FIN 534 – Financial Management, Homework Set #5: Chapter 12

Running head: HOMEWORK SET #5: CHAPTER 12 Homework Set #5: Chapter 12 FIN 534 – Financial Management, Homework Set #5: Chapter 12 Directions Directions: Answer the following questions on a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using the assignment link above. In your own words, complete the Mini-Case on Page 562 of your textbook. 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 you plan to go public with an IPO. With these issues in mind, you need to answer for yourself, and potential investors, the following questions. What is an agency relationship? An agency relationship is a business relationship where a principal gives legal authority to an agent to act on the principal’s behalf when dealing with a third party. An agency relationship is a fiduciary relationship. According to Brigham and Ehrhardt (2017), an agency relationship arises when a principal and agent create an agency relationship. In smaller companies, the president, CEO, owner and principal are often the same person. In legal terms, the principal might be the party who gives legal authority for another party called the agent to act on the principal’s behalf. These principals can be individuals, corporations or even government agencies. 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? No. Explain your answer. There is no contradiction at a one-person company. The owner makes all the decisions, does all the work, reaps all the rewards, and suffers all the losses. This situation changes when the owner begins hiring employees as the employees may not fully share in the owner’s decisions, rewards, and losses. If you expanded and hired additional people to help you, might that give rise to agency problems? Yes. There are potential conflicts when hiring other people as these individuals may not share the same views and decisions of the owner/principal. These conflicts are referred to as agency conflicts. Agency conflicts can occur when the incentives of the agent do not align with those of the principal. 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? As mentioned by Brigham and Ehrhardt (2017), stockholders have control (through the managers) of decisions that affect the firm’s riskiness. An agency conflict might occur between the stockholders and managers. In business finance, agency problems can occur between stockholder and managers. If I maintain enough stock to control the company, a potential agency problem might occur between all stockholders who may not agree with certain stock decisions as I may make decisions that conflict with the best interests of the other shareholders when stockholders or managers own less than 100% of the firm’s common stock. Managers may make decisions that conflict with the best interests of the shareholders. Suppose your company raises funds from outside lenders. What type of agency costs might occur? As noted by Brigham and Ehrhardt (2017), the type of agency costs that might occur is if the company raises funds from outside lenders, the agency costs that might arise will impact the company’s value. The creditors lend funds at rates based on the company’s perceived risk at the time credit or funds are given. The perceived risks are based on (1) the risk of the firm’s existing assets, (2) expectations concerning the potential for future asset additions, (3) the existing capital structure, and (4) expectations concerning future capital structure changes. These risks are the primary determinants of the risk of the firm’s cash flows, and hence the safety of its debt. How might lenders mitigate the agency costs? Lenders might mitigate the agency costs by charging a higher rate to protect themselves in case the company engages in activities that increase risk or issue detailed debt covenants specifying what actions the borrower can and cannot take. Regarding risk, if the company does not increase risk, its weighted average cost of capital (WACC) will be higher than is justified by the company’s risk. This higher WACC will reduce the company’s intrinsic value. Regarding debt covenants, most debt covenants prohibit the borrower from increasing debt ratios above specified levels, repurchasing stock or paying dividends unless profits and retained earnings are above specified amounts, and reducing liquidity ratios below specified levels. These covenants can cause agency costs if they restrict a company from value adding activities (Brigham & Ehrhardt, 2017). 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. According to Brigham and Ehrhardt (2017), six potential managerial behaviors that can harm a firm’s value are: Managers might not expend the time and effort required to maximize the firm’s value. Managers might use corporate resources on activities that benefit themselves rather than shareholders. Managers might avoid making difficult but value-enhancing decisions that harm friends in the company. Managers might take on too much risk or they might not take on enough risk. If the company is generating positive free cash flow, a manager might “stockpile” it in the form of marketable securities instead of returning the free cash flows to investors. Managers might not release all the information that investor’s desire. What is corporate governance? According to Brigham and Ehrhardt (2017), corporate governance is defined as the set of laws, rules, and procedures that influence a company’s operations and the decisions its managers make. List five corporate governance provisions that are internal to a firm and are under its control. As mentioned by Brigham and Ehrhardt (2017), five corporate governance provisions that are internal to a firm and are under its control are: Monitoring and discipline by the board of directors. Charter provisions and bylaws that affect the likelihood of hostile takeovers. Compensation plans. Capital structure choices. Accounting control systems. What characteristics of the board of directors usually lead to effective corporate governance? The characteristics of the board of directors which usually lead to effective corporate governance are: If the CEO is not also the chairman of the board. The board has a majority of true outsiders who bring some type of business expertise to the board and are not too busy with other activities. The board is not too large. Board members are compensated appropriately (not too high and not all cash, but including exposure to equity risk through options or stock). List three provisions in the corporate charter that affect takeovers. Three provisions in the corporate charter that affect takeovers are: Targeted share repurchases also known as greenmail. Greenmail