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JIMMA UNIVERSITY COLLEGE OF BUSINESS AND ECONOMICS MSc in Accounting & Finance

Advanced Financial Management


Acct 612 Instructor: Arega Seyoum Asfaw (PhD) Academic Year: 2013/2005

CHAPTER ONE
1. INTRODUCTION TO FINANCIAL MANAGEMENT & ANALYSIS
Introduction
Financial management is generally defined as the management of capital resources and uses in order to achieve a desired goal. Financial management is that managerial activity which is concerned with the planning and controlling of the firms financial resources. The role of the financial manager is to ensure that there is capital sufficient enough to finance activities, and this capital is available at the right amount, at the right time, and at the lowest cost.

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Relations of Finance with Economics The field of finance is closely related to economics. The financial manager must understand the economic framework within which his firm is operating, and also be able use economic theories as guidelines for efficient business operation. Financial management is, in effect, applied economics because it is concerned with the allocation of a companys scarce financial resources among competing choices.

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The wide array of topics under the title finance may be categorized under three broad sub-headings: Business Finance, Investment Analysis, and Financial Markets. Financial management deals with the management of a firms principal activities investing in assets and raising funds to pay for those assets. A financial managers job is to determine how these crucial activities (investing & financing) may best be carried out. In doing so, the financial manager typically will use data prepared and presented by accountants.

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Whereas the accountants focus is on the careful and correct preparation of financial data, the financial managers focus is on using that data as an input in making decisions. Furthermore, accountants typically rely on an accounting method that recognizes revenues at the time of sale and expenses when incurred, while financial managers emphasize the actual inflows and outflows of cash.

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Investment Analysis Refers to the study of the analysis and management of financial securities. It is concerned with the evaluation of securities (usually stocks & bonds) from the perspective of investors. Financial Markets Are markets where firms issue and investors buy and sell financial securities. These markets range from specialized businesses that assist corporations in selling their securities to large secondary markets where investors can buy and sell the stocks and other securities of major corporations.

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These markets involve a variety of financial intermediaries and middlemen such as investment bankers and stockbrokers. The study of these markets and financial intermediaries is the study of financial markets.

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Financial Institutions and Financial Markets
Firms that require funds from external sources can obtain them in three ways: (i) through a financial institution in the form of loan, (ii) through financial markets, and (iii) through private placement. Financial Institutions Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. These are institutions (public or private) that raise funds (from the public or other institutions) and invests them in financial assets such as deposits, loans, and bonds.

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Functions of Financial Institutions (1) They play as intermediary role in transferring funds from surplus economic unit (savers & investors) to those in need of the funds (deficit economic units). (2) Provide liquidity i.e., the presence of financial institutions facilitates the flow of monies through the economy.

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Types of Financial Institutions
There are two types of financial institutions viz., depository financial institutions and non-depository financial institutions.
Depository Financial Institutions are financial institutions that accepts deposits and channels the money into lending activities. o Depository institutions such as banks and credit unions pay interest on deposits and use the deposits to extend loans. Non-depository Financial Institutions like insurance companies, brokerage firms, and mutual fund companies, sell financial products. o Non-depository financial institutions fund their investment activities through the sale of securities or insurance.

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Common types of financial institutions are listed below:
o Brokerage firm, securities firm stock brokers act as an intermediary between buyers and sellers of securities. In return for the services they provide, they charge a fee. o Insurance Company, insurance underwriter, insurers, underwriters are financial institutions that sell insurance. o Pension fund - a financial institution that collects regular contributions from employers and employees to provide retirement benefit to employees.

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o Investment Company, investment firm, investment trust fund is a financial institution that sells shares to individuals and invests in securities issued by other companies. o Finance Companies are financial institutions (often affiliated with a holding company or manufacturer) that makes loan to individuals or businesses. o Credit Union a cooperative depository financial institution whose members can obtain loans from their combined savings. o Agent bank a bank that acts as an agent for a foreign bank. o Commercial Bank a financial institution that accepts deposits and makes loans and provides other services for the public.

