Characteristics of Agency Theory

Characteristics of Agency Theory

Characteristics of agency theory may be explained in term of separation of ownership and management, management act in best interest, management self interest, conflict between management & owners, Management create cost and balance approach.

1.    Separation of Ownership & Management

Under agency theory management & ownership are two different aspect of organization. Business is managed by manager hired by the owners. Manager acts on behalf of the owner as agent.

2.    Management act in Best interest

Under agency theory, it is believed that manager will work in the best interest of ownership. Therefore a formal hired by the owners to manage the business. It is an ideal situation or case of agency theory.

3.    Management Self Interest

Agency theory recognizes the fact, that management may have their self interest like increase in salary and bonuses. Therefore it is not practical that manager will only focuses on the interest of owners.

4.    Manager & Owner Conflict

Agency theory recognizes that Manager Interest and owner interest conflict with each other. Management may look into short term profit, while ownership is more interested in long term growth. Manager is ready to take risky decision, while owner would love to minimize the risk.

5.    Manager Create Cost

Agency theory explains that Management create number of costs for the ownership. For example an increase in salary is cost for the ownership, as it will reduce the ownership wealth. It is important to remember that any cost of expense is a hit on ownership wealth.

6.    Balance

Agency theory explains a balance between management and ownership. Management should look to ownership interest and ownership should also give due consideration to self interest of management.

Characteristics of Stakeholder Theory

Characteristics of Stakeholder Theory

Characteristics of Stakeholder theory can be explained in term of multiple objectives, director are not agent, and responsibility toward society.

1. 1.    Internal & External Stakeholder

There are number of stakeholder for any organization, which can be broadly classified into internal stakeholder i.e. Employees, supplier and external Stakeholder like Government.

1. 2.    Stakeholder are important

Stakeholder theory believes that stakeholder is important for the business, and therefore organization should adopt appropriate policies to cater their concern and safeguard their interests.

1. 3.    Multiple Objectives

      Stakeholder theory believes there are number of objectives for an organization. There are       different stakeholders and each stakeholder interest is to be safeguarded by the organization.

1. 4.    Directors are not Sole Agent

Director cannot be regarded as sole agent of the shareholder; rather they are responsible to safeguard the interests all stake holders.

1. 5.    Responsibility toward Society

Company also has responsibility toward the society. Therefore due consideration should be given to the issues which effects the society like environmental issues. The example of environmental issues is emission of carbon, noise and pollution, depletion of natural resources.

Advantages of Floating Rate of Interest

Advantages of Floating Rate of Interest

Advantages of floating rate of interest are that you may require paying lower amount, if the interest rate falls or goes down. It means that you may require to pay amount lower than your expectations.

Example

ABC Company borrowed 2 million at LIBOR + 2 %, company was expecting that labor would remain 5%, but actual labor came down to 3%.

Expected Interest (5%+2%) x 2,000,000 = 140,000

Actual Interest (3%+2%) x 2,000,000     = 100,000

Advantage= 140,000-100,000 = $ 40,000

Disadvantage of Floating Rate of Interest

Disadvantage of floating rate of interest is that you may have to pay more than you are expecting to pay, and you will face difficulty to arrange this extra amount.

Example

For example you have borrowed 1 million dollar, predicting that interest rate would remain in single digit, but if rate crosses the single digit. Your bad time starts.

Maximum Interest Cost 1,000,000 x .09 = 90,000

Actual Interest Cost 1,000,000 x 12% = 120,000

Excess cost        120,000-90,000 = $ 30,000

One have not planned for this extra $ 30,000, therefore you may face some serious difficulties to arrange this $ 30,000.

Why Present cash flow is divided by annuity factor for equivalent future cash flows

Why Present cash flow is divided by annuity factor for equivalent future cash flows?

Present cash flows are divided by annuity factor to account for the time value of money; this is very important concept in financial decision making. If we ignore the time value of money, then we can divide the present cash flow with number of years.

What is asset replacement rule for machinery

What is asset replacement rule for machinery?

