十一Corporate Finance Corporate Investing and Financing Decisions

十一Corporate Finance Corporate Investing and Financing Decisions

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十 十 Corporate Finance: Corporate Investing and Financing Decisions 1. A: An Overview of Financial Management a: Discuss potential agency problems of stockholders versus 1) managers and 2) creditors. An agency relationship is created when decision-making authority is delegated to an agent without the agent being fully responsible for the decision that is made. An agency relationship occurs in two common corporate scenarios: 1. the company’s stockholders delegate decision-making authority to the managers (agents), but the managers do not receive the full benefit or cost of their performance, 2. the company’s debtholders delegate authority to managers who act on behalf of the shareholders. In the first scenario, management will not bear the full impact of their decisions since they do not own 100 percent of company. In the second scenario, agency relationship may occur when creditors lend money to corporations. Creditors lend based on specific business and financial risk expectations. The stockholders/management will benefit from risky strategies that simultaneously increase the probability of success and bankruptcy. The manager receives the full benefit of success, but the creditor bears the responsibility for the bankruptcy. This is one reason loans include many restrictive covenants on the corporation’s behavior. b: Describe four mechanisms used to motivate managers to act in stockholders' best interests. 1. Managerial compensation. The total managerial salary package must compensate managers for their performance. This is commonly done through annual performance bonuses and long-term stock options, in addition to an annual salary. There are two main methods that are used to grant shares to management: 1. Performance shares: The manager receives a certain number of shares based on the company achieving predefined performance benchmarks. 2. Executive stock options: Management is granted an option to buy the firm’s shares at a pre-specified price on a specific future date. Executive stock options are typically issued ¡°out-of-the-money¡± to give management the incentive to take actions that will boost the company’s stock price.
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2. Direct intervention by shareholders. As large institutions increasingly own shares, these institutions have the power and sophistication to persuasively intervene on corporate issues. 3. The threat of firing. Shareholders can nominate and elect their own board of directors or persuade the board to ¡°encourage¡± the current management to quit or be fired. 4. The threat of takeovers. If management’s poor performance is reflected in a low stock price, a competitor may buy enough shares to have a controlling interest. At that point, the acquirer can replace management with their own management team. 1.B: The Cost of Capital
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十一Corporate Finance Corporate Investing and Financing Decisions

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