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PAPER NO. 10 CORPORATE FINANCE
This paper is intended to equip the candidate with the knowledge, skills and techniques that will enable him/her to make effective corporate financial decisions.
8.0 LEARNING OUTCOMES
A candidate who passes this paper should be able to:
- Analyse the cost of capital of various sources of debt and equity in a firm
- Formulate appropriate capital structure decisions and select the optimal capital structure of a firm
- Appraise and formulate capital budgeting decisions under environment of certainty, uncertainty and risk
- Manage working capital for a firm
- Analyse mergers and acquisitions and corporate restructuring in firms
- Advise on dividend policy decisions
- Overview of Corporate Finance
- Nature and scope of corporate finance
- Overview of financial decision-making process
- Functions of a finance manager
- The goals of a firm
- Agency theory concepts, conflicts and resolutions
- Measuring managerial performance, compensation and
2. Capital Structure
- Sources of capital
- Factors to consider when selecting source of funds
- Capital structure of a firm and factors influencing capital structure
- Evaluation of financing proposals and determination of operating profit/EPS at the point of indifference, range of combined operating profit within which to recommend the financing option, lease vs. buy decisions
- Capital structure theories: traditional theories; net income (NI) approach; net operating income (NOI) approach; Franco Modigliani and Merton Miller (MM) propositions-MM without taxes, MM with corporate taxes, MM with corporate and personal taxes, and MM with taxes and financial distress costs; trade-off theory and pecking order theory.
- Target capital structure; reasons why a company’s actual capital structure may fluctuate around its target
- Measures of leverage: Overview of leverage; importance of business risk, sales risk, operating risk, and financial risk in leverage; classification of a risk; degree of operating leverage, the degree of financial leverage, and the degree of total leverage; breakeven quantity of sales and determination of the company’s net income at various sales levels; computation of the operating breakeven quantity of sales, evolution of financing options and determination of operating profit (EBIT)/EPS at the point of indifference, range of combined operating profit (EBIT) within each financing
3. Cost of Capital
- The concept and significance of cost of capital
- Components of cost of capital
- Weighted average cost of capital (WACC)
- Marginal cost of capital (MCC)
- Use of marginal cost of capital and the investment opportunity schedule in determination of the optimal capital budget
- Cost of debt capital using the yield-to-maturity approach and the debt-rating approach
- Computation of the cost of non-callable and nonconvertible preferred shares
- Computation of the cost of equity capital using the capital asset pricing model, the dividend discount model, and the bond-yield-plus risk-premium approach
- Computation of the beta and cost of capital for a project
- Uses of country risk premiums in estimating the cost of equity
4. Capital Investment Decisions
- Capital Investment Decisions under Certainty
- Nature of capital investment decisions under certainty
- Classification of capital budgeting decisions
- Ideal features of a capital budgeting technique
- Categories of capital projects
- Basic principles of capital budgeting; evaluation and selection of capital projects: mutually exclusive projects and project sequencing
- Capital budgeting techniques under certainty
- Estimating project cash
4.2 Capital Investment Decisions under Uncertainty
- Nature and measurement of risk and uncertainty
- Investment decision under capital rationing: multi period; investment decision under inflation, investment decision under uncertainty/risk
- Techniques of handling risk: sensitivity analysis; scenario analysis; simulation analysis; decision theory models; certainty equivalent; risk adjusted discount rates; utility curves
- Special cases in investment decisions: projects with unequal lives; replacement analysis; abandonment decisions
- Real options in investment decisions: types of real options; evaluation of capital projects using real options
- Common capital budgeting pitfalls
- Computation of accounting income and economic income in the context of capital budgeting
- Evaluation of a capital project using economic profit, residual income, and claims valuation models for capital
5. Management of Working Capital
- Factors influencing working capital requirements of a firm
- Distinction between working capital and management of working capital
- Working capital concepts; gross and net working capital; seasonal and permanent working capital
- Primary and secondary sources of liquidity; factors that influencing a company’s liquidity position
- Company’s liquidity measures in comparison to those of peer companies
- Evaluation of working capital effectiveness of a company based on its operating and cash conversion cycles; comparison of the company’s effectiveness with that of peer companies
- Effect of different types of cash flows on a company’s net daily cash position
- Computation of comparable yields on various securities; evaluation of a company’s short-term working capital investment and financing policy guidelines
- Company’s management of accounts receivable, inventory, cash and accounts payable over time and compared to peer companies
- Evaluation of the choices of short-term funding available to a company
- Profitability- liquidity trade-off.