Machinery which has lower annual equivalent cost should be selected. Annual equivalent cost can be calculated dividing the present cash flows with the annuity factor.

Asset Replacement Rule example

For example there are two machinery (X, Y) with cost 100 and 150 million respectively. Running cost of both machinery is 40 million per year and useful life is 2 & 3 years, then annual equivalent cost can be calculated as under;

Year	Initial	Running cost	Net Cash	Discount	PV
0	100		100	1	100
1		40	40	.909	36
2		40	40	.826	33
PV					169

Annuity Factor (2 Years) = 1.73

Equivalent machinery cost = 169/1.73

= 98 (first Machinery)

Year	Initial	Running cost	Net Cash	Discount	PV
0	100		130	1	130
1		40	40	.909	36
2		40	40	.826	33
		40	40	.751	30
PV					229

Annuity Factor= 2.48

Equivalent Machinery Cost= 229/2.48

=92 (second Machinery)

Second machinery has lower equivalent cash outflow, and therefore be selected.

Who can demand fresh election of Board of Director

Who can demand fresh election of Board of Director?

Fresh election can be demanded by a substantial shareholder. Substantial shareholder may claim his representation in board of directors. In Pakistan substantial shareholder mean a person holding more than 12.5% of shares.

Who can remove elected Director

Who can remove elected Director?

Shareholder can remove the elected director in general meeting, provided that resolution so passed by more than votes which was taken by the director at the time of elections

What is process of electing subsequent director

What is process of electing subsequent director

Number of director fixed by the first director

1.    notice of number of director at 45 day before meeting

2.    person interested send his consent for election at 14 days before meeting

3.    Notice (consent) of person interested in director is circulated to share 7 days before meeting.

4.    director is selected by voting

5.    Number of votes number of voting shared x number of director to be selected

6.    person get highest number of votes first director, person getting second highest number of votes is second director, in all director is same manner up to the limit (director is required to be elected).

What is casual Vacancy of board of Director

What is casual Vacancy of board of Director?

Casual vacancy may result due to disqualification, death or resignation of directors.

Who would fill the casual vacancy of board of director?

Casual vacancy in board of director would be filled by the Director (remaining director) and such director would serve as director for remaining term.

How many subsequent Directors in Pakistan

How many subsequent Directors in Pakistan?

Number of subsequent director is decided by the first director, and subsequent director are selected in first annual general meeting. Subsequent director are selected by voting procedures.

What is term of subsequent directors?

Term of Director for subsequent director is three years. It important to remember that subsequent director also called elected directors.

Who decide number of Director at time of incorporation in Pakistan

Who decide number of Director at time of incorporation in Pakistan

At the time of incorporation the subscriber to the memorandum (creating company) decided number of director. Term of such directors; normally continue till first general meeting of shareholder, in which number of director is to be decided.

How many Directors for company in Pakistan

How many Directors for company in Pakistan?

Companies law specify minimum and maximum number of director, while the exact number of director a company should have is written /decided by the articles of association. It is important to remember that number of director also depend on the nature of company

1.    Single member Company (One Director)

2.    Private Company ( Minimum director two)

3.    Public Limited Company   (Minimum three Director)

4.    Listed Company  (Minimum Seven Directors )

Companies’ law does not specify maximum number of directors for companies.

What is Basic composition of Board of Directors in Pakistan

What is Basic composition of Board of Directors in Pakistan?

Basic composition of Director means maximum and minimum number of director for a company. Basic composition of director depends on the nature of company. Different country has different basic composition. Basic composition of director is given in the companies law or act or other relevant law.

Who Decide Composition of Board of Director in Pakistan

Who Decide Composition of Board of Director in Pakistan

Basic Composition of board of director i.e. maximum and minimum number of director is normally decided by the regulator, corporate law of the country. Specific number of Directors is decided either by memorandum of association, articles of association or board of directors.

In Pakistan board of Director composition is decided as follow;

·         Minimum number of Director is given or decided by law

·         Number of first Director is decided by subscriber to memorandum subject to law.

