Answer a) There are various benefits of raising funds through bonds rather than by issuing equity. The interest expenses paid on debt instruments like bonds is deductible on the income tax return of Amazon whereas the dividend on equity are not deductible on the income tax return. Moreover, the ownership interest of the existing shareholders in the company will not get diluted as bonds constitutes as debt for the firm. Therefore, issuance of bonds does not influence the ownership of the corporation.
The interest rate charged by banks on loans is generally greater than the interest rate paid by firms to the bond investors. Corporations carry out operations in order to maximize its profitability and therefore, reducing the interest expense is considered as an important factor. Also, issuance of bonds provides greater freedom to the companies to operate. It releases corporations from various restrictions that are usually attached in case of bank loans.
The price of the bond immediately before the payment of the final coupon taking 3% as market interest and 10 years maturity will decrease to $1011.68 from $1012.80.
The price of the bond immediately after the payment of the final coupon taking 3% as market interest and 10 years maturity will be $1012.80.
MSFT = 96.694%
TSLA = 81.829%
MSFT = 0.013
TSLA = 0.031
Correlation coefficient of returns = 0.288
This indicates that there is positive relationship between the returns on the stocks of two listed companies.
Portfolio return = w1 x r1 + w2 x r2 = 58.02% + 32.73% = 90.75%
Portfolio risk = sqroot(w1^2 x sd1^2 + w2^2 x sd2^2 + 2 w1w2 x corr x sd1 x sd2)
= sqroot(0.36x0.000169 + 0.16x0.000961 + 5.57)
= sqroot(11.65015) = 3.413%
Answer a) WACC is defined as the cost of capital where every category of capital is weighted out proportionately. The different sources of capital comprises of bonds, preferred stock, common stock and debt instruments. It is used in financial modeling as a discount rate in order to compute net present value of the company’s business.
WACC = (E/V*Re) + [(D/V*Rd) x (1-t)]
The main objective behind calculating WACC is to identify the cost of different part of capital structure of the company on the basis of the weightage of debt, preferred stock and equity. The corporation make payment of interest at a fixed rate on debt and fixed return on preferred stock. Although, company does not any foxed return in case of equity but sometimes, it pay out dividends in cash form to the shareholders.
Effective interest rate = (Annual Interest / total debt) x 100
= (1600/23414) X100 = 6.83%
Cost of debt (Kd) = Effective interest rate x (1 – Marginal tax rate)
Here tax rate = 21%
Kd = 6.83% x (1 – 21%) = 5.40%
= 1% + 1.17 x 6% = 8.02%
Equity capital = $62060, Debt = $23414
Total of all funds = $62060 + $23414 = $85474
Weight of equity = $62060/$85474 * 100 = 72.61%
Weight of debt = $23414/ $85474*100 = 27.39%
WACC = (E/V*Re) + [(D/V*Rd) x (1-t)] = 5.82% + 0.31% = 6.13%
Answer 4) Agency theory depicts the relationship between the principals and agents. The agent acts on behalf of the principals with regard to specific business transactions and is expected to perform in the best interest of the principals rather than serving his own goals (Moloi & Marwala, 2020). The difference in their interests may lead to the conflicts as there are some cases where agents do not act efficiently in the best interest of their principal. This is in regard to the particular relationship that exists among management and shareholders of the corporation. The shareholders are considered as the true owners and therefore acts as principals and elect the executives to undertake decision making process on their behalf. The major objective of the management who acts as agent is to carry out operations in their best interest. There are various instances when complex issues arrive and the management, unknowingly or knowingly undertake decisions that are not as per the best interest of the shareholders. Agency theory offers parameters for the board members that make strategic decisions. As per this theory, shareholders must be well informed about the activities undertaken by the company, by the board members and the executives who are expected to perform in best interest as agents in order to mitigate some amount of risk regarding the conflict of interest and distrust that mainly happens in this type of relationship (Panda & Leepsa, 2017). Transparency helps in achieving the position that the interest of management of the company and its shareholders are perfectly aligned and the agents are acting truly in the interest of the parties on whose behalf they act.
Corporate Governance is defined as the combination of processes, laws and rules by which corporations are controlled, regulated and operated. This term involves both external and internal factors that may influence the interest of major stakeholders of the company like suppliers, customers, shareholders, management and government regulators (Moore & Petrin, 2017). It is the responsibility of the board of directors to establish an efficient framework of corporate governance that effectively aligns conduct of business with its objectives. The processes that can be specifically outlined in corporate governance comprises of performance measurement, action plans, disclosure practices, procedures for reconciling conflicts of interest, dividend policies, executive compensation decisions, etc. The major elements of corporate governance include various elements like all the shareholders of the corporation must be treated fairly and equally. They must be kept aware about their rights. The relevant information must be communicated with the vendors, employees, community members and the investors. A commitment must be maintained by the board of directors in order to ensure fairness, transparency, accountability and diversity within the defined framework of corporate governance (Baldini et al., 2018). Adequate skills must be acquired by board of directors which are considered as essential to review the practices of the management. The procedures and policies with regard to corporate governance must be held transparent or disclosed to the all the relevant stakeholders. The major purpose of corporate governance is to establish checks and balances procedure that will help in minimizing the conflicts of interest. Conflicts in the interest generally arises when the two involved parties have different or opposing views on the conduct of the business processes. As the board of directors comprises of both external and internal members, corporate governance is considered as the unbiased way to approach major conflicts. This concept has received high attention due to high profile scams and scandals involving misuse of corporate power by the corporate officers. Thus, various rules, regulations and laws have been passed to undertake several components of corporate governance.
