Q 1.

Finance management

Management includes using available resources in an effective manner to achieve

organizational objectives. There are several resources identified, those are scarcely
available. Each and every organization has to utilize these resources with extreme
care to get the optimum use of those resources. Financial resource is one of the
most important and remarkable resource among these kind of scarce resources.
Managing finance is almost difficult as well as expensive in organizational point of
view. However a proper planning of financial resources and effective use of it cannot
be avoidable in the organization’s march towards its ultimate objectives– profitability
& Maximization of Shareholder’s wealth.

2. Agency Relationship Problems of a Public Listed

Company

There are some problems identified in achieving organization’s financial objectives.

One of those main problems is known as Agency Relationship problem.

Agency Relationship: Normally shareholders of a public company would not

directly involve in financial decisions of the firm. They would appoint a private person
as an agent in order to handle the financial functions on behalf of them. In such
cases the share holders are called as principals and the financial manager can be
called as an agent. The relationship between share holders and financial manager
can be described as an agency relationship.

Causes for Agency Relationship Problems: Normally managers would always

tend to get advantages from the firm’s vast financial resources. But the shareholders’
expectations may slightly differ from the objectives of the manager as they wish to
maximize their wealth. This type of expectancy clashes between both parties may
create a separation between them. This separation may leads to some conflicts
between both parties.

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3. Some Main Examples for Agency Relationship
Problems

1. Agency Cost:

The regular salary given to the agents is called as agency cost.

The increased agency cost can be considered as a major problem related to agency
relationship.

2. Incentives and Compensation Given for Agents:

Salary and incentives are the fundamental motivators according to the motivational
theories of management. Every manager would prefer to achieve his/her own
personal objectives by getting more incentives and other benefits from the firm. Also
they may tend to use luxury cars and private vehicles from company’s wealth. This
kind of unnecessary expenses also can be considered as an agency relationship
problem of a company.

3. Unwillingness to invest high risk Ventures:

According to Maslow’s Hierarchy of Needs Theory Job security is one of the main
needs of an employee apart from his physiological needs. Nobody will like to
undertake risky investments since those may lead them towards uncertainty of their
own jobs. But the perception of shareholders is something different. They would like
to maximize their wealth. To maximize shareholder’s wealth, it is essential to
undertake some projects those can provide a fair amount of outcome. But the risk of
project is positively proportional to the profit of the project. So it is unavoidable to
undertake high risk in order to earn high profit. So the unwillingness of the
managers to take high risk ventures may seems to be a barrier in maximizing
shareholder wealth. So this will create conflicts between both parties.

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4. Agency Relationship problems of (CAO) China
Aviations Oil Singapore

In the context of the agency relationship problem of China Aviation Oil Singapore
limited is a more challenging one to explain. Normally in usual conditions agency
problems arise between shareholders and appointed managers. The reason is, in fact
the shareholders or directors does not involve in the management task of the
company instead they appoints mangers to under take the work on behalf of them,
giving the authority of make decisions. Therefore some managers take these
privileges as an added advantage and make decisions that work in favor for there
benefits. Under these conditions through the offer of share options to the mangers as
part of there remuneration, shareholders attempts to align there goals and managers
goals as whole.

In this case, the agency problems of China Aviation Oil (CAO) Singapore lead the
company to its collapse. Actually speaking reason for it is managements improper
planning and unsuccessful decisions are seen as been some of the pointed issues.
The China Aviations Oil Holdings which is the parent and the largest shareholder and
creditor of the China Aviations Singapore had supplied six of China Aviations nine
directors including those who are accused for the security violations, Chen Julin
China Aviations former chief executive and Jia Changbin president, and also Gu
Yanfei chairmen of the parent China Aviations Oil Holdings (CAOH).

Therefore the shareholders of CAOH’s have to look in to areas where the

management went wrong? Fro studies following information were revealed,

Studies found the fundamentals for the collapse of the CAO was occured due to the,
too much intervention of the chairmen’s and presidents in to the Managerial
activities. The reason for this was CAOH holds the most shares of CAO Singapore
hence less value for other shareholders in selecting new directors, because one
major shareholder is dominating the voting power and influences in choosing the
directors who they want and its not a compromise decisions of all the shareholders, a
good example was the six of nine directors were appointed by the CAOH. Because
they had the major shares hence dominating selection power.

The second problem is management was given less opportunity to carry out there
work according to the circumstances. Since the intrusion from the Chairman and
president’s professional managers might not had the opportunity to implement thing
as they want, because the views from the both parties, the manager and president
may defer finally the superior power wins. As per the report from the

Therefore the agency problem in the CAO has stimulated to a certain extend and
resulted to its collapse, the main reason for it were the intervention of chairman and
president in the management. Therefore it should be given more consideration.

