Finance Essays – Management Company Stockholders

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Management Company Stockholders

1.1 Introduction

In business finance management, the main objective of a public-listed company is to maximise the market value of the company and the wealth of the stockholders. Traditionally, stockholders yield the power and authority to hire and fire management should the latter fail to produce high returns with calculated risks for the company. Theoretically, the Finance Manager should act in the best interest of the stockholders by taking appropriate actions that will maximise the stock prices, which is a conservation concept that differs in reality. This will be discussed in depth in this paper.

1.2 Agency Relationship Problems

In a public-listed company, there is a demarcation between the ownership and management due to differing interests, resulting in the possibility of conflicts of interests between the stockholders and the management, usually termed as an agency problem. The stockholders or Principals will appoint the managers or Agents to run the business. This relationship is also known as the Agency Relationship, which give rise to the following problems:

When a company becomes public listed, the owner is appointed as the Agent by the Stockholders.

The separation of management and ownership of the company results in managers making decisions that are not in-sync with the stockholders' objective of maximising their wealth. Managers incurring high expenses by exploiting the perquisites such as expensive office decoration, high remuneration, travelling in business class flights or usage of private jets, claiming high transportation and entertainment costs at the company's expense. This is clearly depicted by the ex-CEO, TT Durai of the National Kidney Foundation (NKF) where it was reported that his annual salary was $600,000 and had lavish personal spending using the monies that were donated to NKF. Managers may adopt an extreme risk aversion attitude and refrain from investing in high risks investments with high returns for fear of losing their job should the investment fail. On the other hand, if they make money, the money will not go into their pockets, instead it will be the stockholders that stand to gain.

The managers may act in their own interests rather than those of the stockholders.

With no turnover or re-appointment of the managers and executives over the years, powers have been monopolised and resulted in vested personal interest of their own. Hence, this will lead to the employment of friends into the management and employing personal audit teams. Using the example of NKF, TT Durai has held the appointment as CEO for a period, resulting in his over-usage of company's funds for his own personal usage, and collaborated with his friends in fake business deals. Lack of proper governance in the company, which results in manipulation of accounting documents and false reporting of financial issues. An example is another charity saga after the NKF scandal of Ren Ci Hospital and Medicare Centre, which involved the Chairman, a Buddhist monk, Ming Yi. Ming Yi had doctored the accounts books and provided false information to the auditors and the Commissioner of Charities. He was also found guilty in lending the hospital's monies to the Mandala Buddhist Cultural Centre whereby he has a share in it. Poor risk management practice. With the increased complexity of investment options, companies failed to identify and thus implement the appropriate risk management policies should any of their investment options fails. The recent bankruptcy of the Lehman Brothers and the near-bankruptcy of the American International Group (AIG) were good examples of poor risk management practice. If theses agency problems are not properly resolved, in time to come, dire consequences may follow that could lead to the bankruptcy of the company, as illustrated in the agency problems in China Aviation Oil Company (Singapore).

1.3 Agency Problems of China Aviation Oil

1.3.1 Brief Background

China Aviation Oil (Singapore) Corporation Ltd (CAO) shocked the stock market with the losses amounting to US$550 million on 30th November 2004 from oil option trading. CAO is a China company that is based in Singapore with it's core business in jet fuel.

Agency Problems

It was revealed during the investigation that CAO has several agency problems, which led to the downfall of the Company. The major problems are as listed as follows: Loss arose after CAO had placed wrong bets on oil price movements. Instead of recuperating from the losses, CAO aggravated the matter by doubling its bets and selling larger put options with longer expirations. CAO's former CEO and Chairman of the parent Company in China made their own decisions instead of adhering to the Company's rules in decision-making process. They collaborated and transferred funds from the parent company to salvage CAO when the put options were rendered worthless. Lack of transparency and proper accounting in that the stockholders were unaware of the situation. Lack of corporate governance and monitoring in the management level by the stockholders.

1.4 Counter-Measures

The agency problems faced by CAO could have been avoided if the following counter-measures were adopted; Proper system of corporate governance authorised by the stockholders. From the on-start, the proper procedures prior to the trading of derivations of oil prices should be to seek approval from the stockholders. However, CAO's ex-CEO made his own decision to venture further, after making some profits by purchasing the put options that eventually led to the loss of US$550 millions. This is an obvious personal decision of the ex-CEO. To aggravate the grim situation, he collaborated with the Chairman of the parent company in China to purchase all the worthless put options in order to salvage CAO from collapsing. If proper governance system has been implemented such as imposing restrictions on the authority of the CEO, the situation would have been salvaged. The stockholders were unaware of the situation as there was a lack of transparency in the accounting reporting. The appointment of a team of external auditors by the stockholders would have put this situation in place with frequent annual or impromptu accounts audits on the management. This would have prevented the forgery of account documents to cover the losses faced by the company. The ex-CEO, CAO was left to run the business without any interference or check-back systems initiated by the stockholders to safeguard their interest. A board of directors can be appointed to supervise the management performance and to ensure that any decisions made are in the best interest of the stockholders. This enables the stockholders to have a hold over the management to ensure that business is profitable and safe. A possible deterrence is to implement a reward and punishment system such as increasing the salaries, bonuses and providing stock options for performance and dismissal for non-performance. An annual review on the re-appointment of the CEO and the executives to prevent possible monopolisation of authority and forming of cliques within the management level.