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o Merchant Bank a credit card processing bank where merchants receive credit for credit card receipts less a processing fee. o Acquirer a bank gaining financial control over another financial institution through a payment in cash or an exchange of stock. o Thrift Institution a depository financial institution intended to encourage personal savings and home buying.

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Generally, financial institutions are required to operate within established regulatory guidelines. This is because any failure in financial institutions will have a contagious effect on the payment system and the whole economy. Therefore, due to their sensitivity and their potential farreaching consequences, there are guidelines which they have to observe in their operations. Thus, every country has its own central or national bank responsible for regulating and supervising financial institutions operating in an economy. In Ethiopia, such regulatory body is the National Bank of Ethiopia.

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Financial Markets Financial markets could mean: (1) the market in which financial assets (such as stock & bonds) are created or transferred. (2) The coming together of buyers and sellers to trade financial products, i.e., stocks and bonds are traded between buyers and sellers in a number of ways including the use of stock exchanges; directly between buyers and sellers, etc.

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Financial markets provide a forum in which suppliers of funds and those who need funds can transact business directly. Financial markets can be both primary and secondary markets for debt and equity securities. Primary market refers to a market in which new, as opposed to previously issued, securities are traded. This is the only time that the issuing company actually receives money for its stock.

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There are three ways in which a corporation may raise capital in the primary market:
(i) Public Issue involves sales of securities to members of the general public (its also called initial public offering (IPO). (ii) Rights Issue involves raising capital from existing shareholders by offering additional securities to them on a preemptive basis. (iii) Private Placement a way of selling securities privately to a small group of investors.

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Once the newly issued securities are in the publics hands, it then begins trading in the secondary market. Secondary markets are markets in which existing, already outstanding, securities are traded among investors. The corporation whose shares are being traded is not involved in the secondary market transaction and, thus, does not receive any funds from such a sale. The proceeds from the sale of a share of IBM stock in the secondary market go to the previous owner of the stock, not to IBM. That is because the only time IBM ever receives money from the sale of one of its securities is in the primary markets.

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In general, financial markets facilitate:
o The raising of capital (in the capital markets), o The transfer of risk (in the derivatives markets); and o International trade (in the currency markets).

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Types of Financial Markets
The financial markets can be divided into different types as follows: a) Capital Markets which consists of:
Stock markets which provide financing through the issuance of shares or common stock and enable the subsequent trading thereof. Bond markets which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

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b) Commodity market which facilitate the trading of commodities. c) Money market which is a market for short-term, highly liquid debt instruments are traded. d) Derivatives market which provide instruments for the management of financial risk.
Futures markets, which provide standardized forward contracts for trading products at some future date.

e) Insurance market which facilitate the redistribution of various risks. f) Foreign exchange market which facilitate the trading of foreign currencies.

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Derivative Products During the 1980s and 1990s, a major growth in financial markets is the trading of derivative products, or derivatives for short. In the financial markets stock prices, bond prices, currency rates, interest rates, and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or unexpectedly exploit risk. The major participants in this markets are hedgers (who want to manage price movement risk) and speculators (who take risk in expectation of profit).

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Primary vs. Secondary Markets The primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of new stock issue, this sale is an initial public offering (IPO).

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Features of Primary Markets 1) It is a market for new long-term capital. 2) The securities are issued by the company directly to investors. 3) The company receives the money and issue new security certificates to the investors. 4) Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

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5) The primary market performs the crucial function of facilitating capital formation in the economy. 6) It does not include certain other sources of new longterm external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as going public.

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Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, while a private placement is a negotiated sale involving a specific buyer. By law, public offering of debt and equity securities must be registered with the authority entrusted with such responsibility.

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Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable. But, on the other side, it enables the firm to have access to a large market the public at large and thus raise large sum of money. Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the authoritative body and do not require the involvement of underwriters.