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5. Solutions for Agency Relationship Problems

1. Monitoring the Manager’s activities:

Shareholders may closely monitor the activities of the managers through various
ways in order to ensure the proper functioning of a manager. For this shareholder’s
may request managers to provide reports annually and can check whether the
managers are functioning align or not with the interests of shareholders. Theses
reports may check through an employed auditor of the firm. The auditors are
requested to express an opinion on the financial reports to shareholders at the
annual general meeting of the firm. The cost spent to check the activities of
managers would called as ‘monitoring cost’.

2. Providing Remuneration Packages to Managers:

Shareholders may provide some incentives to managers to encourage them to work

inline with the maximization of shareholder wealth. These incentives may increase
the motivation of the managers to act towards the maximization of shareholder
wealth. The cost spend on this would referred as ‘bonding cost’.

3. Linking the remuneration needs of Managers with the maximization of

shareholder wealth:

Not only providing remuneration packages to managers but also it is required to link
their remuneration needs with the maximization of shareholder wealth. Shareholders
are doing this by providing some special share options to managers.

Example: Providing a right to buy shares at a pre-set price at a specified date

or range of dates in the future.

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Q 2 .1 Investment Appraisal Methods

When the Business finds a new opening or a new investment; it is natural to feel a
managerial urge to acquire the particular investment in order to grow well in
business.

But it’s the ultimate responsibility of the financial manager to analyze the project and
decide whether it’s profitable or not to undertake the particular project.

 It is appropriate to discuss few words about present value before entering in

to any of the investment appraisal method, since present value is the
fundamental concept for each and every investment appraisal methods.

 Definition of Present Value: Present value can be defined as the current

value of future cash flow discounted at the appropriate discount rate.

FV – Future Value
r - Discount rate (rate of interest)
n - Number of Terms

PV = FV x 1
(1+ r) n

2. Net Present Value (NPV)

The Rationale of Calculating NPV

Adding value for the product is one of the ways to achieve high degree of customer
satisfaction. Researches on total quality management (TQM) and some other management
studies are emphasizing the importance of value adding functions; a business has to adopt in
order to compete successfully in a rapidly growing business world. Net present value is the
method of determining the value that has been added by the business to the particular
investment.

Definition of NPV

The Net Present Value (NPV) of a project or investment can be defined as “The sum of the
present values of the annual cash flows – initial investment.”

The annual cash flows = Cash inflows – Cash outflows

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Steps to follow when Calculating the NPV of an Investment

1. Identify the time range and size of the expected future cash flows generated by
the project/investment
2. Determine the discount rate or the estimated rate of return for the project
3. Calculate the NPV using the equations

NPV Rule: If NPV > 0 – Project can be accepted

If NPV < 0 – Project cannot be accepted

Case 1: In case of NPV> 0

Investment Criteria

Year Cash Cash

Inflow Outflow

Initial ($100 000)

Investment

1 $ 20000

2 $ 30000

3 $ 40000

4 $ 50000

The Desired Interest rate of Return – 10%

NPV - ?
If we consider the above mentioned criteria, first we have to draw a time line
according to the above mentioned information.

0 1 2 3 4

($100,000) $20,000 $30,000 $40,000 $50,000

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Present values for every year can be calculated through the following
method

Amount n Discount PV
Factor

100000 0 1 ($100 000)

20000 1 0.909 18180

30000 2 0.826 24780

40000 3 0.751 30040

50000 4 0.683 34150

NPV 7150

The value of NPV is $7150 it is positive. This means that the investment is returning
more then the desired interest rate of return of 10% per year.

Therefore, the investment can be proceeded.

Advantages and Disadvantages of the NPV

Advantages Of NPV

1. its useful in making financial decisions whether to invest on a project or not.

2. an exact value can be calculated
3. the time value of the cash flow can be determined quickly by using this
method

Disadvantages Of NPV
1. identifying the exact discount rate is difficult
2. the decision criteria must be specified before undertaking appraisal through
this method.

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2. Discounted Payback Method

The discounted payback period can be defined as “The length of time required to
recover the initial cash outflow from the discounted future cash inflows.” Or it can be
said as the length of time until the sum of the discounted cash flows is equal to the
initial investment.

Discounted payback Rule:

If Estimated payback Period > Calculated Payback Period - Project can be accepted If
Estimated payback Period < Calculated Payback Period – Project cannot be accepted

Case 1: In case of pre-specified period < calculated payback period

Investment Criteria:

Year Cash Cash

Inflow Outflow

Initial ($60 000)

Investment

1 $ 20000

2 $ 30000

3 $ 40000

4 $ 50000

Interest Rate of return on investment – 10%

Pre-specified period – 2 years
Discounted Payback Period?
The Discounted Payback period can be calculated through the following
method

Cash Flow Year Discount PV Cumulati

(n) Factor ve PV
1 / (1+0.10)n

20000 1 0.909 18180 18180

30000 2 0.826 24780 42960

40000 3 0.751 30040 73000

50000 4 0.683 34150 107150

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After remaining 2 years = 60000 – 42960
=` 17040

Remaining years = (17040 / 30040) *12

= 6.8 months
= 7 months
Therefore the discount payback time is 2 years and 7 months.
So the prespecified period is less than the calculated period therefore the project not
suitable for proceed.