6. Mergers and Acquisitions
- Classification of merger and acquisition (M&A) activities based on forms of integration and relatedness of business activities
- Common motivation and demotivation behind mergers and acquisitions; mergers and acquisition in global context
- Bootstrapping of earnings per share (EPS); computation of a company’s post- merger EPS
- The relationship between merger motivations and types of mergers based on industry life cycles
- Contrast merger transaction characteristics by form of acquisition, method of payment and attitude of target management
- Pre-offer defence mechanisms and post-offer takeover defence mechanisms
- Computation of Herfindahl-Hirschman Index, and the likelihood of an antitrust challenge for a given business combination
- Discounted cash flow analysis, comparable company analyses, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each
- Computation of free cash flows for a target company, and estimation of the company’s intrinsic value based on discounted cash flow analysis
- Estimation of the value of a target company using comparable company and comparable transaction analyses
- Evaluation of a takeover bid; computation of the estimated post-acquisition value of an acquirer and the gains accrued to the target shareholders versus the acquirer shareholders
- Effect of price and payment method to the distribution of risks and benefits in M&A transactions
- Characteristics of M&A transactions that create value
- Reasons for failed mergers
- Emerging trends in mergers and
7. Analysis of Corporate Growth and Restructuring
- Measurements of growth: methods of determining growth rates, sustainable versus non sustainable growth analysis of potential growth, franchise value and the growth process
- Return on assets (ROA) and return on capital (ROC)
- Common reasons for restructuring
- Relative company return analysis
- Valuation and analysis of corporate restructuring; leveraged buyouts (LBO); divestitures; strategic alliances; liquidation; recapitalisation
- Financial distress, predicting organisational failure, solutions to financial distress
- Financial restructuring; restructuring via capital reorganisation, the impact of financial restructuring on share price and WACC; forms of financial restructuring
- Portfolio restructuring; divestment, demergers, spinoffs, liquidation, equity carve- outs, MBO and management buy in
- Organisational restructuring and emerging trends in corporate
8. Dividend Policy
- Forms of dividends: Regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits: their expected effect on shareholders’ wealth and a company’s financial ratios
- Dividend payment chronology: Declaration date, holder-of-record date, ex- dividend date, and payment dates
- Theories of dividend policy
- Types of information (signals) that dividends convey
- Clientele effects and agency issues: their effect on a company’s payout policy
- Factors that affect dividend policy of a firm
- Dividend payout policies; stable dividend, constant dividend, payout ratio, and residual dividend
- Choice between paying cash dividends and repurchasing shares
- Calculation and interpretation of dividend coverage ratios under net income and free cash flow
- Emerging trends of dividend policy in corporate
9. Islamic Finance
- Justification for Islamic Finance; history of Islamic finance; capitalism; halal; haram; riba; gharar; usury
- Principles underlying Islamic finance: principle of not paying or charging interest, principle of not investing in forbidden items example alcohol, pork, gambling or pornography; ethical investing; moral purchases
- The concept of interest (riba) and how returns are made by Islamic financial securities
- Sources of finance in Islamic financing: muhabaha, sukuk, musharaka, mudaraba
- Types of Islamic financial products: – sharia-compliant products: Islamic investment funds; Takaful the Islamic version of Insurance Islamic Mortgage, Murabahah; Leasing- Ijara; safekeeping- Wadiah; Sukuk- Islamic bonds and securitisation; Sovereign sukuk; Islamic investment funds; Joint venture – Musharaka, Islamic banking, Islamic contracts, Islamic treasury products and hedging products, Islamic equity funds; Islamic derivatives
- International standardisation/regulations of Islamic Finance: Case for standardisation using religious and prudential guidance, National regulators, Islamic Financial Services Board.