1.5 Conclusion

As clearly illustrated by the CAO's issue, agency problems have to be identified and resolved at the earliest time, if not, the company's stocks will fall and the stockholders will suffer a loss. Relevant counter-measures have to be implemented at all levels to prevent any abuse of authority, fraud and insider trading.

2.1 Introduction

In business finance, there are several investment appraisal methods to assist in the determination whether an investment is profitable to partake. These methods include calculation of the Net Present Value (NPV), Average Accounting Return (AAR) and Internal Rate of Return (IRR) to assess the profitability returns of an investment and assessing the Discounted Payback Period to determine the shortest repayment period. Theses individual investment appraisal methods will be further elaborated in the following paragraphs.

2.2 Net Present Value

Net Present Value (NPV) is the measure of how much value is added today by undertaking an investment. In simple terms, NPV of an investment is the difference between an investment's market value and its' cost as shown in the below example: Example 1: Adeline intends to invest in a new project with a start-up cost of $50, 000. The table below shows the cash flows for the new project. The desired rate of return for the investment is at 10% per annum. What is the NPV and advice for Adeline whether she should proceed to invest in the project?
Year Project A Cash Flow ($)
1 10, 000
2 30, 000
3 40, 000
NPV for Project:
n Cash Flow ($) Disc. F. = 1 / (1 + 0.1)n PV ($)
0 - 50, 000 1 - 50, 000
1 10, 000 0.909 9, 090
2 30, 000 0.826 24, 780
3 40, 000 0.751 30, 040
NPV at 10% = $13, 910
The project has a positive NPV, which is $13, 910. This means that the investment is returning more than the desired rate of return of 10% per annum. As such, Adeline should invest in the project. In the calculation of NPV, there are certain advantages and disadvantages as follows: Advantages: It provides a correct advice based on a perfect capital market situation and provides correct ranking for mutually exclusive projects. It gives an absolute value. It allows for time value of the cash flows.   Disadvantages: It is very difficult in identifying the correct discount rate. NPV appraisal method requires the decision criteria to be specified before appraisal can be undertaken. In other words, if it is a positive NPV, the project will be accepted, whereas if it is a negative NPV, the project will be rejected.

2.3 Discounted Payback Method

Discounted Payback Method determines the period in which initial investment is equal to the sum of the discounted cash flows. The rule states that an investment is acceptable if its discounted payback time is less than some pre-specified number of years as explained by using the same scenario in Example 1:
n Cash Flow ($) Disc. F. = 1 / (1 + 0.1)n PV ($) Cumulative PV($)
1 10, 000 0.909 9, 090 9, 090
2 30, 000 0.826 24, 780 33, 870
3 40, 000 0.751 30, 040 63, 910
Initial investment cost is $50, 000. Amount remaining after 2 years = $50, 000 - $33, 870 = $16, 130 Remaining year = $16, 130 / $30, 040 x 12 months = 6.4 months Therefore, the discounted payback time = 2 years 6.4 months The advantages and disadvantages in the Discounted Payback Method are as follows: Advantages It takes into account the time value of money. It is easy to understand. It does not accept negative NPV value. Disadvantages It may reject positive NPV investment. It requires an arbitrary cut-off point. It ignores cash flows beyond the cut-off date. It is biased against long-term projects or investment such as Research and Development projects or land-banking investment.