Advantages and Disadvantages of Payback method

Advantages

1. its an easy method to understand and do

2. this method doesn’t accepts the investments that show a negative value.
3. it takes in to account the time value of the cash flow.

Disadvantages

1. Requires an arbitrary cutoff point.

2. This method Ignores cash flows beyond the cutoff point.

3. May reject positive NPV projects also.

4. Research & Development oriented projects cannot be undertaken based on

the conclusions derived from this method

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 4. Average Accounting Return (AAR)
Average Accounting Rate of Return can be defined as “A measure of the return on an
investment over a given period, equal to average projected earnings minus taxes,
divided by average book value over the duration of the investment.” This can be
denominated through the following formula also.

Average Net Income

Average Book Value

Average Accounting Rate of Return Rule:

If AAR > Targeted AAR – Project can be accepted

If AAR < Targeted AAR – Project cannot be accepted

Case 1 :In case of AAR > Targeted AAR

Investment Criteria:

To open a new warehouse in a shopping complex, the required investment for

renovation is $500 000. The warehouse has a four-year lease and everything will be
reverted to the shopping complex owner after that time. The required investment
would be 100% depreciated (Straight-line method) over the four years. The profit is
taxed at 25%. The table below gives the revenue and expenditures for the 4 years.
The AAR intended is 20% per annum. Decide whether to accept the project or not.

Year 1 Year 2 Year 3 Year 4

Revenue 300 000 350 000 360 000 400 000
Expenditure 100 000 150 000 100 000 120 000

The AAR can be calculated through the following method

Solution: Annual Depreciation = $ 500 000/4 = $125 000

Year 1 Year 2 Year 3 Year4

Revenue 300000 350000 360000 400000
Expenditure (100000) (150000) (100000) (120000)
Earnings Before Depreciation 200000 200000 260000 280000
Depreciation (125000) (125000) (125000) (125000)
Earnings Before Tax 75000 75000 135000 155000
Tax @ 25% (18 750) (18 750) (33 750) (38 750)
Net Income 56 250 56 250 101 250 116 250

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Average Net Income = $56 250 + $56 250 + $101 250 + $ 116 250

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= $82 500.

Average Book Value = 500 000 + 0

2
=250000

AAR = Average net Income x 100

Average book value

= (82 500/ 250 000) x 100

= 33%

Calculated AAR > Expected AAR

Since our expected average accounting return is 20% the project is accepted.

Advantages &Disadvantages of AAR Method

Advantages

1. its very easy to understand and calculate

2. Accounting Information is always available, therefore calculating AAR
is always possible.

Disadvantages

1. Calculating a true rate of return on investment is impossible through this

method since this method is not considering the time value of money.
2. This method Uses an arbitrary cutoff point and a benchmark to consider
whether the investment is acceptable.
3. This method is fully depending on the book value, but not the cash flow and
the market value of investment.

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4. The Internal Rate of return (IRR)

The IRR is the annualized effective compounded return rate which can be earned on
the invested capital. This method is a most important alternative for NPV.

IRR = Interest 1 + NPV 1 x (Interest 2 – Interest 1)

NPV 1 + NPV 2

IRR Rule:
If IRR > Required Return - Project can be accepted
If IRR < Required Return – Project cannot be accepted

Case study
Year Cash flows
0 $ 10000
1 $ 3000
2 $ 2000
3 $ 1000
We have to calculate the IRR?
If the required return is 15% is it wise to accept the project?

When the NPV is at 10%

Cash Flow Year Discount PV

(n) Factor
1 / (1+0.10)n

10000 o 1 (10000)

3000 1 0.909 2727

2000 2 0.826 1652

1000 3 0.751 751

NPV 9676

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When the NPV is at 20%

Cash Flow Year Discount PV

(n) Factor
1 / (1+0.20)n

10000 o 1 (10000)

3000 1 0.833 $2 499

2000 2 0.694 $1 388

1000 3 0.579 $ 579

NPV 9465

IRR by Formula = 10 + (9676) x (20-10)

9676+ 9465

= 5.5055%

Since we require a 15% return in investment, the above project is not accepted.

Advantages &Disadvantages of IRR Method

Advantages,
1. The result of this method is given in the percentage form. Percentage form is
really easy for management since it is a normal method.

2. It is an advantage to use this method since this method taking in to

consideration of the time value of money.

Disadvantages
1. Since this method is reporting on terms of percentage, it ignores the
difference in project magnitude and so is unreliable when evaluating project
of great different in sizes.

2. This method cannot be viewed upon to give correct advice for mutually
exclusive investment decisions.

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 3. Decision rule breakdown for multiple IRR

Reference :

• The definition of the most of the investment appraisal methods were

retrieved from the following website www.12magage.com

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