The business environment is full of conflicts of interest. These arises when entities only make efforts to serve their own interests instead of fulfilling their professional duties and responsibilities. Bernard Madoff Investment Scandal is regarded as the major case of Ponzi scheme that undertook the advantage of consumer suspicions (Mugarura, 2017). Agency problem is better depicted by the Ponzi schemes. In agency theory, it has been claimed that a lack of incentive alignment and oversight may led to such problems. Bernard Lawrence ‘Bernie’ Madoff was a money manager who implemented and executed Ponzi scheme, deceiving large number of investors over a period at least 17 years. Investors have invested funds and their trust in Madoff as Bernard established an image of respectability, he made promises to offer high returns and claimed to undertake legitimate strategy (Sher, 2016). They thought that undertaking fund management external to the traditional banking institution will help them in saving money and reducing fees. All the client funds were deposited by Madoff into a single bank account that he further used to pay off the amount to the existing clients. He financed redemptions by attracting investment from new investors. Ponzi schemes took advantage of the consumer doubts and fears with regard to banking industry although the established financial institutions help in decreasing the risk by enforcing legal procedures. All these investments led to the creation of an environment where the consumers could not effectively make sure that the agent is performing in the best interest of its principals. The scam of Bernie Madoff is considered as the notable example of Ponzi scheme. Madoff led to an extravagant bogus business that eventually cost the investors to approximately $16.5 billion in the year 2009 (Nash et al., 2018). However, it is difficult to determine the period when Madoff started to exploit his investors. The returns promised by him were higher in comparison to the various investment banks and entities were offering during that time. The returns were so promising that nearly all of his investors trusted him. All the money received from investors was deposited in the bank account and financed the requests of redemption with the newly financed money. In the starting of 2008, he started receiving a large number of requests for redemption from his clients who were feared by the global financial crisis. In the previous years, the redemption requests were usually lesser than the new flows of fund amount and therefore, those requests got easily fulfilled and the Ponzi scheme kept running. However, in December 2008, as the account of Madoff, the entity faced $7 billion as requests for redemption. His fraud scheme got unraveled when he failed to pay to his investors and made confession about the same in front of his brother and sons. Consequently, Madoff was charged criminally and was convicted for his fraud actions. The last statements of the funds showed that it had $64.8 billion in the client assets. At the age of 71 in 2009, Madoff pleaded shamefaced in front of eleven federal felony counts comprising of wire fraud, securities fraud, perjury, mail fraud and money laundering. The Ponzi scheme now became a compelling sign of culture of dishonesty and greed (Barak, 2012). He was punished with 150 years of imprisonment and was ordered to forfeit $170 million in assets. Several questions remained with regard to Bernie Madoff and how he actually managed to cheat people for such a longer period of time. Therefore, from this scandal, it can be claimed that agents or Madoff has performed in his own interest rather than in the best interest of his investors. Investors are benefitted from the success of the company and have a desire or expectation from the executives of the corporation to perform fairly and in the interest of investors. However, the corporate leader, Bernie Madoff did not have the similar interest as that of his investors. He only tried to maximize his income at the cost of investors.
Baldini, M. A., Bronzetti, G., & Sicoli, G. (2018). The influence of corporate governance's decision on corporate social responsibility. International Journal of Business Performance Management, 19(1), 16-35.
Barak, G. (2012). Theft of a nation: Wall street looting and federal regulatory colluding. Rowman & Littlefield Publishers.
Moloi, T., & Marwala, T. (2020). The Agency Theory. In Artificial Intelligence in Economics and Finance Theories (pp. 95-102). Springer, Cham.
Moore, M., & Petrin, M. (2017). Corporate Governance: Law, Regulation and Theory. Macmillan International Higher Education.
Mugarura, N. (2017). The use of anti-money laundering tools to regulate Ponzi and other fraudulent investment schemes. Journal of Money Laundering Control.
Nash, R., Bouchard, M., & Malm, A. (2018). Twisting trust: social networks, due diligence, and loss of capital in a Ponzi scheme. Crime, Law and Social Change, 69(1), 67-89.
Panda, B., & Leepsa, N. M. (2017). Agency theory: Review of theory and evidence on problems and perspectives. Indian Journal of Corporate Governance, 10(1), 74-95.
Sher, Y. (2016). Branding in Ponzi investment schemes (Doctoral dissertation, The IIE).
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