Finance Final Exam The Finance function The Agency Problem, any relationship, agency problem how to solve

e http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/ACCA%20F9%20Chapter%201.as px http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Agency%20theory.aspx http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Forms/AllPages.aspx?Paged=TRU E&p_FileLeafRef=Forex%20SWAPs%2easpx&p_ID=552&View=%7b7F89D2A3-561C-463F-B9A 6-C74BEA9D8A51%7d&FolderCTID=0x012001&PageFirstRow=401 https://sites.google.com/site/accastudymaterial/accaf9bppstudytext2011 Agency theory is often used to describe the relationships between the various interested parties in a firm and can help to explain the various duties and conflicts that occur. Agency relationships occur when one party, the principal, employs another party, the agent, to perform a task on their behalf. In particular, directors (agents) acts on behalf of shareholders (principals). Agency problem: It involves the problem of directors controlling a company whilst shareholders own the company. In the past, a problem was identified whereby the directors might not act in the shareholders (or other stakeholders) best interests. Agency theory considers this problem and what could be done to prevent it. How to reduce the problems caused by agency relationships: Agency problem resolution measures: Meetings between the directors and key institutional investors Voting rights at the AGM in support of, or against, resolutions Proposing resolutions for vote by shareholders at AGMs Accepting takeovers Divestment of shares is the ultimate threat Need for corporate governance If the market mechanism and shareholder activities are not enough to monitor the company then some form of regulation is needed Capital Marking http://www.oswego.edu/~edunne/340ch3.htm Financial Institutions Financial institutions channel the flow of funds between investors and firms. Individuals deposit funds at commercial banks, purchase shares of mutual funds, purchase insurance protection with insurance premiums, and contribute to pension plans. All of these financial institutions provide credit to firms by purchasing debt securities or providing loans or other credit products. In addition, all of these financial institutions except commercial banks purchase stocks issued by firms. Valuing stocks http://www.transtutors.com/homework-help/corporate-finance/stock-valuation/dividend-gr owth-model/non-constant-growth/ http://www.investorwords.com/8233/stock_valuation.html The Gordon growth model / dividend discount model has a number of characteristics that make it useful and appropriate for many applications. The model: Is applicable to stable, mature, dividend-paying firms. Is appropriate for valuing market indices. Is easily communicated and explained because of its straightforward approach Can be used to determine price-implied growth rates, required rates of return, and

value of growth opportunities Can be used to supplement other, more complex valuation methods

There are also some characteristics that limit the applications of the GGM Valuations are very sensitive to estimates of growth rates and required rates of return, both of which are difficult to estimate with precision The model cannot be easily applied to non-dividend-paying stocks Unpredictable growth patterns of some firms would make using the model difficult and the resulting valuations unreliable

Equity finance Issue method New shares issues: A company seeking to obtain additional equity funds may be: a. An unquoted company wishing to obtain a Stock Exchange quotation b. An unquoted company wishing to issue new shares, but without obtaining a Stock Exchange quotation c. A company which is already listed on the Stock Exchange wishing to issue additional new shares The methods by which an unquoted company can obtain a quotation on the stock market are: a. An offer for sale b. A prospectus issue c. A placing d. An introduction Offer for sales: An offer for sale is a means of selling the shares of a company to the public An unquoted company may issue shares, and then sell them on the Stock Exchange, to raise cash for the company. All the shares in the company, not just the new ones, would then become marketable. Shareholders in an unquoted company may sell some of their existing shares to the general public. When this occurs, the company is not raising any new funds, but just providing a wider market for its existing shares (all of which would become marketable), and giving existing shareholders the chance to cash in some or all of their investment in their company. When companies go public for the first time, a large issue will probably take the form of an offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional investors privately. Why would a company consider going public? What are some advantages and disadvantages? A firm is said to be going public when it sells stock to the public for the first time. A company s first stock offering to the public is called an initial public offering (IPO).