10. Green/Environmental Finance
- The nature and scope of green or environmental finance
- Green financing strategies and challenges
- Carbon finance, emissions trading, green trading and renewable energy
- Green finance trading of financial instruments
- Valuation of green financial instruments namely; green bonds, green stocks, green derivatives, grants and guarantees
- Theoretical and methodological approaches in developing green financial framework
- Modern risks emerging from ecological, social, and geopolitical environment in green finance context
- Green finance trends and regulation locally and globally
11 Corporate Risk Management
- The nature and scope of corporate risk management in firms
- Value of risk management and comparative advantages of risk taking
- Value at risk and numerical and parametric methods of VaR in a firm
- Description of CVaR and CVaR in Basel Regulation
- Regulation of Bank risk and use of VaR
- Risk management, corporate governance and financial crisis
- Corporate risk management trends in firms
Complete copy of CIFA Corporate Finance Notes is available in SOFT copy (Reading using our MASOMO MSINGI PUBLISHERS APP) and in HARD copy
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OVERVIEW OF CORPORATE FINANCE
Nature and scope of corporate finance
Corporate finance is the area of finance dealing with the sources of funding and the capital structure of corporations and the actions that managers take to increase the value of the firm to the shareholders, as well as the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Investment analysis (or capital budgeting) is concerned with the setting of criteria about which value-adding projects should receive investment funding, and whether to finance that investment with equity or debt capital. Working capital management is the management of the company’s monetary funds that deal with the short-term operating balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).
The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company’s financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms “corporate finance” and “corporate financier” may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.
Financial management overlaps with the financial function of the Accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm’s value to the shareholders.
Outline of corporate finance
The primary goal of financial management is to maximize or to continually increase shareholder value. Maximizing shareholder value requires managers to be able to balance capital funding between investments in projects that increase the firm’s long term profitability and sustainability, along with paying excess cash in the form of dividends to shareholders. Managers of growth companies (i.e. firms that earn high rates of return on invested capital) will use most of the firm’s capital resources and surplus cash on investments and projects so the company can continue to expand its business operations into the future. When companies reach maturity levels within their industry (i.e. companies that earn approximately average or lower returns on invested capital), managers of these companies will use surplus cash to payout dividends to shareholders. Managers must do an analysis to determine the appropriate allocation of the firm’s capital resources and cash surplus between projects and payouts of dividends to shareholders, as well as paying back creditor related debt.
Choosing between investment projects will be based upon several inter-related criteria.
- Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of
- These projects must also be financed appropriately.
- If no growth is possible by the company and excess cash surplus is not needed to the firm, then financial theory suggests that management should return some or all of the excess cash to shareholders (i.e., distribution via dividends).
This “capital budgeting” is the planning of value-adding, long-term corporate financial projects relating to investments funded through and affecting the firm’s capital structure. Management must allocate the firm’s limited resources between competing opportunities (projects).
Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital. Investments should be made on the basis of value-added to the future of the corporation. Projects that increase a firm’s value may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions. When no growth or expansion is possible by a corporation and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company’s stock through a share buyback program.
Financial decision making process
Managers and business owners must weigh financial considerations with every major decision they make for their firm. Whether the decision involves capital expansion, hedging assets or acquiring major equipment or merging with another firm, solid financial analysis will provide the assurance that the decision is made with the best information available. There are six factors to consider.
1. The Opportunity
Financial analysis begins with a thorough description of the project being undertaken. This narrative includes background of the project, the current status and how you intend to complete the project. If, for example, you are planning to expand your business by building a new facility, you should explain why you have outgrown your current location, why the proposed addition will solve your problem and how long it will take to become operational.
