CORPORATE FINANCE (UKFF 3013)

JANUARY 2023 TRIMESTER

TUTORIAL 2 (WEEK STARTING 06 FEB 2023)
THE FINANCE FUNCTION (CHAPTER 1)

QUESTION 1
Some managers, if asked what the main objective of their business is, may simply state: ‘To
survive!’ What do you think of this as a primary objective?

SOLUTION
Survival may be a basic objective for a business. However, shareholders will expect to
receive returns from their investment and will not be interested in businesses that simply
see this as their primary objective. Nevertheless, there may be times when survival has to
become the main objective. In a highly competitive economy, a business has to pursue
shareholder wealth maximisation in order to survive. Under such circumstances,
shareholder wealth maximisation and survival become inextricably linked.

QUESTION 2
How might the managers of a business increase short-term profits at the expense of long-term
profits? Try to think of at least two ways.

SOLUTION
Managers may reduce operating expenses, and so increase short-term profits, by:
 reducing research and development expenditure
 cutting staff training and development
 buying lower-quality materials
 reducing marketing expenditure
 cutting quality control mechanisms.

QUESTION 3
The following details relates to F Berhad’s, a multinational public listed company on Bursa
Malaysia. They operate in various sectors. The breakdown of activities by percentage of total
annual turnover are provided:
Department stores 30%
Clothing 24%
Building materials 20%
Hotels and catering 16%
Electronics 10%

Additional information on the company is:

Current share price: RM2.34
Average annual share price growth over past five years: 5%
Multinational sector average annual share price growth over past 5 9%
years
Level of gearing based on market values (debt/debt + equity) 23%
Multinational sector gearing level based on market values (debt/debt 52%
+ equity)
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THE FINANCE FUNCTION (CHAPTER 1)

The Board of Directors of the company were given share options by its remuneration
committee five years ago. In one year’s, time, the share options will allow each director to buy
100,000 shares in the company at a price of RM2.00. The directors’ average annual salary
currently stands at RM200,000 on a five-year rolling contract basis, while average salaries in
the multinational sector are RM150,000 and tend to be a three-year rolling contract.

REQUIRED:

(a) Using the information above to illustrate your answer, critically discuss the extent to which
F Berhad can be said to be suffering from an agency problem.
(b) Discuss how the issues you have identified in part (a) can be addressed to reduce the
agency problem.

SOLUTION

(a) Agency implies that managers (as agents) maximise their own wealth rather than that of
their shareholders (the principals) due to asymmetry of information, differing objectives
and divorce of ownership and control. Hence, we need to look for clear signs that agency
problems are present.

The first thing to note is that F Berhad has diversified its activities across a range of
different industries. This is often justified in the name of reducing risk for shareholders, but
shareholders should have already diversified themselves through the portfolios they hold.
Companies tend to diversify their activities for managerial motives, such as to increase
job security by diversifying unsystematic risk.

Second, F Berhad is maintaining a gearing ratio significantly below the industrial average.
This is another example of the agency problem as shareholders prefer higher levels of
debt because of the cheaper cost of debt finance and are prepared to accept higher
levels of financial risk because they have a diversified portfolio. Managers, however,
prefer equity finance as too high a level of financial risk could jeopardise their job
security.

A more obvious example of the agency problem is that the directors’ average salaries are
above the industry norms and they have five-year contracts, contravening corporate
governance directives like the Greenbury Report. Managers are likely to become
complacent with contracts of such length.

There is also a problem with the use and terms of the share options. Given the historical
growth rate in share price of 5 per cent, the company’s share price five years ago when the
directors were given the share options would have been approximately £1.83. For the
share price to climb above £2 in less than five years represents a very unchallenging target
If managers were to exercise the options in a year’s time, their gain would be:
(2.34 × (1.05) – 2.00) × 100,000 = £45,700 This is a big reward for underperforming the
sector share price growth rate of 9 per cent.