There are several advantages and disadvantages to going public: Advantages to going public: Going public will allow the family members to diversify their assets and reduce the riskiness for their personal portfolios It will increase the liquidity of the firms stock, allowing the family stockholders to sell some stock if they need to raise cash It will make it easier for the firm to raise funds. The firm would have a difficult time trying to sell stock privately to an investor who was not a family member. Outside investors would be more willing to purchase the stock of a publicly held corporation which must file financial reports with the SEC. Going public will establish a value for the firm. Disadvantages to going public The firm will have to file financial reports with the SEC and perhaps with state officials. There is a cot involved in preparing these reports. The firm will have to disclose operating data to the public. Many small firms do not like having to do this, because such information is available to competitors. Also, some of the firms officers, directors, and major stockholders will have to disclose their stockholdings, making it easy for others to estimate their net worth. Manager of publicly-owned corporations have a more difficult time engaging in deals which benefit them personally, such as paying themselves high salaries, hiring family members, and enjoying not-strictly-necessary, but tax-deductible, fringe benefits. If the company is very small, its stock may not be traded actively and the market price may not reflect the stocks true value The advantages of public ownership would be recognized by key employees, who would most likely be granted stock options, which would certainly be more valuable if the stock were publicly traded. Rights issues A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the current market value, in proportion to their exiting holdings. This right of pre-emption: Enables them to retain their exiting share of voting rights Can be waived with the agreement of shareholders Shareholders not wishing to take up their rights can sell them on the stock market Advantages and disadvantages of rights issues Advantages: It is cheaper than a public share issue It is made at the discretion of the directors, without consent of the shareholders or the Stock Exchange It rarely fails Existing shareholders equity stakes are not diluted, provided they take up their rights Disadvantages: There is a limit to how much can be raised through this method as existing shareholders are only willing to invest so much. A rough rule of thumb is that rights issue could raise up to 25% of the existing equity value of the firm If shareholders do not take up their rights, then their shareholding will be diluted

http://www.helium.com/items/1987511-what-are-the-pros-and-cons-of-convertible-bonds http://www.moneyihub.com/convertible-bonds-an-introduction/ What are Convertible bonds Sometimes corporations include a convertible feature as part of a bond offering. Convertible bonds (bonds for which bondholders have the option to convert the bonds into shares of stock) can be converted into (that is, exchanged for ) shares of stock at the option of the bondholder. Among the reasons for issuing convertible bonds rather than straight debt are (a) to sell the bonds at a higher price (which means a lower effective interest cost), (b) to use as a medium of exchange in mergers and acquisitions, and (c) to enable smaller firms or debt-heavy companies to obtain access to the bond market. Sometimes convertible bonds serve as an indirect way to issue stock when there is shareholder resistance to direct issuance of additional equity. They have the following advantages: Shareholder control is not affected, as bondholders do not have voting rights. Therefore, exiting shareholders retain full control of the company. Tax saving will result, as bond interest is deductible for income tax purposes. Dividends are not. Earnings per share may be higher, as the dividends paid will not be diluted further by additional shares. Therefore, each share retains its earning per share ration. Note that there are disadvantages to issuing bonds: Interest must be paid on a periodic basis. The principal (face value) will have to be repaid upon maturity of the bond. By comparison, common shareholders are not promised dividends on a regular basis, and their investment does not have to be repaid at any time. What a leasing Leasing, as a financing concept, is an arrangement between two parties, the leasing company or lessor and the user or lessee, whereby the former arranges to buy capital equipment for the use for the latter for an agreed period of time in return for the payment of rent. The rentals are predetermined and payable at fixed intervals of time, according to the mutual convenience of both the parties. However, the lessor remains the owner of the equipment over the primary period. By resorting to leasing, the lessee company is able to exploit the economic value of the equipment by using it as if he owned it without having to pay for its capital cost. Lease rentals can be conveniently paid over the lease period out of profits earned from the use of the equipment and the rent cent percent tax deductible. There are two basic forms of lease: operating leases and finance leases. The following are the advantages of leasing: 1. Permit Alternative Use of Funds: A leasing arrangement provides a firm with the use and control over asset without incurring huge capital expenditure. The firm is required only to make periodical rental payments. It saves considerable funds for alternative uses which would otherwise be tied up in fixed capital. Faster and Cheaper Credit: Depending on tax structure of the lessee it costs less than other methods of acquiring assets. It permits firms to acquire new equipment without going thorough formal scrutiny procedure. Hence acquisition of assets under leasing agreement is cheaper and faster than any other source of finance.