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Secondary Markets
It is the financial market for trading of securities that have already been issued in an initial private or public offering. Once a newly issued stock is listed on a stock exchange, investors and speculators can easily trade on the exchange, as market makers provide bids and offers in the new stock. This market is a market on which an investor purchases an asset from another investor rather than an issuing corporation. A good example is The New York Stock Exchange (NYSE). All stock exchanges are part of the secondary market, as investors buy securities from other investors instead of an issuing company.

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Money Market vs. Capital Market Financial markets can also be classified in terms of the maturity period of the securities traded. The two key financial markets are the money market and the capital market.

Money Market is the market for short-term securities, i.e., securities that have a maturity period of one year or less. Capital Market is the market for long-term financial securities (usually bonds and stocks).

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Real vs. Financial Assets Real assets: can be tangible or intangible. Plant, machinery, office, factory, furniture and building are examples of tangible real assets, while technological knowhow, technological collaborations, patents and copy rights are intangible real assets. The firm sells financial assets or securities, such as shares and bonds or debentures, to investors in capital markets to raise necessary funds. Financial assets also include lease obligations and borrowings from banks, financial institutions and other sources.

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Funds applied to assets by the firm are called capital expenditures or investment. The firm expects to receive return on investment and distribute return as dividends to investors.

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Equity vs. Borrowed Funds There are two types of funds that a firm can raise: equity funds and borrowed funds. A firm sells shares (stock) to acquire equity funds. Shares represent ownership rights of their holders. Buyers of shares are called shareholders, and they are the legal owners of the firm whose shares they hold. Shareholders invest their money in the shares of a company in the expectation of a return on their invested capital. The return on the shareholders capital consists of dividend and capital gain.

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Shareholders can be of two types: ordinary (or common) and preference. Preference shareholders receive dividend at a fixed rate, and they have a priority over ordinary shareholders. Preference shareholders also have preferential right over assets of a firm when the firm is liquidated. The payment of dividends to shareholders is not a legal obligation; it depends on the discretion of the board of directors.

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Equity funds can also be obtained by a company by retaining a portion of earnings available for shareholders. This method of acquiring funds internally is called earnings retention. Retained earnings are undistributed profits of equity capital; they are, therefore, rightfully a part of the equity capital. The retention of earnings can be considered as a form of raising new capital.

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Retained earnings are used as a source of financing for the following reasons: a) to alleviate problem of financing from common stock b) when there is difficulty to raise capital from external sources c) when there is high cost of issuing additional shares d) to save the companys cash which could be paid as a cost of capital.

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Another important source of securing capital is creditors or lenders. Lenders are not the owners of a company. They make money available to the firm on a lending basis and retain title to the funds lent. The return on loans or borrowed funds is called interest. The amount of interest is allowed to be treated as expense for computing corporate income taxes; thereby provide a tax shield to the firm.

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Financial Management Decisions The functions of raising funds, investing them in assets and distributing returns earned from assets to shareholders are respectively known as financing, investment and dividend decisions. While performing these functions, a firm attempts to balance cash inflows and outflows. This is called liquidity decision; and added to the list of important finance decisions.

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Important finance functions or decisions include: 1. Investment (or long-term asset-mix) Decision
Investment or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. The two important aspects of investment decision are: (a) evaluation of the prospective profitability of new investments, and (b) the measurement of a cut-off rate against which the prospective return of new investments could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk.

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2. Financing (Capital Structure) Decision
Financing decision involves the financial manager decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firms capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his/her firm. The firms capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases risk.

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A proper balance will have to be struck between return and risk. When the shareholders return is maximized with minimum risk, the market value per share will be maximized and the firms capital structure would be considered optimum.

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3. Working Capital (Liquidity) Decision
The third question concerns working capital management. Working Capital refers to the firms short-term assets and liabilities. Managing the firms working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. Some of the questions about working capital that must be answered are:
a) how much cash and inventory should be kept on hand? b) should there be a credit sale? If so, at what terms, and to whom shall it be extended? c) how will any needed short-term financing be obtained?

