Financial management notes narain

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  • 7/30/2019 Financial management notes narain


    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


    E.g. personal wealth, job security, lifestyle, fringe

    benefits, [email protected]

  • 7/30/2019 Financial management notes narain


    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]

  • 7/30/2019 Financial management notes narain


    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]

  • 7/30/2019 Financial management notes narain


    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]

  • 7/30/2019 Financial management notes narain


    B: Agency Costs

    Incurred to respond to potential market

    forces by preventing or minimising agency

    problems and contributing to themaximisation ofowners wealth

    [email protected]

  • 7/30/2019 Financial management notes narain


    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]

  • 7/30/2019 Financial management notes narain


    Types of structuring expenses

    1. Incentive Plans-

    To tie management compensation with share


    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

    [email protected]

  • 7/30/2019 Financial management notes narain


    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




  • 7/30/2019 Financial management notes narain


    Capital Budgeting Decision Process

    While evaluating projects, an attempt is

    made to:-1. Reduce costs and benefits to a single


    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


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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