INSTRUCTION: ANSWER ALL QUESTIONS

QUESTION 1 (15 marks)

(a) Who owns a corporation? What is the main reason that an agency relationship exists
in the corporate form of organization? In this context, what is meant by an agency
relationship, agency problem and agency cost?
(5 marks)

Answer:
In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firm’s
management. This separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management may act in their own or
someone else’s best interests, rather than those of the shareholders. If such events occur, they
may contradict the goal of maximizing the share price of the equity of the firm.

Agency problems arise when conflict exists between parties in the agency relationship,
when principal (shareholders) hires an agent (managers) to act on his or her behalf. The
primary agency conflicts arise between shareholders and managers; and shareholders and
bondholders. This agency problems occurs when the agent (managers) place personal goals
and maximize for their own satisfactions & benefits.

Or in simple terms, “Agency problems” is a potential conflict of interest between; (1)

outside shareholders and the managers, (2) shareholders and creditors/bondholders.
“Agency problems” arises whenever the manager of a firm own less than 100% of the firm’s
common stock.

(b) Can there be a difference between profit maximization and shareholder wealth
maximization? If so, what could cause this difference? Which of the two should be the goal of
the firm and its management? Why? (5 marks)

Answer:
Profit maximization and maximizing shareholder wealth could conflict. For example,
company could accept very high return (and also very high risk projects) that do not return
enough to compensate for the high risk. Profits, or net income (commonly measured by
EPS), are accounting numbers and therefore subject to manipulation. It would be possible to
show positive profits when shareholder wealth was actually being decreased.

There are THREE aspects of cash flows that affect an investment value (firm’s stock price):
1) Amount of expected cash flows (bigger is better), 2) Timing of the cash flow stream
(sooner is better), 3), Risk of the cash flows (less risk is better). Thus, profit maximization is
NOT consistent with wealth maximization because of: 1) Profits DO NOT consider timing of
EPS, 2) Earnings DOES NOT represent cash flows available to stockholders, and 3) profit
maximization FAILURE to consider risk (risk NOT involved).

The corporation’s primary goal is stockholder wealth maximization, which translates to

maximizing the price of the firm’s common stock.
(c) List the three principal forms of business organization? What are at least THREE the
primary advantages of corporations? (5 marks)

Answer:
The three main forms of business organization are; (1) sole proprietorships, (2) partnerships,
and (3) corporations.

Advantages of Proprietorships and Partnerships Disadvantages

1. Easy to form 1. Limited life
2. Few regulations 2. Unlimited liability
3. No corporate income taxes 3. Hard to raise capital
4. Being one’s own boss
Advantages of Corporations Disadvantages
1. Unlimited life 1. Double taxation
2. Easy to transfer ownership 2. Costly set up
3. Limited liability 3. Costly period reports
required
4. Easier to raise capital

1) The proprietorship.
ADVANTAGES: (1) it is easily and inexpensively formed, (2) it is subject to few government
regulations, and (3) the business pays no corporate income taxes, (4) secrecy.
DISADVANTAGES: (1) it is difficult for a proprietorship to obtain large sums of capital; (2)
the proprietor has unlimited personal liability for the business’s debts, and (3) the life of a
business organized as a proprietorship is limited to the life of the individual who created it.

2) Partnership.
ADVANTAGES: (1) low cost and ease of formation, (2) can raise more funds than sole
proprietorship, (3) more available brain power and managerial skills, (4) the tax treatment of
a partnership is similar to that for proprietorships, which is often an advantage.
DISADVANTAGES: (1) unlimited liability, (2) limited life of the organization, (3) difficulty of
transferring ownership, and (4) difficulty of raising large amounts of capital.

3) Corporation.
ADVANTAGES: (1) unlimited life, (2) easy transferability of ownership interest, (3) limited
liability, (4) better access to financing, (5) can hire professional managers.
DISADVANTAGES: (1) corporate earnings may be subject to double taxation (in US), (2)
more complex, expensive and time-consuming to organize than other forms, (3) subject to
greater government regulation, (4) lacks secrecy, because stockholders must receive
financial reports.
 QUESTION 2 (15 marks)

(A) Given the balance sheets and selected data from the income statement of SMG Industries
that follow, answer parts (a)–(c).

(a) Calculate the firm’s operating cash flow (OCF) for the year ended December 31,
2006. (5 marks)

(b) Calculate the firm’s free cash flow (FCF) for the year ended December 31, 2006.
(5 marks)

(c) Interpret, compare, and contrast your cash flow estimates in parts (a) and (b).
(5 marks)

SMG Industries
Balance Sheets
(in $ millions)
December December Liabilities and December December
Assets 31, 2006 31, 2005 Stock-holders’ 31, 2006 31, 2005
Equity