2. Accounting Considerations
Your analysis will include pro forma balance sheets, income statements and projected cash flow — with and without the expansion. This will be necessary to convince investors that you have thought through details and can justify the expense of the project being undertaken.
3. Financial Considerations
Financial considerations include the details regarding the cost of the project, what working capital is required and the sources of any funds that you do not already control. If you plan to borrow funds, then weigh the cost and terms of each potential lender — venture capitalist, bank or private investor. Determine what collateral is required and if there are any special terms and conditions.
4. Risk Factors
Assessing risk factors is essential. Many risks cannot be avoided. Fire, accidents on the job, business interruptions and non-performance by a contractor are just a few of the risks you may encounter. Some require insurance; others you may self-insure. In any case, you must assess probabilities and present alternatives. Market risks and some risks of operations are uninsurable. If there is an environmental impact, then that too must be factored into your risk analysis.
5. ROI Forecast
While the forecast is implied in your pro forma financial statements, you need to address the return on investment, presenting best-case, likely case and worst-case scenarios. Since it is impossible to project business conditions with absolute certainty, offering a range of forecasts will provide assurance to investors that even with the worst case the project will have an acceptable return.
6. Legal Issues
Whatever project you are contemplating, there will be legal considerations. A physical expansion will raise environmental issues. The purchase of major equipment will require contractual agreements. There are federal, state and local ordinances and regulations that must be followed, and tax considerations that must be met at all levels.
Role of the Financial Manager
The role of the Financial Manager is to make the right decisions in order to achieve the objectives of the company in the future.
The four key areas that the Financial Manager is concerned with are as follows:
(a) The raising of long-term finance:
The company needs finance for investment and in order to expand. Finance can be raised from shareholders or from debt – it is the job of the Financial Manager to be aware of the different sources of finance and to decide which source to use.
(b) The investment decision:
Decisions have to be made as to where capital is to be invested. For example, is it worth launching a new product? Is it worth expanding the factory? Is it worth acquiring another company?
It is the Financial Manager’s role to decide on which criteria to employ in making this kind of investment decision.
(c) The management of working capital:
In order for the company to operate, it will have to accept a certain level of debtors and it will have to carry a certain level of stock.
Although these are needed to operate the business successfully, they require long-term investment of capital that is not directly earning profits.
Debtors and stock are just two components of working capital (working capital = current assets less current liabilities) and it is a job of the Financial Manager to ensure that the working capital is managed properly i.e. that it is high enough to enable to company to operate efficiently, but that it does not get out of control and end up wasting money for the company.
(d) The management of risk:
One of the roles of the Financial Manager is to manage the risk due to changing exchange rates if the business trades abroad, and to manage the risk due to changes in interest rates if the business borrows or deposits money.
Finance function is one of the major parts of business organization, which involves the permanent and continuous process of the business concern. Finance is one of the interrelated functions which deal with personal function, marketing function, production function and research and development activities of the business concern. At present, every business concern concentrates more on the field of finance because, it is a very emerging part which reflects the entire operational and profit ability position of the concern. Deciding the proper financial function is the essential and ultimate goal of the business organization.
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Finance manager is one of the important role players in the field of finance function. He must have entire knowledge in the area of accounting, finance, economics and management. His position is highly critical and analytical to solve various problems related to finance. A person who deals finance related activities may be called finance manager.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate the financial requirement of the business concern. He should estimate, how much finances required to acquire fixed assets and forecast the amount needed to meet the working capital requirements in future.
2. Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate how the finance is mobilized and where it will be available. It is also highly critical in nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the reasonable and stable return from the investment. He must be well versed in the field of capital budgeting techniques to determine the effective utilization of investment. The finance manager must concentrate to principles of safety, liquidity and profitability while investing capital.
4. Cash Management
Present day’s cash management plays a major role in the area of finance because proper cash management is not only essential for effective utilization of cash but it also helps to meet the short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing, production, personnel, system, research, development, etc. Finance manager should have sound knowledge not only in finance related area but also well versed in other areas. He must maintain a good relationship with all the functional departments of the business organization.
