Class notes

Corporate Finance

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Course
Corporate Finance

Institution
University Of East London (UEL)

Agency Problems and Investment Efficient Markets and Behavioural Finance Equity Markets Corporate Debt, Hybrid Finance, and Leasing Capital Structure Payout Policy Modern Portfolio Theory and the CAPM Managing Risk Mergers and Takeovers

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Uploaded on June 17, 2023
Number of pages 23
Written in 2022/2023
Type Class notes
Professor(s) Dr. chao
Contains All classes

corporate finance
business
finance
risk management
portfolio management
accounting and finance

Institution
University of East London (UEL)
Education Unknown
Course
Corporate Finance

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Corporate Finance
Section A
26/09/22
Agency Problems and Investment

Agency Problems: Managers
There are several agency problems that can interfere with value maximising investment:
- Reduced effort: managers may not put forth their full effort
- Perks: office accommodations, overspending at company meetings etc.
- Empire building: the desire to grow the business
- Entrenching investment: creating projects that are rewarding the skills of existing managers
- Overinvestment: investing beyond the point where NPV falls to zero
- Insufficient divestment: reluctance to sell off buildings or product lines or close a loss-
producing business line

Agency Problems: Shareholders
- Too many projects for top management to analyse
- Details are beyond the view of the executives
- Many decisions aren’t in the capital budget, small decisions add up
- Executives are subject to human error

Risk Taking
1. Managers who reach the top ranks of a large corporation must have taken risks
2. Managers who are compensated with stock options have an incentive to take more risk;
value of an option increases when the risk of the firm increases
3. Gambling for redemption – sometimes managers have nothing to lose by taking on risks.
4. Organisations hesitate to curtail successful risky activities -> agency cost, subprime crisis

Monitoring
Agency costs can be reduced by monitoring managers’ actions but monitoring costs money and
encounters diminishing returns. Monitoring is primarily done by the following entities:
- The board of directors are elected to represent shareholder interests
- Auditors can recommend changes and issue a qualified opinion that suggests managers are
covering something up if their recommendations are not followed
- Lenders also monitor the assets of companies to which they have loaned large sums of
capital in order to protect their own investments
- Shareholders can take the ‘Wall Street Walk’ (sell their shares, run away lmao)
- Takeovers if assets are not being used efficiently

Management Compensation
Attempt to ensure that compensation is reasonable and linked to performance.
For US public companies, compensation is the responsibility of the compensation committee of the
board of directions – the Securities and Exchange Commission (SEC) and NYSE require that all
directors on the compensation committee be independent.

Residual Income or Economic Value Added (EVA)
Emphasises NPV concepts in performance evaluation over accounting standards – looks more to
long-term than short-term decisions. Tracks shareholder value than accounting measurements.
EVA = income earned – income required
EVA = income earned – [cost of capital * investment]
e.g. EVA = 150 – [0.1 * 1,000] = £50 million

,Economic Profit
Economic profit = capital invested multiplied by the spread between return on investment and the
cost of capital.
EP = (ROI – r) * capital invested
EP (Return – cost of capital) * capital invested
e.g. EP = (0.15 – 0.1) * 1,000 = £50 million

Pros and Cons of EVA
+ Managers are motivated to only invest in projects that earn more than they cost
+ EVA makes cost of capital visible to managers
+ Leads to a reduction in assets employed
- Unclear whether EVA is a consequence of bad management or other factors
- Data on which it is based

Example: EVA
A movie producer generates $30 million in net income during the four-month run of the movie
Revenge of the Finance Professors. Movie rentals and post-theater income is forecasted to be
nominal. The cost to produce the movie was $100 million. Given a 10% cost of capital, what is the
EVA of the project and was it a good investment?

EVA = 30 – (0.10 * 100) = $20 million
While EVA is positive, the movie industry highlights a major shortfall of EVA. It ignores the fact that
no long-term benefit accrues from a movie – thus, the positive EVA is misleading. Despite the high
quality subject matter, the project is a loser.

Accounting Measurements of Performance
Rate of Return = [cash receipts + change in price]/beginning price
Rate of Return = [c1 + (P1 – P0)]/P0

Economic Income = Cash Flow + Change in Present Value
Rate of Return = [C1 + (PV1 – PV0)]/P0

Economic Accounting
Income Cash flow + change in PV = Cash flow + Change in BV =
Cash flow – Economic depr. Cash flow – Accounting depr.
Return PV at start of year BV at start of year

Forecasted Book Income, ROI, and EVA

, Forecasted Economic Income, Rate of Return, and EVA

Peer Book ROI

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