Cash $ 3,500 $ 3,000 Accounts payable $ 3,600 $ 3,500

Marketable 3,800 3,200 Notes payable 4,800 4,200
securities
Accounts 4,000 3,800 Accruals 1,200 1,300
receivable
Inventories 4,900 4,800 Total current $ 9,600 $ 9,000
liabilities
Total current $16,200 $14,800 Long-term debt 6,000 6,000
assets
Gross fixed assets $31,500 $30,100 Total liabilities $15,600 $15,000
Less:
Accumulated 14,700 13,100
depreciation Common stock $11,000 $11,000
Net fixed assets $16,800 $17,000 Retained earnings 6,400 5,800
Total assets $33,000 $31,800 Total stockholders’
equity $17,400 $16,800
Total liabilities and
stockholders’ $33,000 $31,800
equity

Income Statement Data (2006, in $millions)

Depreciation expense $1,600

Earnings before interest and taxes (EBIT) 4,500
Taxes 1,300
Net profits after taxes 2,400
 Answer:
a. Operating cash flow = EBIT – Taxes + Depreciation
= $4,500 – $1,300 + $1,600
= $4,800

b. Free cash flow = OCF – D FA – (DCA – DA/P – DAccruals)

= 4,800 – (31,500 – 30,100) – [(16,200 – 14,800) – (3,600 – 3,500) – (1,200 –
1,300)]
= $2,000

c. OCF is higher than FCF because operating does not include interest expense,
while this is part of net income. FCF not only looks at operations but all looks at
whether a company has added assets or reduced liabilities uses of cash) or
reduced assets and increased liabilities (sources of cash).

QUESTION 3 (15 marks)

Below is the key financial data for Tom Yam Industries as of 2007.

Key Financial Data

Tom Yam Industries:
Sales RM4,500,000
Cost of Good Sold RM3,600,000
Net profit after taxes RM337,500
Total assets (42% is net non-current assets) RM6,750,000
Total liabilities (40% is non-current liabilities) RM3,375,000
Financial leverage multiplier 2

Industry Averages:
Total asset turnover 0.71
Debt ratio 33.0%
Financial leverage multiplier 1.50
Return on total assets 6.75%
Return on equity 10.00%
Net profit margin 9.50%

(a) Calculate: (10 marks)

i. Current Ratio = CA/CL = 3915000/2025000 = 1.933 times

ii Gross Profit Margin = Gross profit/Sales = 900000/4500000

= 20%

iii. Net Profit Margin = Net Profit/Sales = 337500/4500000

= 7.5%
 iv. Total Asset Turnover = Sales / Total Assets = 4500000/6750000
= 0.667 times

v. Debt Ratio = Total Debt/Total Assets = 3375000/6750000

= 50%

(b) Construct the DuPont system of analysis using the following financial data for Mah
Wee Industries and determine which areas of the firm need further analysis as to
compare to the industry average. (Hint: ROE = ROA x Financial leverage multiplier)
(5 marks)
Answer:

ROE = NPM x TATO x FLM

= 7.5% x 0.67 x 2 = 10.05%

DuPont System of Analysis: Mah Wee performs equally to IA according to the return
on equity. However, when dissecting the financial data further into three key
components of the DuPont system (a profit-on sales, efficiency of asset use, and a
use of leverage component), some areas of improvement may be highlighted. Mah
Wee Industries has a lower net profit margin and return on total assets than
industry averages. Nevertheless, the firm makes up for the low profit margin through
excessive use of leverage (a 50% debt ratio versus 33 percent for the industry).
Financial risk could be reduced resulting in the same return on equity by increasing
the net profit margin and reducing debt.

QUESTION 4 (15 marks)

(a) To buy his favorite car, Umar is planning to accumulate money by investing his salary
bonuses for the next five years in ASB which pays a 10 percent annual rate of return. The car
will cost RM55,000 at the end of the fifth year and Umar’s bonus is RM8,250 a year. Will
Umar accumulate enough money to buy the car? (5 marks)

FVA = 8250 (FVIFA 10%, 5)

= 8250 ( 6.1051)
= RM50367.08 (not enough)
(b) Ten years ago, Tarmizi purchased a painting for RM300. The painting is now worth
RM1,020. Tarmizi could have deposited RM300 in a savings account paying 12 percent
interest compounded quarterly. Which of these two options would have provided Tarmizi
with a higher return? (Hint: use EAR to compare) (5 marks)

Purchase a painting
FV = PV (1+i)n =
1020 = 300 (1+i)10
(1+i)10 = 3.4 (refer table)
i = 13% (Provide higher return)

Saving account
EAR = (1 + 0.12/4)4 - 1 = 12.55%

(c) Salwa has just graduated from high school and has received an award for RM5,000.
She would like to deposit the money in an interest earning account until she graduates from
college (i.e., four years from now). In her search for the highest interest earning account, she
has narrowed the list down to the following two accounts: 1) Bank Bumicome pays 9 percent
compounded annually, and 2) Bank Bumicute pays 8 percent compounded semi-annually.
Which is better offer, and how much will Salwa have upon graduation from college?
(5 marks)
Bank Bumicome: n = 4, i = 9%, m = 1
FV = 5000 (1.09)4 = 5000 ( 1.4116) = RM7057.908

Bank Bumicute: n = 4; i = 8%, m = 2

FV = 5000(1.04)8 = 5000 (1.3686) = RM6843.00

Salwa should deposits in Bank Bumicome because of the high FV.