(b) Given the company appears to have major agency and corporate governance problems,
these could be reduced by some of the following actions:
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• get managers to refocus the business in one area of specialisation and realise
economies of scale and operation;
• instruct managers to increase the level of debt finance as the current level of gearing is
unlikely to minimise the company’s cost of capital;
• restructure share options so that gains are achievable if managers stretch themselves;
• monitor managers to ensure they are not maximising their own wealth. The degree of
success depends on the monitoring method used and the structure of the company’s
shareholders as someone must pay for monitoring to take place;
• reduce salaries back in line with industry averages and tie part of the salary to a
performance-related variable (e.g. company share price relative to the sector). Introduce
one-year rolling contracts to keep managers on their toes;
• examine the constitution of the remuneration committee and the backgrounds of
nonexecutive directors, and make appropriate changes where necessary.
Ultimately, the shareholders might want to exercise their right to vote out directors at the
AGM if they think that their performance has been poor.

QUESTION 4
‘One effect of the recent globalisation of business is that it is now easier for owners and
managers to escape their ethical obligations than in previous eras.’ Can you think of any
reasons in support of this viewpoint?

SOLUTION
Some believe that modern capitalism is less ethical than the capitalism of previous eras. It is
claimed that the free movement of capital (and labour) across frontiers has weakened ties
between the various stakeholders. Where managers of global businesses are geographically
remote from the business’s operations, they can more easily ignore the pain inflicted on other
stakeholders resulting from their decisions. Roger Scruton, the eminent philosopher, has
argued that, in the past, things were different. Owners and managers lived in the same country
and same town as those affected by their decisions and it was very difficult to avoid the
obligations of neighbourhood.

The methods identified, however, may undermine the long-term competitiveness and
performance of the business.

QUESTION 5

R Berhad is a long-established petrochemical manufacturer, producing rare chemical products

in the east coast. The company’s products are marketed in USA, Europe and the Pacific
regions.

One of the company’s code of ethics is environmental responsibility. Last year, the company
was fined for an untreated discharge into a local river.

Over the years, the company’s share price has performed well. Now, there is concern that
price and cost competition from new entrants into the domestic market will have a significant
impact on the firm’s profitability and the dividends. R Berhad borrowed heavily to finance its
working capital requirements for local and overseas businesses. The management is
evaluating different foreign currency hedging methods to minimise its currency risk on the
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payments to its overseas suppliers. The hedging methods that are available to R Berhad are
leading, lagging, forward and money markets.
The company is now considering expanding into other businesses through mergers or
acquisition. The finance director has proposed that the company acquire 100% of the equity of
D Berhad, an oil refinery company. The acquisition will be financed via a bond issue that will
not significantly impact upon the company’s existing credit rating and its capital structure. The
cost of capital is 7%.

Required:
a) Untreated discharge into a local river causes damage to environment. Environmental risk is
material to shareholder value. Discuss.

b) Agency conflicts may arise because of the differences in the interests of the owners and
managers. Explain the reasons for agency conflicts.

SUGGESTED ANSWER
(a)
R Berhad was fined for an untreated discharge into a local river. This is considered as
environmental accident and the risk for the environmental damage is clearly material to
shareholder value and is likely to remain so while the company continues to manufacture
petrochemical products.

The shareholders will evaluate the extent and nature of the risk and assess whether the risk
profile of the business matches their own attitudes to or appetite for the environmental risk. In a
portfolio of shares, some investors will want to blend the environmental risks and returns, and
knowing about a company’s environmental risks is important in making these judgements.

The environmental risk information will allow the shareholders to judge how the risk might
affect the company’s value and hence the potential volatility and attractiveness of the share.
The penalty imposed on the company is capable of affecting returns, costs or both. When the
shareholders are aware of the environmental pollution and if the environmental risk is material,
the shareholders would have discounted the share price accordingly. The shareholders will
also evaluate the new risk controls put in place by the management because these measures
could be vital in restoring investor confidence. In particular, they should reassure shareholders
that the accident should not re-occur, or that if it were to re-occur, further controls would be in
place to offset the worst of the damage.
(b)
A manager has an interest in receiving benefit from his or her position as a manager. These
include all the benefits that come from status, such as a company car, use of a company
airplane, lunches, attendance at sponsored sporting events, and so on. Managers may work
less hard than they would if they were the owners of the company. The effect of ‘lack of effort’
could be lower profit and lower share price.

The interest of middle managers and the interest of senior managers might well be different,
especially if senior management are given pay incentives to achieve higher profits, but the
middle managers are not.