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Flexibility: Leasing arrangements may be tailored to the lessees needs more easily that ordinary financing. Lease rentals can be structured to match the lessees cash flows. It can be skipped during the months when the cash flows are expected to below. Facilitates Additional Borrowings: Leasing may increase long-term ability to acquire funds. The lessee can utilize more funds for working capital needs. Moreover, acquisition of assets under the lease agreement does not alter debt equity ratio. Hence, the lessee can go for additional borrowings in case need arises. Protection against obsolescence: A firm can avoid risk of obsolescence by entering into operating lease agreement. This is highly useful in respect of assets which become obsolete at a faster rate. No Restrictive Covenants: The restrictive covenants such as debt equity ratio, declaration of dividend etc. which are usually imposed under debenture or loan agreement are absolutely absent in a lease agreement. Hundred Percent Financing: Lease financing enables a firm to acquire the use of an asset without having to make a down payment. So hundred percent financing is assured to the lessee. Boon to Small Firm: The firms which are either small or have uncertain records of earning are able to obtain the use of asset through lease financing. It is a boon to small firms and technocrats who are able to make promoter s contribution as required by financial institutions.

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Disadvantages of Leasing: 1. Lease is not suitable mode of project finance. This is because rentals are repayable soon after entering into lease agreement while in new projects cash generations may start only after a long gestation period. 2. Certain tax benefits/ incentives such as subsidy may not be available on leased equipment. 3. The value of real assets such as land and building may increase during lease period. In such a case the lessee loses the advantage of a potential capital gain. 4. The cost of financing is generally higher than that of debt financing. 5. A manufacturer who wants to discontinue a particular line of business will not in a position to terminate the contract except by paying heavy penalties. If it is a owned asset the manufacturer can sell the equipment at his will. 6. If the lessee is not able to pay rentals regularly, the lessor would suffer a loss particularly when the asset is a sophisticated one an less liquid. 7. In case of lease agreement, it is lessor who has purchased the asset from the supplier and not the lessee. Hence, the lessee by himself is not entitled to any protection in case the supplier commits breach of warranties in respect of the leased assets. 8. In the absence of exclusive laws dealing with the lease transaction, several problems crop up between lessor and lessee resulting in unnecessary complications and ad voidable tension.

Merger and Acquisition Economic reasons why one company merges with or takes over another company: The economic reasons for takeovers centre on the belief that shareholder wealth will be enhanced by the deal. This increase in wealth can arise from a number of sources:

Synergy, whereby the value of the combined firms exceeds that of the separate firms combined Economies of scale: common in horizontal mergers, spreading fixed costs can be realized through production, marketing, management and accounting e.g. one head office with less staff than exists in the two companies currently. Economies of vertical integration value added as a step backward or forward no longer needed. Complementary resources can take several forms e.g. one firm strong in production but weak in marketing can merge with one that has opposite characteristics. Use of surplus funds- e.g. firms in mature industries or where firm has few attractive prospects on its own. The elimination of inefficient management. Entry into new markets e.g. instead of starting from scratch. To provide market share. To provide growth.

Financial reasons why one company merges with or takes over another company: The financial reasons for takeovers increasing shareholder wealth include: Financial synergy e.g. decrease in the cost of capital Acquisition of an undervalued target when markets are inefficient Benefit from relative tax considerations Increase in EPS or boot-strapping Possible reasons that shareholders of acquiring companies barely benefit from takeovers include: If the bid is contested, the acquisition can cost the company more than it originally intended to pay Predicted synergy and economies of scale may fail to materialize Managers of acquiring company may not be able to run the business of the acquired company well. This ma be due to their lack of knowledge and expertise in the new business The quality of the acquired assets may turn out to be worse than expected There may be problems in the process of integration of two firms, such as cultural difference.

Four defences after its board has received the takeover bid: Financial anti-takeover defences If a company is concerned about being acquired by another company, several anti-takeover defenses can be implemented. As a minimum, most companies concerned about takeovers will closely monitor the trading of their stock for large volume changes. There are four defences of the followings Poison Pills One of the most popular anti-takeover defenses is the poison pill. Poison pills represent rights or options issued to shareholders and bondholders. These rights trade in conjunction with other securities and they usually have an expiration date. When a merger occurs, the rights are detached from the security and exercised, giving the holder an opportunity to buy more securities at a deep discount.