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Goal of the Firm: Profit vs. Wealth If we were to consider possible financial goals we might come up with many ideas such as the following:
Survival To avoid financial distress and bankruptcy Beat competition, maintain control, achieve flexibility Maximize sales or market share Minimize costs & risks Maximize profits Maintain steady earnings growth [i.e., maximization of earnings per share & maximization of RoE].

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The goals listed above are all different, but they tend to fall into two groups. The first of these which involves sales, market share, and cost control relates to increasing profitability. Whereas the goals involving bankruptcy, avoidance, stability and safety relates in some way to controlling risk. Unfortunately, there is some trade-offs between the goals of profitability & risk. The pursuit of profitability normally involves some element of risk, thus it is not possible to maximize both safety and profitability simultaneously. What we need, therefore, is a goal that encompasses both of these factors.

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Profit Maximization
Would profit maximization serve as a goal of the firm? If we investigate profit maximization as a goal of the firm, it fails with respect to the following operational infeasibilities: 1) It is vague because the definition of the term profit is ambiguous.
Does it mean an absolute figure expressed in Birr or a rate of profitability? Does it mean short-term or long term profit? Does it refer profit before tax or after tax? Does it refer total profit or profit per share?

2) It ignores the time dimension of financial decision.


It does not make a distinction between returns received at different time periods.

3) It ignores the risk dimension of the financial decision


Risk & returns are positively correlated. A figure that maximizes profit might generate excessive risk & thereby a lower stock price.

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The goal of profit maximization, for example, compares investment alternatives by examining their expected values or weighted average profits. Whether one project is riskier than another does not enter into these calculations. In reality, projects differ a great deal with respect to risk characteristics, and to ignore these differences in the practice of financial management can result in incorrect decisions.

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Finally, and possibly most important, accounting profits fail to recognize one of the most important costs of doing business. When we calculate accounting profits, we consider interest expense as a cost of borrowing money, but we ignore the cost of the funds provided by the firms stockholders. We have to think that, what if the firms stockholders, could earn 12% with the same money in another investment of similar risk? Should the firms managers accept the investment because it will increase the firms profits?

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Therefore, if we are to base financial decisions on a goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the real world. For the reasons given, the goal of maximizing profits usually is not the same as maximizing market price per share. The market price of a firm's stock represents the value that market participants place on the company.

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Shareholders Wealth Maximization (SWM) The objective of shareholders wealth maximization (SWM) is an appropriate and operationally feasible criterion to choose among the alternative financial actions. It provides a clear measure of what financial management should seek to maximize in making investment and financing decisions on behalf of owners (shareholders). Shareholders wealth maximization means maximizing the net present value (or wealth) of a course of action to shareholders.

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The net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV crates wealth for shareholders and, therefore, desirable. A financial action resulting in negative NPV should be rejected since it would destroy shareholders value.

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The objective of shareholders wealth maximization addresses the questions of the timing and risk of the expected benefits. These problems are handled by selecting an appropriate rate (the shareholders opportunity cost of capital) for discounting the expected flow of future benefits. It is important to emphasize that benefits are measured in terms of cash flows, not in terms of the accounting profits. The wealth maximization principle implies that the fundamental objective of a firm is to maximize the market value of existing shareholders common stock.

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The Agency Relationship
If you are the sole owner of a business, then you make the decisions that affect your own well-being. But what if you are a financial manager of a business and you are not the sole owner? In this case, you are making decisions for owners other than yourself; you, the financial manager, are an agent. An agent is a person who acts forand exerts powers ofanother person or group of persons. The person (or group of persons) the agent represents is referred to as the principal. The relationship between the agent and his or her principal is an agency relationship. There is an agency relationship between the managers and the shareholders of corporations.

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Problems with the Agency Relationship In an agency relationship, the agent is charged with the responsibility of acting for the principal. Is it possible the agent may not act in the best interest of the principal, but instead act in his or her own self-interest? Yesbecause the agent has his or her own objective of maximizing personal wealth.

