SF Worksheet One Answers

8/13/2019 SF Worksheet One Answers

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BF2244 Strategic Finance

Worksheet One - Solutions

1. a. This action might appear, superficially, to be a grant to formeremployees and thus

not consistent with value maximisation. However, such benevolent actionsmight enhance the firms reputation as a good place to work, might result in

greater loyalty on the part of current employees, hence reducing staff turnover and

retraining costs, and might contribute to the firms recruiting efforts. All these

may help improve the workforce and their productivity. Therefore, from a broader

perspective, the action may be value maximising. Of course if the firm gives too

much away and is not able to recoup these costs through increased productivity,

etc, then it could reduce shareholder value

b. The reduction in dividends to allow increased reinvestment can be consistent with

maximisation of current market value. If the firm has attractive investment

opportunities (i.e. positive NPV projects), then it could make sense to reduce thedividend in order to free up capital for the additional investments. However, if the

firm was retaining the dividends to invest in poor projects (i.e. negative NPV

projects) then this would reduce shareholder value

c. Although the drilling appears to be a very risky investment, with a low probability

of success, the project may be value maximising if a successful outcome (although

unlikely) offers a sufficiently high return. For example, a one in five chance of

success is acceptable if the payoff for finding oil is ten times the costs of

exploration. So long as the expected return is in line with the risk it can be

consistent with value maximisation.

2. a. Increased market share can be an inappropriate goal if it requires reducing prices to

such an extent that the firm is harmed financially. Increasing market share canbe part

of a well-reasoned strategy, but one should always remember that market share is not a

goal in itself. The owners of the firm want managers to maximise the value of their

investment in the firm.

b. Minimising costs can also conflict with the goal of value maximisation. For example,

suppose a firm receives a large order for a product. The firm should be willing to pay

overtime wages and to incur other costs in order to fulfil the order, as long as it can

sell the additional product at a price greater than those costs. Even though costs per

unit of output increase, the firm still comes out ahead if it agrees to fill the order.

Obviously, reducing costs can also usually be achieved by reducing quality. This is

almost certainly going to be detrimental to long term shareholder value.

c. Expanding profits is a poorly defined goal of the firm. For example:

(i) There may be a trade-off between accounting profits in one year versus

accounting profits in another year. For example, writing off a bad investment

may reduce this years profits but increase profits in future years. Which years

profits should be maximised?


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(ii) Investing more in the firm can increase profits, even if the increase in profits is

insufficient to justify the additional investment. In this case the increased

investment increases profits, but can reduce shareholder wealth.

(iii) Profits can be affected by accounting rules, so a decision that increasesprofits using one set of rules may reduce profits using another.

(iv) Costs such as advertising and R&D can be cut to boost short term profitsbut at the expense of longer term profitability.

3. The agency problem arises because there may be a conflict of interests between whatthe manager (i.e. CEO or Agent) wants and what the owners (i.e. shareholders or

Principals) want. We know the shareholders are only concerned about maximising

their return. The manager on the other hand may be influenced by; how much he/she

is paid, the size of the company, how many holidays he/she has, how many employees

he/she has, how many countries he/she trades in, and so on.

To alleviate the agency problem, we need to re-focus the managers attention back on

shareholder wealth (SHW). One way is by closely monitoring the manager, but the

alternative is to link the thing he/she is most concerned about i.e. their pay, to SHW.

But is it really that simple? Consider the following two scenarios A and B:

A B

Salary 0m Salary 5m

Bonus: Bonus

Low SHW 0m Low SHW 0mAverage SHW 5m Average SHW 0m

High SHW 15m High SHW 10m

In A we have linked all of the CEO pay to the value of the firm. So if the CEO

does very well he gets a big reward, if he does badly he gets nothing. Here, the CEO

is likely to be so afraid of performing badly (and getting zero) that he tends to play

things too safe not wanting to take any risks at all. i.e. he may pass up on slightly

risky, but positive NPV projects, that the shareholders would have preferred to take.

In Bwe link less of CEO pay to the value of the firm. He gets a salary no matter what

the performance, and it is only if he does very well that he know gets a bonus. Here

the manager may now take too many risks, going all out for the big bonus. i.e. he may

take up very risky, negative NPV projects that the shareholders would have preferred

to avoid.

Both link pay to performance, but both can still encourage the manager to do things

against the interests of the shareholders. Another words, solving the agency problem is

not as easy as it looks!

4. In an ideal world obviously we would all want to avoid trading with Company A.However, from a finance theory perspective, the decision must come down to one of

maximising shareholder value and not one purely of ethics. Thus from a finance point of


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7. Which of the following would appear to violate the EMH?a. A positive correlation between the return on the market in one quarter and the

change in aggregate corporate profits in the next quarter

NO: The markets will probably anticipate the results before they are officially

announced. Anticipation of higher earnings will drive the market up, just asanticipation of lower earnings would drive it down. Put another way, the signal you

get from the company is when they report high(low) earnings in Q2, by this time the

share price has already risen(dropped), so it is too late to use that information to make

money.

b. A director making superior returns on purchases of shares in his own companyYES: If it is done repeatedly, it may be an example of insider dealings and would

represent a violation of the strong-form of market efficiency

c. Companies who report unexpectedly high earnings offering higher returns thanusual on their share for several months after the results announcement

YES: The stock price would appear to be reacting too slowly to the improved earnings

figures. This would violate semi-strong form efficiency. Put another way, the signal

you get is when the firm announces unexpectedly high or low profits. If you were to

buy (sell) every time, as soon as you heard the news, you would consistently make an

abnormal profit thus indicating the market was not efficient.

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