is the practice of buying a voting stake in a company with the threat of a hostile takeover to force the target company to buy back the stake at a premium. In the area of mergers and acquisitions, the greenmail payment is made in an attempt to stop the takeover bid. The target company is forced to repurchase the stock at a substantial premium to stop the takeover. Shareholder rights provisions also known as a poison pill. A poison pill is a tactic utilized by companies to prevent or discourage hostile takeovers. A company targeted for a takeover uses a poison pill strategy to make shares of the company’s stock look unattractive or less desirable to the acquiring firm. Restricted voting rights. This provision automatically cancels the voting rights of any shareholder who owns more than a specified amount of company stock (Brigham & Ehrhardt, 2017). Briefly, describe the use of stock options in a compensation plan. As noted by Brigham and Ehrhardt (2017), stock compensation is a way corporations use stock options to reward employees. Because startup companies typically do not have the cash on hand for compensating employees, the companies may offer stock compensation instead. Executives and staff may share in the company’s growth and profits that way. Many laws and compliance issues must be adhered to, such as fiduciary duty, tax treatment and deductibility, registration problems and expense charges. What are some potential problems with stock options as a form of compensation? Some potential problems with stock options as a form of compensation are: New judgments are upon the company and the books. The idea is for stock options to be exercised eventually. Stock ownership by an employee means you have a new party staring over the company’s shoulder. New critics are ready to analyze whether capital is being properly deployed, earnings are being adequately distributed, and proper business deductions are being taken. It can harm business planning efforts. If the company is contemplating selling the firm to an outside party, management will likely want to keep the market probing private. If, however, an employee has become an owner, the company can only withhold exploratory inquiries for so long. Investment bankers will advise the company that buyers are hesitant to pursue deals where there are some small stock options and minority shareholders in the mix. It complicates the negotiations and drags out the close. It adds complexity. The granting of stock and stock options is not without complications. From an accounting standpoint, the firm will need to currently book the value of stock options which can be a tricky task for a company that does not trade on the market. Also, business decisions will need to be made about how much the company wants to facilitate the exercise of the options. It can be a tax trap for the company. Section 409A has some specific rules for what is considered a deferred compensation arrangement. The challenge is that a company cannot effectively issue discounted stock options without it being treated as deferred compensation, and subject to a sizable tax penalty. The problem is even bigger for privately held businesses because their stock is not always easy to value. An accidentally discounted stock option may occur, and tax penalties will follow. A comprehensive annual business valuation may be necessary. It can cause unhappy employees. When times are good, stock options are appealing. However, as we’ve experienced in the last few years, times may not be good when the options vest. What was thought to be a reward for hard work in the past may be perceived as an empty promise in the here-and-now? Especially with privately held companies, suspicions may surface (Somayye & Mohamad, 2013). What is block ownership? As stated by Somayye and Mohamad (2013), block ownership refers to the amount of stock owned by individual investors and large-block shareholders (investors that hold at least 5 per cent of equity ownership within the firm). For example, in terms of shares, these owners are often able to influence the company with the voting rights awarded with their holding. How does it affect corporate governance? Since the source of agency problems is that managers have inadequate stakes in their firms, large shareholders known as blockholders/block ownership can play a critical role in governance, because their sizable stakes give them incentives to bear the cost of monitoring managers (Brigham & Ehrhardt, 2017). Large shareholders can exert governance through two main mechanisms. The first is direct intervention within a firm, otherwise known as voice. Examples include suggesting a strategic change via either a public shareholder proposal or a private letter to management, or voting against directors. A second governance mechanism, trading a firm’s shares, otherwise known as exit also known as taking the “Wall Street Walk.” If the manager destroys value, block holders can sell their shares, pushing down the stock price and thus hurting the manager after exiting. Before exiting, the threat of exit induces the manager to maximize value (Somayye & Mohamad, 2013). Briefly explain how regulatory agencies and legal systems affect corporate governance. Regulatory agencies and legal systems affect corporate governance by imposing fines and penalties when regulatory policy and procedures and state/federal laws are not adhered to. As stated by Brigham and Ehrhardt (2017), the regulatory/legal environment includes the laws and legal system under which a company operates. The regulatory/legal environments include the agencies that regulate financial markets such as the Securities Exchange Commission (SEC). The United States Securities and Exchange Commission (SEC) is an independent agency of the United States federal government. The SEC holds primary responsibility for enforcing the federal securities laws, proposing securities rules, and regulating the securities industry, the nation's stock and options exchanges, and other activities and organizations, including the electronic securities markets in the United States. The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust (Securities and Exchange Commission, 2017). References Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management (15th ed.). Mason, OH: South- Western Cengage Learning. Securities and Exchange Commission . (2017, September). Who are we? Retrieved from https://www.sec.gov/. Somayye, A., & Mohamad Reza, A. (2013). Block share ownership and corporate earning: Evidence from Tehran Stock Exchange. Management Science Letters, Vol 3, Iss 1, Pp 129-134(2013), (1), 129.

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