A: As depicted in the given case, the CEO of a company is considering entering into an agreement to buy another company. However, the price is perceived to be too high but gives an opportunity to the CEO for leading and managing a much bigger company that is associated with higher pay and prestige. As such, it can be clearly seen that there is presence of an agency conflict in the preset business scenario. This is because there is an ethical dilemma for the CEO of the company to either choose increased pay and power for fostering the personal growth or meet the objective of maximizing the shareholder welfare. The agency theory of corporate governance has argued that business leaders and managers are the agents acting on the behalf of the principal mainly the shareholders and owners and creating higher value for them. The agency conflict occurs when there goals are not mutually aligned with each other and business managers tend to place emphasis on meeting his/her personal objectives rather than meeting the responsibility of maximizing a firm performance to create high value for the shareholders.
As such, in given case also there is an agency conflict if the CEO places emphasis on driving his/her personal growth by buying another company to achieve higher pay and authority and ignoring its long-term implications on the performance of a firm. The CEO knows that price of buying another company can be too high and this can have a negative impact on the profit position of the firm in long-term and resulting in creating less return for the shareholders. The agency conflict can be regarded as ethical one in which CEO can take unobservable actions for increasing their own utility at the expense of the shareholders. The relevant ethical considerations that need to be taken for addressing this type of conflict is maintaining trust relations between the shareholders and the managers, increasing transparency in the business operations and aligning the goals of the business managers with that of the shareholders to avoid the occurrence of such type of conflict.
B: As per the theory of agency, it is highly necessary for the aligning the interest and objectives of the business managers with that of the shareholders to overcome the possible occurrence of any type of conflict. The strategies that can be used for ensuring that managers are motivated to act in the direction of promoting the interest of the shareholders is creating a mutual relation of trust and faith between them by developing the mutually aligned goals and beliefs. The non-alignment of the goals of the shareholders and managers can result in occurrence of fraudulent activities in which managers tend to take unethical course of action for increasing their personal growth and thus ignoring the value created for the shareholders. This can results in negatively impacting the goodwill and performance of the organization and thus shareholders need to ensure that managers are motivated to act in their best interest by ensuring the adoption of adequate strategies in place.
The executive compensation system is one of the best strategies that is available to the shareholders in this context for ensuring that managers are motivated to increase the return created for the shareholders by taking actions that enhances the long-term performance of a company. The performance related pay system in which business managers receives additional incentives or rewards in the context of placing higher efforts and achieving the stated goals helps in resolving the agency conflict issues. The incentives can be used to align management and shareholders interest because these payments motivates managers to place in their best efforts as per their personal growth and pay is linked to achieving the long-term goals and objectives of an organization. Therefore, it can be said that increase in the log-term performance of an organization creates higher returns for the shareholders and ensuring that their interest and objectives are protected.
Part a:
Given |
Amount |
Relevant/Irrelevant |
Treatment |
Cost paid for feasibility study |
$ 25,000.00 |
Irrelevant |
It is sunk cost, so not been considered for investment appraisal purpose |
Machine Cost |
$ 350,000.00 |
Relevant |
Initial investment and Cash flow at year 0 |
Life of machine |
4 years |
So, machine will depreciated using straight line depreciation method as depreciation rate is not given |
