise of many local shops. Some firms may actually
engage in predatory pricing which involves making a loss to force a rival out of business.
c) Co-operatives
Co-operatives may have completely different objectives to a typical PLC. A co-operative is run
to maximize the welfare of all stakeholders – especially workers. Any profit the co-operative
makes will be shared amongst all members.
3) Nature of agency conflict
An agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, an agency problem usually
refers to a conflict of interest between a company's management and the company's
stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed
to make decisions that will maximize shareholder wealth even though it is in the manager’s best
interest to maximize their own wealth.
4) Managerial compensation
Managerial remuneration is compensation for services provided to a company in a managerial
capacity. This can include cash payments, along with benefits like stock options, health
insurance, and bonuses. Managers are typically paid more than the people they supervise,
although they tend to make less than the executives at the head of the company. Some pay
structures are transparent, making it easy to determine how much money managers make,
while others may be confidential.
5) Managerial incentive
Managerial incentive structures correspond to the strategic priorities of the firms with different
ownership [Link] the incentive structures and strategic priorities vary by corporate
ownership, firm performances are comparable.
Financial Markets
Explain three functions of the central depository system (CDS) in your country.
[Link] of securities, that is, elimination of physical movement of securities.
[Link], that is, elimination of physical certificates or documents showing
entitlement of a security so that ownership exists only as computer words.
[Link] delivery and payment, that is, simultaneous, exchanging or transferring securities.
[Link] of detailed listing of investments according to the type of security held
[Link] delivery of returns, that is, effective distribution of dividends, right issues, interest and
bonds issue.
Discuss four functions of the capital markets regulator in your country.
[Link] development of institutional investors, for example pension funds, insurance firms.
- Provide adequate information to players in the market in order to prevent insider trading.
[Link] operate a compensation fund to protect investors from financial losses should licensed
brokers fail to meet their contractual obligations.
[Link] serve as an efficient bridge between the public and private sector.
[Link] remove bottlenecks and create awareness for investment in long term securities.
[Link] an environment which will encourage local companies to go public.
Explain the following terms as used in capital markets:
(1) Best efforts offering
This is a system used by investment bankers where they agree to sell as many securities as
they can at an established price. They have no responsibility for unsold securities.
(ii) Pre-emptive rights
Existing common stockholders have the right to preserve their proportionate ownership in
corporations. E.g. rights issue
(ii) Green shoe provision.
Underwrites often obtain the option to purchase additional stock at the offering price. This option
usually lasts several weeks after the offering.
Explain three measures that developing countries could implement in order to improve
their financial markets.
[Link] a wide range of financial instruments/securities.
Most financial markets of developing countries have limited financial securities, therefore there
is a need to introduce a variety of financial assets.
[Link] of awareness
This can be done through conferences, seminars so as to create awareness about the
functioning and operations of the stock markets.
[Link] cross border listing.
This is the listing of firms in more than one stock market. This facilitates taping both institutional
and retail investors, regionally and globally.
[Link] of appropriate policies.
Sound policies which are geared towards developing all aspects of capital markets will lead to
growth and development of any capital markets.
Briefly explain why companies list their shares on more than one stock exchange.
• To raise funds for development purposes
• To enhance or promote growth and development of stock markets
• To improve relations between local and other investors regionally and globally.
• So as to diversify and spread risk thereby creating increasing stability on share prices.
• It attracts overseas investors and consumers and thus improves product awareness in other
markets.
Distinguish between "untraded debt" and "floating-rate debt"
Untraded debt-refers to debt instruments that are not usually traded or tradable in organized
and other financial markets.
Floating rate debt on the other hand are debt instruments which are issued at floating rate of
interests i.e. the rate of interest will keep on fluctuating with time. This means that market rates
of interest on loans also increase and vice versa.
Outline the factors that contribute to the slow growth of capital markets in many
emerging economies.
[Link] political and legal environment e.g. harsh laws, unfavorable tax policies etc.
[Link] of sound policies.
Failure to automate stock markets which are largely manual.
[Link] on the part of potential investors
regarding activities of capital markets.
[Link] is a limited number of securities in emerging economies.
Distinguish between "financial gearing" and "operating gearing
Financial gearing is the use of the financing costs in order to improve the EPS of the company.
It shows the percentage change in the EPS as a result of the changes in the EBIT. It's measured
using the degree of financial leverage (DFL).
Operating gearing is the use of the operating costs in order to improve the profitability of the
company. It therefore shows the percentage change in the earnings before interest and tax
(EBIT) as a result of the changes in the sales. It's calculated using the degree of operating
leverage (DOL).
Differentiate between the following sets of terms
[Link] markets and secondary markets
a).Primary markets-Are those financial markets in which the financial securities are issued for
the first time in the stock exchange. Like for companies that are making an initial public offering
will sell its securities for the first time in the primary financial markets.
b).Secondary markets-Are those markets for subsequent selling and purchase of the financial
securities i.e. a company which is already listed in the stock exchange will sell its securities in
secondary financial markets.