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In a large corporation, for example, the managers may enjoy many fringe benefits, such as golf club memberships, access to private jets, and company cars. These benefits (also called perquisites, or perks) may be useful in conducting business and may help attract or retain management personnel, but there is room for abuse. What if the managers start spending more time at the golf course than at their desks? What if they use the company jets for personal travel? What if they buy company cars for their teenagers to drive? The abuse of perquisites imposes costs on the firmand ultimately on the owners of the firm. There is also a possibility that managers who feel secure in their positions may not bother to expend their best efforts toward the business. This is referred to as shirking, and it too imposes a cost to the firm.

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Finally, there is the possibility that managers will act in their own self-interest, rather than in the interest of the shareholders when those interests clash. For example, management may fight the acquisition of their firm by some other firm even if the acquisition would benefit shareholders. Why? In most takeovers, the management personnel of the acquired firm generally lose their jobs.

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Many managers faced this dilemma in the merger mania of the 1980s. So what did they do? Among the many tactics, Some fought acquisition of their firmswhich they labeled hostile takeoversby proposing changes in the corporate charter or even lobbying for changes in state laws to discourage takeovers. Some adopted lucrative executive compensation packages called golden parachutesthat were to go into effect if they lost their jobs. Such defensiveness by corporate managers in the case of takeovers, whether it is warranted or not, emphasizes the potential for conflict between the interests of the owners and the interests of management.

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Costs of the Agency Relationship There are costs involved with any effort to minimize the potential for conflict between the principals interest and the agents interest. Such costs are called agency costs, and they are of three types: monitoring costs, bonding costs, and residual loss.

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(1) Monitoring Costs - are costs incurred by the principal to monitor or limit the actions of the agent. In a corporation, shareholders may require managers to periodically report on their activities via audited accounting reports, which are sent to shareholders. The accountants fees and the management time lost in preparing such reports are monitoring costs. Another example is the implicit cost incurred when shareholders limit the decision-making power of managers. By doing so, the owners may miss profitable investment opportunities; the foregone profit is a monitoring cost.

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The board of directors of corporation has a fiduciary duty to shareholders; that is the legal responsibility to make decisions (or to see that decisions are made) that are in the best interests of shareholders. Part of that responsibility is to ensure that managerial decisions are also in the best interests of the shareholders. Therefore, at least part of the cost of having directors is a monitoring cost.

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(2) Bonding Costs: are incurred by agents to assure principals that they will act in the principals best interest. The name comes from the agents promise or bond to take certain actions. A manager may enter into a contract that requires him or her to stay on with the firm even though another company acquires it; an implicit cost is then incurred by the manager, who foregoes other employment opportunities.

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(3) Residual Loss: despite using monitoring and bonding devices, there may still be some divergence between the interests of principals and those of agents. The resulting cost, called the residual loss, is the implicit cost that results because the principals and the agents interests cannot be perfectly aligned.

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Motivating Managers: Executive Compensation One way to encourage management to act in shareholders best interests, and so minimize agency problems and costs, is through executive compensationhow top management is paid. There are several different ways to compensate executives, including: Salary. The direct payment of cash of a fixed amount per period. Bonus. A cash reward based on some performance measure, say earnings of a division or the company. Stock appreciation right. A cash payment based on the amount by which the value of a specified number of shares has increased over a specified period of time (supposedly due to the efforts of management).

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Performance shares. Shares of stock given to the employees, in an amount based on some measure of operating performance, such as earnings per share. Stock option. The right to buy a specified number of shares of stock in the company at a stated pricereferred to as an exercise price at some time in the future. The exercise price may be above, at, or below the current market price of the stock. Restricted stock grant. The grant of shares of stock to the employee at low or no cost, conditional on the shares not being sold for a specified time.

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The basic idea behind stock options and restricted stock grants is to make managers owners, since the incentive to consume excessive perks and to shirk are reduced if managers are also owners. As owners, managers not only share the costs of perks and shirks, but they also benefit financially when their decisions maximize the wealth of owners. Hence, the key to motivation through stock is not really the value of the stock, but rather ownership of the stock.