|
Sale value of machine |
$ 100,000.00 |
Relevant |
This cash flows will generated in year 5 and will be considered for tax purpose as book value of machine is zero and all this amount will attract tax expense |
Sale produced each year |
$ 135,000.00 |
Relevant |
Cash flow from year 1 to year 5 |
Investment in account receivable |
$ 35,000.00 |
Relevant |
Will be treated as working capital investment in year 0 |
Investment in inventory (Average value) |
($25000+$95000)/2 = $60000 |
Relevant |
Will be treated as working capital investment in year 0 |
Loan Repayments each year |
$57,700 |
Relevant |
Cash outflow from year 1 to 5 |
Use of old equipments (Sale value at year 0) |
$ 63,000.00 |
Relevant |
Will be treated as cash outflow at Year 0 |
Tax rate |
30% |
Statement of cash flows |
||||||
Particulars |
Year 0 |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Cash flows at year 0/start |
||||||
Cost of machine |
$ (350,000) |
|||||
Investment in account receivable |
$ (35,000) |
|||||
Investment in inventory |
$ (60,000) |
|||||
Use of old machine |
$ (63,000) |
|||||
Cash flows over the life |
||||||
Sale produced each year |
$ 135,000 |
$ 135,000 |
$ 135,000 |
$ 135,000 |
$ 135,000 |
|
Less: Loan repayments each year |
$ (57,700) |
$ (57,700) |
$ (57,700) |
$ (57,700) |
$ (57,700) |
|
Less: Depreciation of the year |
$ (70,000) |
$ (70,000) |
$ (70,000) |
$ (70,000) |
$ (70,000) |
|
Earnings before depreciation and tax |
$ 7,300 |
$ 7,300 |
$ 7,300 |
$ 7,300 |
$ 7,300 |
|
Less: Tax @ 30% |
$ (2,190) |
$ (2,190) |
$ (2,190) |
$ (2,190) |
$ (2,190) |
|
Earnings after depreciation and before tax |
$ 5,110 |
$ 5,110 |
$ 5,110 |
$ 5,110 |
$ 5,110 |
|
Add: Depreciation |
$ 70,000 |
$ 70,000 |
$ 70,000 |
$ 70,000 |
$ 70,000 |
|
Earnings before dep and after tax |
$ 75,110 |
$ 75,110 |
$ 75,110 |
$ 75,110 |
$ 75,110 |
|
Cash flow at the end |
||||||
Sale value of machine |
$ 100,000 |
|||||
Less: Tax expense on sale |
$ (30,000) |
|||||
Add: Inventory recovered |
$ 60,000 |
|||||
Add: Account receivable recovered |
$ 35,000 |
|||||
Total cash flows |
$ (508,000) |
$ 75,110 |
$ 75,110 |
$ 75,110 |
$ 75,110 |
$ 240,110 |
Part b: Calculation of inflation adjusted cost of capital
Approach: Use of constant prices and real rate
Given:
Calculation of real cost of capital
Statement to calculate the NPV of the project |
|||
Year |
Cash flows |
PVF @ 8.74% |
PV |
0 |
$ (258,000.00) |
1.000 |
$ (258,000.00) |
1 |
$ 75,110.00 |
0.920 |
$ 69,073.02 |
2 |
$ 75,110.00 |
0.846 |
$ 63,521.26 |
3 |
$ 75,110.00 |
0.778 |
$ 58,415.73 |
4 |
$ 75,110.00 |
0.715 |
$ 53,720.55 |
5 |
$ 240,110.00 |
0.658 |
$ 157,929.63 |
NPV |
$ 144,660.18 |
Part c: Grand Touring Ltd can go with the project as it has positive present cash flows of $144660.18 and it will help the company to earn higher rate of return than the required rate of return of 12% adjusted to inflation.
(a): Weighted Average Cost of Capital (WACC) method is used for measuring the cost of capital and determines the optimal debt and equity sources to be used in capital structure of a firm. As such, it determines the risk level of a company s perceived by the market through assessing the return of its assets so that the investors earn an required rate of return.
(b): The assumptions used in determining WACC does not hold true in the following conditions:
(a) The five steps to be followed in establishing a credit policy are stated as follows:
(b): In this case Sagun Ltd entered in purchase contract with supplier with term “1/10, net 25”. In order to avail the discount company needs to enter in the loan agreement to fulfill the financing needs. Bank interest rate is 12% on borrowed funds.
Given:
Need to calculate the effective interest rate of given credit term and compare it with bank interest rate:
Let us assume that the amount payable to supplier is $100, which mean there is option to pay $99 after 10 days or complete $100 in 15 days after that
Recommendation: So, if discount is not being taken that than company has to bear interest rate of 27.69% while company can easily avail the discount through taking a bank loan at 12%, so it is advised to enter the loan agreement with the bank and avail the discount.
(c): Formula to calculate the operating cycle= Days in inventory + Days in account receivables
Given:
So, operating cycle of Rameshwor will be = 50 days + 30 days = 80 days
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