[Link] markets and Money markets.
a).Capital markets-Are those markets for long term sources of finance. Long term loans for
development of the country are normally offered through the capital market. The major roles of
the capital markets include;
● It provides long term sources of finance which is important for development purposes
● It provides permanent finance which is necessary for strong financial base for going
concern.
● It's a channel through which foreign investments find their way into the country.
b).Money markets-It's a market concerned with short term financial securities. It offers the
following services;-
● It offers a medium through which short term financial securities can be discounted.
● It offers advice to the concerned parties as to which appropriate finance will meet their
financial requirements.
● It acts as a source of finance to small businesses which are unable funds in capital
markets.
● It is a channel through which government investment such as treasury bills and
government bonds are offered to the general public.
3. Brokers and jobbers
a).A broker is an agent who buys and sells securities on behalf of his clients on a commission
basis. He is a member of the stock exchange who can be suspended in case of [Link]
gives advice to the client and sometimes manages the clients' portfolio.
b).Jobbers are principals who buy and sell securities on their own name. Since jobbers are
experts in the market they are not allowed to deal with the general public and can therefore deal
with the brokers or other jobbers.
Explain the main factors behind the rapid development of capital markets in your
country.
• The Capital Market Authority has been educating investors through advertisements and press
releases. As a result investors make informed decisions leading to development of capital
markets.
• Incentives given by the government to investors e.g. tax incentives
• Political [Link] absence of war and turmoil within the Kenyan borders has led to
development of industries.
• Introduction of a wider range of financial instruments in the market e.g. futures, warrants,
options e.t.c.
• Proper regulation by the CMA ensures that trading is well regulated and investors do not lose
funds in the market. This has led to investor confidence in the capital market.
• Encouraging development of institutional investors like insurance funds, pension schemes etc.
Briefly describe the three forms of capital markets efficiency.
The forms of efficiency are defined by the type of information that is released to the market. The
three forms of efficiency are:
• Weak form efficiency
This is where the share prices fully and instantaneous reflect the past/ historical information that
has been released in the market
• Semi - strong form of efficiency
This is where the share price fully and instantaneously reflect both past and present information
that has been released to the market
• Strong form of efficiency
This is where the share price fully and instantaneously reflects both past, present and future
information that has been released in the market.
Dividend Theory
Describe two types of dividends which a corporate entity could pay its shareholders.
[Link] – this is the payment of actual cash from the company directly to the shareholders and
is the most common type of payment. The payment is usually made electronically (wire
transfer), but may also be paid by check or cash.
[Link] – stock dividends are paid out to shareholders by issuing new shares in the company.
These are paid out pro-rata, based on the number of shares the investor already owns.
Highlight four assumptions necessary for the dividend irrelevance theory to hold
Some of the assumptions for this theory are:
1. Taxes do not exist: Personal income taxes or corporate income taxes.
2. When a company issues a stock, there are no flotation costs or transaction costs.
3. When a firm decides its capital budgeting, dividend policy has no impact on it.
4. Information is readily and freely available to all investors. Information about the firm’s
future prospects is available to the company’s manager as well as investors.
5. Leverage has zero impact on the cost of capital of the company.
Outline four advantages of paying scrip dividends.
[Link] company can use additional cash for capital investment as it does not have to pay
immediate cash if shareholders opt for taking shares instead.
Shareholders can maximize their shareholding without paying extra transaction costs.
[Link] increases a company's total share capital.
[Link] become eligible to obtain tax benefits.
[Link] share remains somewhat unaffected in case of share dividend issue.
5.A scrip dividend also provides extra time for the company, which is typically the difference
between the payment date and dividend declaration date.
Discuss the effect of the following concepts on the firm's dividend policy.
a).Clientele effect
The clientele effect explains the movement in a company's stock price according to the
demands and goals of its investors. These investor demands come in reaction to a tax,
dividend, or other policy change or corporate action which affects a company's shares.
b)."Homemade dividend.
It suggests that investors are indifferent to the dividend distribution policy of a company, and
they can sell a portion of their equity portfolio to generate immediate cash inflow.
Enumerate four ways in which the dividend decision affects the wealth maximization goal
of a company quoted in the securities exchange of your country.
i. High retention enhances future growth and value of the company
ii. High dividend increases the value of the shares and the company as a whole
iii. High retention reduces the firm's gearing leading to decrease in cost of capital and an
increase in the value of the company.
iv. Retained earnings is a cheap source of funds which end up increase the NPV of the projects
undertaken and the value of the firm as a whole
Explain three ways in which a company could pay dividends to its shareholders.
[Link] – this is the payment of actual cash from the company directly to the shareholders and
is the most common type of payment. The payment is usually made electronically (wire
transfer), but may also be paid by check or cash.
[Link] – stock dividends are paid out to shareholders by issuing new shares in the company.
These are paid out pro-rata, based on the number of shares the investor already owns.
[Link] – a company is not limited to paying distributions to its shareholders in the form of
cash or shares. A company may also pay out other assets such as investment securities,
physical assets, and real estate, although this is not a common practice.