Question one
Explain why each of the following situations is an agency problem and what costs to the firm might result from it. Suggest how the problem might be dealt with short of firing the individual(s) involved.
The front desk receptionist routinely takes an extra 20 minutes of lunch to run personal errands (3 marks)
The situation is an agency issue because the receptionist gets paid for unproductive time, spent in the form of additional lunch time. The solution to this problem might include installation of a time clock that the receptionist has to press before leaving the work station and again when resuming work. The strategy will ensure that the receptionist returns to her work point on time.
Division managers are padding cost estimates in order to show short-term efficiency gains when the costs come in lower than the estimates. (3 marks)
This is an agency problem because it involves opportunity costs. In other words, the money budgeted for the proposed project is not utilized for additional projects that may increase value creation. To deal with this problem, the reward system should focus on closeness of employees’ estimates to the real cost.
The firm’s chief executive officer has secret talks with a competitor about the possibility of a merger in which he would become the CEO of the combined firms. (3 marks)
The issue costs the agency by increasing the chances of selling the firm for a price lower than its fair value. To control the agency costs, the company may be opened for other firms’ purchase bids. The open bidding has the potential to yield the company’s fair price.
A branch manager lays off experienced full-time employees and staffs customer service positions with part-time or temporary workers to lower employment costs and raise this year’s branch profit. The manager’s bonus is based on profitability. (3 marks)
This is an agency problem because firing the full-time staff is only profitable in the short-term. In the long run, profitability of the company will be affected negatively. The problem can be addressed by providing a stock incentive plan to the manager so that his compensation is tied to stock price. This way, the manager will have to make decisions that benefit the firm instead of prioritizing personal interests at the expense of the company.
Question two
“A firm’s risk and expected return directly affect its share price.”
Required
Using well-reasoned answers evaluate the statement above. (6 marks)
The financial manager has to assess risk and return in order to maximize share price. These are two key aspects in performance of a business’ share price. Risk represents the possibility of incurring financial loss. Therefore, assets with increased chances of loss are riskier than those with lower chances. Certainty of asset return reduces variability and risk level. Return refers to the overall loss/gain from an investment after a duration of time. Return results from cash distribution over time period as a percentage of the investment value at the beginning of that period. For every financial decision, a particular amount of risk and return is involved and the unique way in which these factors combine influences the share price.
Question three
Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:
Expected Expected
Investment return risk index
X 14% 7%
Y 12% 8%
Z 10% 9%
Required
If Sharon Smith were risk-indifferent, which investments would she select? Explain why. (4 marks)
For a risk-indifferent manager, the expected return remains the same as risk doubles. In other words, such a manager does not focus on change in return even when the risk increases. Therefore, if Sharon Smith is risk-indifferent, she would select investment Y. Initially, expected returns was 12% and risk index 6%. For investment Y, the risks rise to 8% while returns remain 12%.
If she were risk-averse, which investments would she select? Why?
(4 marks)
A risk-averse manager expects the return to increase as risks rise. Generally they expect higher returns to help them compensate for higher risks. If Sharon Smith is risk-averse, she would select investment X. Although the risk index increases from 6% to 7%, the returns also increase from 12% to 14%.
If she were risk-seeking, which investments would she select? Why? (4 marks)
The risk-seeking manager expects the returns to decrease as risks increase. The managers in this category willingly give up part of their returns to take additional risk. If Sharon Smith is a risk-seeker, therefore, she would select investment Z. Here, the expected returns decrease from 12% to 10% while risk rises from 6% to 9%.