The remuneration of directors and senior managers is often related to the size of the company,
rather than its profits. This gives managers an incentive to grow the company, and increase its
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sales turnover and assets, rather than to increase the returns to the company’s shareholders.
Management are more likely to went to re-invent profits in order to make the company bigger,
rather than pay-out the profits as dividends.

Shareholders are concerned about the long-term financial prospects of the company, because
the value of their shares depends on expectations for the long –term future, in contrast,
managers might only be interested in the short-term. These is partly because they might
receive annual bonuses based on short-term performance, and partly because they might not
expect to be with the company for more than a few years. Managers might therefore have an
incentive to increase accounting return on capital employed (or return on investment), whereas
shareholders have a greater interest in long term share value.

QUESTION 6
What are some of the problems involved in the use of profit maximization as the goal of
the firm? How does the goal of maximization of shareholder wealth deal with those
problems?

SUGGESTED ANSWER
The goal of profit maximization is too simplistic in that it assumes away the problems of
uncertainty of returns and the timing of returns.

Rather than use this goal, we have chosen maximization of shareholders' wealth—that
is, maximization of the market value of the firm's common stock—because the effects of
all financial decisions are included. The shareholders react to poor investment or
dividend decisions by causing the total value of the firm's stock to fall and react to good
decisions by pushing the price of the stock upward. In this way all financial decisions
are evaluated, and all financial decisions affect shareholder wealth.

QUESTION 7
Explain ways in which the directors of a public listed company can be encouraged to
achieve the objective of maximisation of shareholder wealth.

SUGGESTED ANSWER
The directors can be encouraged to achieve the objective of maximising shareholder
wealth through managerial reward schemes and through regulatory requirements.

Managerial reward schemes

As agents of the company’s shareholders, the directors may not always act in ways
which increase the wealth of shareholders, a phenomenon called the agency problem.
They can be encouraged to increase or maximise shareholder wealth by managerial
reward schemes such as performance-related pay and share option schemes.
Through these methods, the goals of shareholders and directors may increase in
congruence. Performance-related pay links part of the remuneration of directors to some
aspect of corporate performance, such as levels of profit or earnings per share. One
problem here is that it is difficult to choose an aspect of corporate performance which is
not influenced by the actions of the directors, leading to the possibility of managers
influencing corporate affairs for their own benefit rather than the benefit of shareholders,
for example, focusing on short-term performance while neglecting the longer term.
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Share option schemes bring the goals of shareholders and directors closer together to
the extent that directors become shareholders themselves. Share options allow directors
to purchase shares at a specified price on a specified future date, encouraging them to
make decisions which exert an upward pressure on share prices. Unfortunately, a
general increase in share prices can lead to directors being rewarded for poor
performance, while a general decrease in share prices can lead to managers not being
rewarded for good performance. However, share option schemes can lead to a culture of
performance improvement and so can bring continuing benefit to stakeholders.

Regulatory requirements
Regulatory requirements can be imposed through corporate governance codes of best
practice and stock market listing regulations. Corporate governance codes of best
practice, such as the MCCG 2012/ MCCG 2017/ MCCG 2021, seek to reduce corporate
risk and increase corporate accountability. Responsibility is placed on directors to
identify, assess and manage risk within an organisation. An independent perspective is
brought to directors’ decisions by appointing non-executive directors to create a balanced
board of directors, and by appointing non-executive directors to remuneration committees
and audit committees.

Stock exchange listing regulations can place obligations on directors to manage

companies in ways which support the achievement of objectives such as the
maximisation of shareholder wealth. For example, listing regulations may require
companies to publish regular financial reports, to provide detailed information on
directorial rewards and to publish detailed reports on corporate governance and
corporate social responsibility. ESG

QUESTION 8
Daily Clothing Bhd is a medium sized trading company situated in the Klang Valley. It
has been trading for ten years and is managed by its main shareholders who are the
original founders of the company. Most of the employees are also shareholders, having
been given shares as bonuses in previous years. The main business of the company is
the supply of commercial and industrial clothing. Its mission statement is ‘We maximize
our shareholder value through supplying good value clothing for our customers’. The
company also practices several codes of business ethics. The code of ethics also
covers environmental responsibility.

Since its incorporation, Daily Clothing Bhd has experienced rapid expansion via
generic growth. The company has had a very efficient credit controller who has
managed the credit control department efficiently by preparing the aging lists on a
weekly basis and collected payments from debtors on time. He introduced early
settlement cash discounts and managed to reduce bad debts. This improved the
liquidity of the company. During his tenure, the overdraft was within the required limit.