2.4 Average Accounting Return

Average Accounting Return (AAR) is similar to NPV, in making capital budgeting decisions. AAR is based on the average accounting return; a project is acceptable if its AAR exceeds a target average accounting return as illustrated: Example 2: Zak set up a car grooming shop with the required investment of $300, 000. The shop's lease will expire in 5 years' time; the depreciation will be a straight line over the 5 years. Profit is taxed at 20%. The table below shows the revenue and expenses for the 5 years. An average accounting return of 15% per annum is intended. Should this project be accepted?
1st year 2nd year 3rd year 4th year 5th year
Revenue($) 150, 000 200, 000 250, 000 180, 000 270, 000
Expenses($) 50, 000 100, 000 110, 000 70, 000 110, 000
Annual Depreciation = $300, 000 / 5 = $60, 000
1st year 2nd year 3rd year 4th year 5th year
Revenue($) 150, 000 200, 000 250, 000 180, 000 270, 000
Expenses($) 50, 000 100, 000 110, 000 70, 000 110, 000
Earning before depreciation($) 100, 000 100, 000 140, 000 110, 000 160, 000
Depreciation($) 60, 000 60, 000 60, 000 60, 000 60, 000
Earning before tax($) 40, 000 40, 000 80, 000 50, 000 100, 000
Tax @ 20%($) 8, 000 8, 000 16, 000 10, 000 20, 000
Net Income($) 32, 000 32, 000 64, 000 40, 000 80, 000
Average Net Income = $(32, 000 + 32, 000 + 64, 000 + 40, 000 + 80, 000) / 5 = $248, 000 / 5 = $49, 600 Average book value of investment = $300, 000 / 2 = $150, 000 AAR = $49, 600 / $150, 000 x 100% = 33.07% Since the intended average accounting return is 15% per annum, this investment is considered more than acceptable. However, there are certain advantages and disadvantages whilst using the AAR as follows: Advantages: It is easy to understand and compute. The accounting information is easily available and hence, it is always possible to calculate AAR. Disadvantages AAR is not a true representation of investment as it failed to take into account the time value of money. It uses an arbitrary cut-off point and a benchmark to consider whether an investment is acceptable. It is based on the book value of the investment and not the cash flows and the market value of investment.

2.5 The Internal Rate of Return

Internal Rate of Return or IRR is an important alternative to NPV in which a single rate of return for the investment is identified to summarise the merits of a project. IRR only depends on the cash flows and not the rate of interest offered by banks. Based on IRR rule, an investment is acceptable if the IRR exceeds the desired return, if not, it will be rejected. This is shown as follows: Example 3: The initial cost of investment of Project Runway is $10, 000. The cash flows are $3,500 in the first year, $5,000 in the second year and $4000 in the third year. Calculate the NPV at 10% and 20% and the IRR if a 15% return of investment is require. Should this project be taken up?
n Cash Flows($) Disc. F. = 1 / (1 + 0.1)n PV($) Disc. F. = 1 / (1 + 0.15)n PV($)
0 - 10, 000 1 - 10, 000 1 - 10, 000
1 3500 0.909 3, 181.50 0.870 3, 045
2 5, 000 0.826 4, 130 0.756 3, 780
3 4, 000 0.751 3, 004 0.658 2, 632
315.50 - 543
IRR = 10 + (315.50) x (15 - 10) / 315.50 + 543 = 10 + (1577.5 / 858.5) = 10 + 1.838 = 11.84% Since the expected rate of return is 15%, the above project should not be undertaken. The following are the advantages and disadvantages of IRR: Advantages: It gives the results in terms of percentage in which management is familiar. It takes into account the cash flows and the time value of money. Disadvantages: Since the results are in percentage, it ignores the difference in project magnitude and hence, is unreliable when evaluating projects of great difference in size. IRR decision rule will break down for multiple IRR calculations. IRR cannot be depended on to provide correct advice for mutually exclusive investment decisions.

References

1. Commercial Affairs Department 2007, Singapore, Case of China Aviation Oil, viewed on 10 Sep 08, <http://www.cad.gov.sg/serv/pro/cas/Case+of+China+Aviation+Oil.htm> 2. China Aviation Oil (Singapore) Corporation Ltd, 2005, China Aviation Oil (Singapore) Corporation Ltd announces findings of PricewaterhouseCoopers pursuant of its investigations, viewed on 10 Sep 08, <bankrupt.com/misc/ChinaAviationPWCReportAnnouncement.pdf> 3. Chong Chee Kean 2008, Ren Ci Probe - Ten Charges Against Ming Yi, The Straits Times, viewed on 17 Sep 08, <http://www.straitstimes.com/Free/Story/STIStory_258042.html> 4. Kent, Bakar H, Powell, Gary E (2005), Understanding Financial Management - A Practical Guide, Blackwell Publishing. 5. Malcolm Borthwick, 2005, Investors throw China Aviation a lifeline, BBC News viewed on 10 Sep 08, <http://news.bbc.co.uk/go/pr/fr/-/2/hi/business/4074404.stm> 6. Seah Chiang Nee 2007, NKF Scandal - Ripples widely felt, The Star viewed on 17 Sep 08, <http://www.littlespeck.com/content/politics/CTrendsPolitics-070113.htm> 7. Wayne Arnold, 2005, After crash, China Aviation Oil offers creditors sweeter repayment deal, International Herald Tribute, The Global Edition of the New York Times viewed on 10 Sep 08, < http://www.iht.com/articles/2005/05/12/business/chiav.php>
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