Golden Parachutes Another popular anti-takeover defense is the Golden Parachute. Golden parachutes are large compensation payments to executive management, payable if they depart unexpectedly. Lump sum payments are made upon termination of employment. The amount of compensation is usually based on annual compensation and years of service. Golden parachutes are narrowly applied to only the most elite executives and thus, they are sometimes viewed negatively by shareholders and others. In relation to other types of takeover defenses, golden parachutes are not very effective. White Knight If the target company wants to avoid a hostile merger, one option is to seek out another company for a more suitable merger. Usually, the Target Company will enlist the services of an investment banker to locate a "white knight." The White Knight Company comes in and rescues the Target Company from the hostile takeover attempt. In order to stop the hostile merger, the White Knight will pay a price more favorable than the price offered by the hostile bidder. Green Mail If the acquirer is an investor or group of investors, it might be possible to buy back their stock at a special offering price. The two parties hold private negotiations and settle for a price. However, this type of targeted repurchase of stock runs contrary to fair and equal treatment for all shareholders. Therefore, green mail is not a widely accepted anti-takeover defense.

Reasons for an organization embarking on a strategy of divestment Strategy of divestment A divestment strategy may be adopted due to various reasons: 1. A business that had been acquired proves to be mismatch and cannot be integrated within the company. Similarly, a project that proves to be in viable in the long-term is divested. 2. Persistent negative cash flows from a particular business create financial problems for the whole company, creating the need for divestment of that business. 3. Severity of competition and the inability of a firm to cope with it may cause it to divest. 4. Technological up gradation is required if the business is to survive but where it is not possible for the firm to invest in it, a preferable option would be to divest. 5. Divestment may be done because by selling off a part of a business the company may be in a position to survive. 6. A better alternative may be available for investment, causing a firm to divest a part of its unprofitable business. 7. Divestment by one firm may be part of a merger plan executed with another firm, where mutual exchange of unprofitable divisions may take place. 8. Lastly, a firm may divest in order not to attract the provisions of the MRTP Act or owing to oversize and the resultant inability to manage a large business.

http://www.management4all.org/2009/11/merger-and-acquisition.html Purpose of Merger and Acquisition : The company which proposes to acquire another company is known differently in different modes of acquisition, the familiar ones are predator, offerer, corporate raider etc. the transferee company is also denoted as victim, offeree, aquiree or target etc. The purpose for an offerer company for acquiring another company shall be reflected in the corporate objectives. It has to decide the specific objectives to be achieved through acquisition. The possible purpose for acquisition are : 1. Procurement of supplies : Acquisition could be to safeguard the source of supplies of raw material or intermediary product, to obtain economies of purchases in the form of discount, savings in transportation costs, overhead costs etc. and also finally to standardize the materials. 2. Revamping production facilities : one of the most important purpose of acquisition is to achieve economies of scale by amalgamating production facilities through more intensive utilization of plants and resources. Acquisitions also are resorted to standardizing products specifications, improving the quality of product etc. Obtaining improved production technology and know how from the offeree company to reduce cost and improve quality is one of the purposes of acquisitions. 3. Market expansion and strategy : the most important purpose behind M&A is to eliminate competition and protect existing market. In the process acquisitions also aim at obtaining new market outlets of the offeree for new product development or diversification and enhancing product range. Market expansion also reduces advertising costs, improves public image and allows strategic control of patents and copy rignts. 4. Financial strength : one of the most important purpose of M&A is to improve liquidity and cash. The financial strengths lie in the disposal of surplus and outdated assets, which automatically enhance capacity and enable them to avail tax benefits. 5. Genaral gain : The purpose of M&A is to improve its own image and attract superior managerial talent to manage its affairs. The general gains from M&A also include offering better customer satisfaction and services to the users of the products. 6. Development plans : The purpose of acquisition is backed by offeror companys own development plans. The plan might include expansion of operations, supplementing funds, eliminating competition, strengthen its market position etc. Thus, the purpose and the requirement of the offeror company go a long way in selecting a suitable partner for merger or acquisition in business combinations.