Recently, the credit controller resigned and migrated to another country. After his
resignation, the company’s credit control department was poorly managed by an
inexperienced and inefficient newly recruited credit controller. The ineffective credit
control has had serious effect on the company’s overdraft. The company too was fined
for discharging washing detergents into a local river without any treatment. At the
recent board meeting, discussions were held on the liquidity of the company and the
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breach of environmental ethics. It was also highlighted that the board had insisted the
management to reduce its overdraft urgently.

REQUIRED:
(a) Discuss how Daily Clothing Bhd’s financial objective might be achieved and
measured.

SUGGESTED ANSWER
Daily Clothing Bhd’s mission is to maximise shareholder value. Shareholder value is
linked to dividend payment as well as capital gain. To increase dividend, the company
needs to identify and undertake investments which give positive net present values. If
the company accepts investments with positive NPVs, free cashflows for the company
will increase. A positive NPV represents an investment return that is greater than that
required by a company’s providers of finance, offering the possibility of increased
dividends being paid to shareholders from future cash flows. When there is ample cash
available and high dividends are paid, demand for the shares will increase and the
market value of the company, theoretically at least, increases by the amount of the
NPV. Shareholder’s wealth is therefore increased if positive NPV projects are accepted
and, again theoretically, shareholders wealth will be maximised if a company invests in
all projects with positive NPVs.

(b) Advise the directors of Daily Clothing Bhd on the benefit(s) the other
stakeholders will receive if the company’s financial objective is achieved.

SUGGESTED ANSWER
When Daily Clothing Bhd’s financial objective is achieved, it will benefit other
stakeholders either directly or indirectly. The stakeholders are:
 Customers
 Suppliers
 Government
 Employees
 Lenders

QUESTION 9

Assume you own stock in a company, and you are in the process of selling the stock to another
investor. Since the transaction will occur between the buyer and seller, the company will
receive no direct cash flows as a result of the sale. Why should the company’s management
care about the price you get for your shares if the company does not receive any direct cash
flow from the transaction?

SOLUTION

The current market price of the stock of the company reflects, among other things, market
opinion about the quality of firm management. If the sale price is low, this indirectly reflects on
the reputation of the managers, as well as potentially impacting their standing in the
employment market. Alternatively, if the sale price is high, this indicates that the market
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believes current management is increasing firm value, and therefore doing a good job. An
increase in the selling price would mean that shareholder wealth was maximized.
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Customers – When Daily Clothing is financially successful, it would be able to

invest in new technology equipment and facilities. This will improve the quality of the
clothing.
Suppliers- If the company is financially sound, it would be able to pay the suppliers
on time and at the same time purchase more materials.
Government –When Daily Clothing Bhd earns more profit, it will pay more tax.
Additionally, employment opportunities offered would help to reduce unemployment.
Employees- Managers and supporting staff would feel a greater sense of job
security and increased job satisfaction and enhanced motivation.
Lenders- If the company is financially sound; the credit risk will be low.

(c) Untreated discharge into a local river causes damage to the environment.
Will environmental risk affect Daily Clothing Bhd’s value?

Daily Clothing Bhd was fined for an untreated discharge into a local river. This is
considered as an environmental accident and the risk for the environmental damage
is clearly material to shareholder value and is likely to remain so while the company
continues its business activities.
The shareholders will evaluate the extent and nature of the risk and assess whether
the risk profile of the business matches their own attitudes to or appetite for the
environmental risk. In a portfolio of shares, some investors will want to blend the
environmental risks and returns, and knowing about a company’s environmental
risks is important in making these judgements.
The environmental risk information will allow the shareholders to judge how the risk
might affect the company’s value and hence the potential volatility and
attractiveness of the share. The penalty imposed on the company is capable of
affecting returns, costs or both. When the shareholders are aware of the
environmental pollution and if the environmental risk is material, the shareholders
would have discounted the share price accordingly. The shareholders will also
evaluate the new risk controls put in place by the management because these
measures could be vital in restoring investor confidence. In particular, they should
reassure shareholders that the accident should not re-occur, or that if it were to re-
occur, further controls would be in place to offset the worst of the damage.

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