Financial goals of the firm
Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion: markets managers of firms direct their efforts toward areas of attractive profit potential using market prices as their signals. Choices and actions that increase the firm’s profit are undertaken while those that decrease profits are avoided. To maximize profits the firm must maximize output for a given set of scarce resources, or equivalently, minimize the cost of producing a given output.
Applying Profit-Maximization Criterion in Financial Management
Financial management is concerned with the efficient use of one economic resource, namely, capital funds. The goal of profit maximization in many cases serves as the basic decision criterion for the financial manager but needs transformation before it can provide the financial manger with an operationally useful guideline. As a benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not take account of risk; it does not take account of time value of money; it is ambiguous and sometimes arbitrary in its measurement; and it does not incorporate the impact of non- quantifiable events.
Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of uncertainty: When, as is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it is no longer clear what is to be maximized. When faced with uncertainty (risk), most investors providing capital are risk averse. A good decision criterion must take into consideration such risk.
Timing Another major shortcoming of simple profit maximization criterion is that it does not take into account of the fact that the timing of benefits expected from investments varies widely. Simply aggregating the cash flows over time and picking the alternative with the highest cash flows would be misleading because money has time value. This is the idea that since money can be put to work to earn a return, cash flows in early years of a project’s life are valued more highly than equivalent cash flows in later years.
Therefore the profit maximization criterion must be adjusted to account for timing of cash flows and the time value of money.
Subjectivity and ambiguity A third difficulty with profit maximization concerns the subjectivity and ambiguity surrounding the measurement of the profit figure. The accounting profit is a function of many, some subjective, choices of accounting standards and methods with the result that profit figure produced from a given data base could vary widely.
Qualitative information Finally many events relevant to the firms may not be captured by the profit number. Such events include the death of a CEO, political development, and dividend policy changes. The profit figure is simply not responsive to events that affect the value of the investment in the firm. In contrast, the price of the firms share (which measures wealth of the shareholders of the company) will adjust rapidly to incorporate the likely impact of such events long before they are their effects are seen in profits.
Because of the reasons stated above, Value-maximization has replaced profit- maximization as the operational goal of the firm. By measuring benefits in terms of cash flows value maximization avoids much of the ambiguity of profits. By discounting cash flows over time using the concepts of compound interest, Value maximization takes account of both risk and the time value of money. By using the market price as a measure of value the value maximization criterion ensures that (in an efficient market) its metric is all encompassing of all relevant information qualitative and quantitative, micro and macro. Let us note here that value maximization is with respect to the interests of the providers of capital, who ultimately are the owners of the firm. – The maximization of owners’ wealth is the principal goal to be aimed at by the financial manager.
In many cases the wealth of owners will be represented by the market value of the firm’s shares – that is the reason why maximization of shareholders wealth has become synonymous with maximizing the price of the company’s stock. The market price of a firms stocks represent the judgment of all market participants as to the values of that firm
-it takes into account present and expected future profits, the timing, duration and risk of these earnings, the dividend policy of the firm; and other factors that bear on the viability and health of the firm. Management must focus on creating value for shareholders. This requires Management to judge alternative investments, financing and assets management strategies in terms of their effects on shareholders value (share prices).
- Social Responsibility and Ethics
It has been argued that the unbridled pursuit of shareholders wealth maximization makes companies unscrupulous, anti social, enhances wealth inequalities and harms the environment. The proponents of this position argue that maximizing shareholders wealth should not be pursued without regard to a firm’s corporate social responsibility. The argument goes that the interest of stakeholders other than just shareholders should be taken care of. The other stakeholders include creditors, employees, consumers, communities in which the firm operates and others. The firm will protect the consumer; pay fair wages to employees while maintaining safe working conditions, support education and be sensitive to the environment concerns such as clean air and water. A firm must also conduct itself ethically (high moral standards) in its commercial transactions.
