Agency Relationship Within Business Finance Essay

Question 1

Agency-Relationship is a relationship in which one person has legal authority to act on behalf of another. Agent has a legal and ethical responsibility to make decision that furthers the interests of the shareholders. When the interests of the agents and shareholders conflicts each other, an agency problem will be appeared. There are several examples of companies which had serious Agency-Relationship problems and resulted their Chief Executive Officers sent to jail. For the first example, a former chairman and a executive director of publicly listed Field Group Holdings Limited, charged by Hong Kong's Independent Commission Against Corruption, have been convicted at the District Court of conspiracy to defraud shareholders of the company and the Stock Exchange of Hong Kong (SEHK) in relation to a fake joint venture in a gas pipeline project in Chongqing, Mainland China and of money laundering in relation to the proceeds. To complete the fraudulent scam, the CEOs further caused the SEHK and the shareholders of Field Group Holdings Limited to approve the issue and allotment of the shares to the shareholders. They were found guilty of two counts of conspiracy to defraud. To prevent this kind of agency-relationship problem, first, is to encourage employees to identify the risk and notify to the manager. The management should develop and implement control over these kinds of circumstances. For the second example, a former research executive at a biotech company has pleaded guilty to one count of conspiracy to defraud shareholders that she and others caused the biotech company to issue false claims about a test to detect Down syndrome. The crime carries a maximum sentence of 25 years in prison along with fines potentially reaching hundreds of thousands of dollars. The problem in this case is Elizabeth Dragon who knew the truth about the test, but she told the public it was a near-perfect success. She misled investors with overstated information about a significant new product that never to be made. Investors' interest was harmed as they were believed in those fault information. As a result, the company image was damaged as well. Public will lost their faith in the company. To prevent this kind of agency-relationship problem, the management should implement a set of monitoring employee to handle research and development test data and result. Limit few employees can be accessed to the important data base. For the third example, a toy holdings company and its CEO had announced that it had purchased majority share interest in a manufacturing company. The Purchase price was to be large amount in stock and cash. The facts was the CEO and the toy holdings company has only paid half of the cash amount to the exiting majority shareholder of which the CEO had to burrow the funds from an investor. The CEO had expressed to the exiting shareholder that he needed to have control of the entity before he could secure the rest of the funds needed to complete the transaction. No other monies have ever been paid. The CEO finally has pleaded guilty of defrauding shareholders. The Company has lost all credibility due to unpaid invoices with wholesalers. The interest of the shareholders was not secured. To prevent this kind of agency-relationship problem, the management should reconcile bank statement within a month of receipt in order to detect any irregularities. Periodic reviews of contracts, financial documents, and accounting policies should be keeping checking so as to detect any irregularities. Some control plan can be set by the management for detecting and preventing fraudulent activities in the company. The management should be monitored the control plan regularly to ensure the control plans are effective and working. Question 2 Assuming our company ABC has the initial investment and cash flow as below table. We are going to demonstrate the estimate cash flows for the first 5 years by several investment appraisal methods for Project A. Estimate Cash flow Year Project A 0 -100000 1 60000 2 40000 3 30000 4 30000 Assume the initial investment amount is $10,000. Estimate cash flow is as the table shows.

Net Present Value (NPV)

Suppose the desired interest rate of return is 10% per annum. Year Discount factor Cash flow PV 0 1 -100000 -100000 1 0.909 60000 54540 2 0.826 40000 33040 3 0.751 30000 22530 4 0.683 10000 6830

The NPV is $16,940 which is positive. The returning on the investment is over the interest rate 10 per annum. The investment project should be taken. Advantage NPV can provide us absolute value when considering taking the project or not. It considers the time value of money that irrespective of the exact time at which the cash flow is made. Disadvantage NPV cannot apply on intangible benefits. The size of the investment has not been measured.

Internal Rate of Return (IRR)

The NPV at 10% is $16,940. If now the rate of return is 20%, the NPV will be $-70. Year Discount factor Cash flow PV 0 1 -100000 -100000 1 0.833 60000 49980 2 0.694 40000 27760 3 0.579 30000 17370 4 0.482 10000 4820

The estimated IRR is 19.96%. (Formula: 10+(16940)x(20-10)/(16940+70)=19.96%) If we need 12% return on the investment, the project should be taken. Advantage it is a simple way to communicate the value of the investment to people who doesn't know the estimation details. Disadvantage Unrealistic rates of return are given. For the above case, the investment is financially attractive and should be taken immediately. But in the real world, IRR of 19.96% implies there is an opportunity to reinvest future cash flows at 19.96%, rather than an actual return of 19.96%. IRR approach cannot be applied on mutually exclusive projects.

The Payback Period

Year Project A Cumulative Cash Flow 0 -100000 0 1 60000 60000 2 40000 100000 3 30000 130000 4 10000 140000 The payback period is 2 years. The investment project is acceptable. Advantages It is easy to calculate and simple to use. Profitable opportunities for long-term investment will not be overlooked as they involve a shorter wait for revenues to flow. Disadvantage Time value of money and inflation are not considered. It only concerns the liquidity of the cash flow, not the effect on business profitability. It ignores cash flows beyond the cutoff date. It biased against long-term projects, such as research and development.

The Profitability Index (PI)

According to the above calculation, we are using the figures to calculate the PI as shown in the table below. Initial investment $100,000 NPV 16940 PV $116,940 The profitability index is 1.1694. (Formula: (116940/100000)) Since the PI greater than 1.0, which means this project has positive NPV, the project should be taken. Advantage It is easy to understand and communicate. It considers all cash flows of the investment and the time value of money. Disadvantage It only can be used for divisible projects. It ignores the size of the investment.

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