·         Number of subsequent Director by first Director subject to law.

Fixed Installment Loan Calculation

Fixed Installment Loan Calculation

Fixed installment loan installment can be calculated by dividing the loan amount by the annuity factor.  This would provide us the equal cash outflows (loan installment).

Fixed Installment Loan Calculation Example

Mr. Saleem is planning to take 1 million $ from a bank. Interest rate is 12% and term of loan is 5 years, what would be yearly installment.

Solution

In first place we would calculate, the annuity factor, and then we would divide the loan amount by the annuity factor.

1.    Annuity Factor

Annuity Factor= 1-(1.012)^-5

                           .12

Annuity Factor = 3.60

2.    Fixed installment

Annual installment = 1,000,000/ 3.60

277,777 – Yearly installment

Total Market Value from Equity & Debt

Total Market Value from Equity & Debt

Total market Value of entity may be calculated from the market value of debt and market value of equity. Total market value is calculated by simply adding market value of Debt & Equity.

Vt= Ve + Vd

Vt= Total Market Value

Ve= Market Value of equity

Vd= Market Value of debt

Total Market Value from Debt & Equity Example

XYZ Company market value of equity is 50 million, while market value of debt is 35; total market value has been calculated for XYZ as under.

Vt= Ve+Vd

Vd= 50+ 35

Vd= 85 (Total Market Value)

Market Value of Debt from Market Value of Equity

Market Value of Debt from Market Value of Equity

Market Value of debt can be calculated from the relationship between Total value of entity, market value of debt and market value of equity. This relationship has been explained by following formula

Vt= Ve + Vd

Vt= Total Market Value

Ve= Market Value of equity

Vd= Market Value of debt

Market Value of Equity Example

ABC Company has current value of 350 million, equity market value is 100, calculate debt market value?

Vd= Vt-Ve

Vd= 350-100

Vd= 250 (Market value of equity)

Market Value of Equity and Total Value of Company

Market Value of Equity and Total Value of Company

Market Value of equity can be calculated from the Total value of entity and market value of debt. Formula for calculating market value of equity is

Ve= Vt-Vd

Ve= Market Value of equity

Vt= Total Market Value

Vd= Market Value of debt

Market Value of Equity Example

Company total market value is 250 million, the market value of debt is 50 million, and then market value of equity can be calculated as under

Ve= Vt-Vd

Ve= 250-50

Ve= 200 (Market value of equity)

Volatility of Project

Volatility of Project

Volatility of project varies with the length of period. it means longer period project has higher volatility and shorter period has small volatility. Relationship between time and volatility has been explained by the following formula

S.D (Longer period) = S.D (short period of time) √T – measure of volatility

Volatility of Project example

Project has cash inflow of 200,000 annual. Life of project is 5 years. Volatility in cash flow is 30,000. Calculate the cash inflow for 5 year and volatility.

Cash flow 5 years = 200,000 x 5 years = 1,000,000

Volatility for 5 Years = 30,000 x √5

=30,000x2.236

= 67080

Risk in Return

Risk in Return

Risk in return means that expected return may not be achieved. This risk can be measured with the help variance and standard deviation.

1.    High Volatile Return

High volatile return means return differ substantially from the expected value (average value of return. high volatile return also differ substantially from each other.

2.    Risk of Return measurement

Risk of return may be measured by statically technique i.e. calculating variance and standard deviation.

Variance = p Σ(r-r)²

S.D = √ p Σ(r-r)²

Risk Modeling

Risk Modeling

In risk modeling a project is treated as model and such model is constructed based on the expected outcomes. This model then checks by changing the outcomes (i.e. inflow and outflows).

1.    Model Construction

First step in risk modeling is construction of well planned model. Such model is based on future expected outcome is created. a lot of working and detail analyses is performed to create a suitable model for project.

2.    Analyses with Variation

Second step is risk Modeling is analyses with variation in outcome. It means that how the result (NPV) will change by changing the different outcome (variable) of model. For investment appraisal mainly there are two main variable revenue, cost, and investments.