Being socially responsible and ethical cost money and may detract from the pursuit of shareholders wealth maximization. So the question frequently posed is: is ethical behavior and corporate social responsibility inconsistent with shareholder wealth maximization?
In the long run, the firm has no choice but to act in socially responsible ways. It is argued that the corporation’s very survival depend on it being socially responsible. The implementation of a pro-active ethics ad corporate social responsibility (CSR) program is believed to enhance corporate value. Such a program can reduce potential litigation costs, maintain a positive corporate image, build shareholder confidence, and gain the loyalty, commitment and respect of firm’s stakeholders. Such actions conserve firm’s cash flows and reduce perceived risk, thus positively effecting firm share price. It becomes evident that behavior that is ethical and socially responsible helps achieve firm’s goal of owner wealth maximization.
Ø Growth and expansion.
This is a major objective for small companies which seek to expand operations so as to enjoy economies of scale.
Difficulty of Achieving Shareholders Wealth Maximization
Two difficulties complicate the achievement of the goal of shareholder wealth maximization in modern corporations. These are caused by the agency relationships in a firm and the requirements of corporate social responsibility (As discussed above).
An agency relationship is created when one party (principal) appoints another party (agent) to act on their (principals) behalf. The principal delegates decision making authority to the agent. In a firm agency relationship exists between;
- Shareholders and management
- Shareholders and creditors
- Shareholders and the government
- Shareholders and auditors
Shareholders and management
The separation of ownership and control in most modern corporations’ causes a conflict of interest between the personal interest of appointed managers (agent) and the interests of the owners of the firms (principals).this conflict is known as the agency conflict.
The following are some decisions by managers which would result in a conflict with shareholders:
- Managers may use corporate resources for personal use.
- Managers may award themselves hefty pay rises
- Managers may organize mergers which are intended for their benefit only and not for the benefit of
- Managers may take holidays and spend huge sums of company
- Managers may use confidential information for their benefit (insider trading)
Resolution of conflict
1. Performance based remuneration
This will involve remunerating managers for actions they take that maximize shareholders wealth. The remuneration scheme should be restructured in order to enhance the harmonization of the interest of shareholders with those of management. Managers could be given bonuses, commissions for superior performance in certain periods.
2. Incurring agency costs
Agency costs refer to costs incurred by shareholders in trying to control management behavior and actions and therefore minimize agency conflicts.
These costs include:
- Monitoring costs. They arise as a result of mechanisms put in place to ensure interests of shareholders are met. They include cost of hiring external auditors, bonding assurance which is insurance taken out where the firm is compensated if manager commits an infringement, internal control system implementation.
- Opportunity costs which are incurred either because of the benefit foregone from not investing in a riskier but more profitable investment or in the due to the delay in decision making as procedures have to be followed(hence, a timely decision will not be made)
- Restructuring costs are those costs incurred in changing or altering an organizations structure so as to prevent undesirable management
- Board of directors– a properly constituted board plays the oversight role on management for the
3. Threat of corporate takeover
When management of a firm under performs this result in the shares of that firm being undervalued there is the threat of a hostile takeover. This threat acts to force managers to perform since should the firm be taken over they will be replaced.
4. Shareholders intervention
The shareholders as owners of the company have a right to vote. Hence, during the company’s AGM the shareholders can unite to form a bloc that will vote as one for or against decisions by managers that hurt the company. This voting power can be exercised even when voting for directors. Shareholders could demand for an independent board of directors.
5. Legal protection
The companies act and bodies such as the capital markets authority have played their role in ensuring trying to minimize the agency conflict. Under the companies act, management and board of directors owe a duty of care to shareholders and as such can face legal liability for their acts of omission or commission that are in conflict with shareholders’ interests. The capital market authority also has corporate governance guidelines.
Use of corporate governance principles which specify the manner in which organizations are controlled and managed. The duties and rights of all stakeholders are outlined.
- Stock option schemes for managers could be introduced.
These entitle a manager to purchase from the company a specified number of common shares at a price below market price over duration. The incentive for managers to look at shareholders’ interests and not their own is that, if they deliver and the company’s share price appreciates in the stock market then they will make a profit from the sale.
- Labour market actions
such as hiring tried and tested professional managers and firing poor performers could be used. The concept of ‘head hunting’ is fast catching on in Kenya as a way of getting the best professional managers and executives in the market but at a fee of course.
Shareholders vs. creditors
In this relationship the shareholders (agent) are expected to manage the credit funds provided by the creditors (principal). The shareholders manage these funds through management.
Debt providers/creditors are those who provide loan and credit facilities to the firm. They do this after gauging the riskiness of the firm.
The following actions by shareholders through management could lead to a conflict between them and creditors
1. Shareholders could invest in very risky projects
The management under the directive of the shareholders may undertake highly risky investments than those anticipated by the providers of long term debt finance. The creditors would not be interested in highly risky projects because they stand to lose their funds when the investments collapse. Even if the risky projects succeed they would not benefit because they only get a fixed rate of return.
2. The dividend payments to shareholders could be very high
An increase in the dividend rate in most cases is financed by a decrease in investments. This in turn reduces the value of bonds. If the firm is liquidating and it pays a liquidating dividend to its shareholders, the providers of capital could be left with worthless claims.
- Default on interest payments to bondholders
- Shareholders could organize mergers which are not beneficial to creditors
- Shareholders could acquire additional debt that increases the financial risk of the firm
- Manipulation of financial statements so as to mislead creditors
- Shareholders could dispose of assets which are security for the credit given
- Under investments
The shareholders may invest in projects with a negative net present value.
- The shareholders may adopt an aggressive management of working capital. This may bring conflicts in liquidity position of the firm and would not be in the interest of the debt holders
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Resolution of this conflict
- Restrictive covenants– these are agreements entered into between the firm and the creditors to protect the creditor’s interests.
These covenants may provide restrictions/control over:
- Asset based covenants- These states that the minimum asset base to be maintained by the
- Liability based covenant- This limits the firm’s ability to incur more
- Cashflow based covenant- States minimum working capital to be held by the firm. This may restrict the amount of dividends to be paid in
- Control based covenant – Limits management ability to make various decisions
e.g. providers of debt fund may require to be represented in the BOD meetings.
- Creditors could also offer loans but at above normal interest rates so as to encourage prompt payment
- Having a callability clause to the effect that a loan could be re-called if the conflict of interest is severe
- Legal action could also be taken against a company
- Incurring agency costs such as hiring external auditors
- Use of corporate governance principles so as to minimize the
Shareholders and the government
The shareholders operate in an environment using the license given by the government. The government expects the shareholders to conduct their business in a manner which is beneficial to the government and the society at large.
The government in this agency relationship is the principal and the company is the agent. The company has to collect and remit the taxes to the government. The government on the other hand creates a conducive investment environment for the company and then shares in the profits of the company in form of taxes. The shareholders may take some actions which may conflict the interest of the government as the principal.
These may include;
- The company may involve itself in illegal business activities
- The shareholders may not create a clear picture of the earnings or the profits it generates in order to minimize its tax liability.(tax evasion)
- The business may not response to social responsibility activities initiated by the government
- The company fails to ensure the safety of its employees. It may also produce sub standard products and services that may cause health concerns to their consumers.
- The shareholders may avoid certain types of investment that the government
Solutions to this agency problem
- The government may incur costs associated with statutory audit, it may also order investigations under the company’s act, the government may also issue VAT refund audits and back duty investigation costs to recover taxes evaded in the
- The government may insure incentives in the form of capital allowances in some given areas and locations.
- Legislations: the government issues a regulatory framework that governs the operations of the company and provides protection to employees and customers and the society at large.ie laws regarding environmental protection, employee safety and minimum wages and salaries for
- The government encourages the spirit of social responsibility on the activities of the
- The government may also lobby for the directorship in the companies that it may have interest in. i.e. directorship in companies such as KPLC, Kenya etc