Corporate Finance: Essay Quiz Risk Premium, NPV and Agency Relationship

Explain why the risk premium of a stock does not depend on its diversifiable risk.

Evaluate the following projects using the Net Present Value criteria. Assume a cost of capital of 10%.

Project A: Initial Cash Outflow: -RM250,000

                Year 1 Cash Flow: RM25,000

                Year 2 Cash Flow: RM125,000

                Year 3 Cash Flow: RM175,000

Project B: Initial Cash Outflow: -RM250,000

                Year 1 Cash Flow: RM150,000

                Year 2 Cash Flow: RM100,000

                Year 3 Cash Flow: RM75,000

(i) What are the NPVs for the projects and what do these numbers inform you?

Answer: 

The risk premium of a stock is primarily influenced by its systematic risk, which is the risk associated with market movements that cannot be diversified away. Diversifiable risk, on the other hand, pertains to risks that can be mitigated through diversification—such as risks specific to a particular company or industry.

Explanation of Risk Premium and Diversifiable Risk

1. Systematic vs. Diversifiable Risk:
   • Systematic Risk: This is the inherent risk that affects the entire market or a large segment of the market. It includes factors such as economic changes, political instability, and natural disasters. Investors require compensation for this risk in the form of a risk premium.
   • Diversifiable Risk: Also known as unsystematic risk, this type of risk is specific to a single asset or small group of assets. It can be reduced or eliminated through diversification in a portfolio.
2. Capital Asset Pricing Model (CAPM):
   • According to CAPM, the expected return on an asset is determined by its systematic risk (beta). The formula is:
     $$E(R_i)=R_f+{\beta }_i(E(R_m)-R_f)$$
     where $E(R_i)$ is the expected return on the asset, $R_f$ is the risk-free rate, ${\beta }_i$ is the asset's beta (measure of systematic risk), and $E(R_m)$ is the expected return of the market.
   • This model illustrates that only systematic risk affects the required return or risk premium, as diversifiable risks can be mitigated by holding a diversified portfolio.
3. Implication for Investors:
   • Investors are not compensated for diversifiable risks because they can eliminate them through diversification. Therefore, the risk premium reflects only the compensation for bearing systematic risk.

Net Present Value (NPV) Calculation for Projects A and B

To evaluate Projects A and B using NPV criteria with a cost of capital of 10%, we will calculate each project's NPV based on their cash flows.

NPV Formula

The NPV can be calculated using the formula:

$$NPV=\sum _{t=1}^n\frac{C{F}_t}{(1+r{)}^t}-C_0$$

where:

• $C{F}_t$ = Cash flow at time $t$
• $r$ = Discount rate (cost of capital)
• $C_0$ = Initial investment
• $n$ = Total number of periods

Project A Cash Flows

• Initial Cash Outflow: RM250,000
• Year 1 Cash Flow: RM25,000
• Year 2 Cash Flow: RM125,000
• Year 3 Cash Flow: RM175,000

Calculating NPV for Project A:

$$NP{V}_A=\frac{25,000}{(1+0.10{)}^1}+\frac{125,000}{(1+0.10{)}^2}+\frac{175,000}{(1+0.10{)}^3}-250,000$$

Calculating each term:

• Year 1: $\frac{25,000}{1.10}=22,727.27$
• Year 2: $\frac{125,000}{(1.10{)}^2}=102,564.10$
• Year 3: $\frac{175,000}{(1.10{)}^3}=131,687.54$

Summing these values:

$$NP{V}_A=22,727.27+102,564.10+131,687.54-250,000=6,978.91$$

Project B Cash Flows

• Initial Cash Outflow: RM250,000
• Year 1 Cash Flow: RM150,000
• Year 2 Cash Flow: RM100,000
• Year 3 Cash Flow: RM75,000

Calculating NPV for Project B:

$$NP{V}_B=\frac{150,000}{(1+0.10{)}^1}+\frac{100,000}{(1+0.10{)}^2}+\frac{75,000}{(1+0.10{)}^3}-250,000$$

Calculating each term:

• Year 1: $\frac{150,000}{1.10}=136,363.64$
• Year 2: $\frac{100,000}{(1.10{)}^2}=82,644.63$
• Year 3: $\frac{75,000}{(1.10{)}^3}=56,834.21$

Summing these values:

$$NP{V}_B=136,363.64+82,644.63+56,834.21-250,000=-26,157.52$$

Summary of Results

Project	NPV (RM)	Decision
A	6,978.91	Accept
B	-26,157.52	Reject

(ii) If the projects are independent, which would you accept according to the NPV criterion?

Answer:

Acceptance of Independent Projects Based on NPV Criterion

When evaluating independent projects using the Net Present Value (NPV) criterion, each project is assessed individually. If a project has a positive NPV, it indicates that the project is expected to generate more cash than the cost of the investment, thus adding value to the firm. Conversely, a project with a negative NPV is expected to result in a net loss and should be rejected.

Summary of NPVs from Previous Calculation

• Project A: NPV = RM 6,978.91 (Positive)
• Project B: NPV = RM -26,157.52 (Negative)

Decision Based on NPV Criterion

Since the projects are independent:

• Accept Project A: Because it has a positive NPV of RM 6,978.91, which indicates it will add value to the firm.
• Reject Project B: Because it has a negative NPV of RM -26,157.52, indicating it will detract from the firm's value.

According to the NPV criterion:

• Accept Project A
• Reject Project B

This decision-making approach allows for maximizing shareholder wealth by selecting projects that are expected to generate positive returns.

(iii) If the projects are mutually exclusive, which would you accept according to the NPV criterion?

Answer:

Acceptance of Mutually Exclusive Projects Based on NPV Criterion

When projects are mutually exclusive, it means that the acceptance of one project precludes the acceptance of the other. In this case, the decision should be based on which project has the higher NPV, as this will maximize the value added to the firm.

Summary of NPVs from Previous Calculations

• Project A: NPV = RM 6,978.91 (Positive)
• Project B: NPV = RM -26,157.52 (Negative)

Decision Based on NPV Criterion

Since the projects are mutually exclusive:

• Choose Project A: It has a positive NPV of RM 6,978.91, indicating it is expected to add value to the firm.
• Reject Project B: It has a negative NPV of RM -26,157.52, indicating it would reduce the firm's value.

According to the NPV criterion for mutually exclusive projects:

• Accept Project A
• Reject Project B

By selecting Project A, the firm maximizes its potential return and enhances shareholder wealth.

(iv) Both projects have in total RM325,000 of cash inflows and the same initial cash outflow. Explain why both projects do not have the same NPV.

Answer:

The Net Present Value (NPV) of a project is influenced by the timing and magnitude of cash flows, not just their total amount. While both projects may have the same total cash inflows of RM 325,000 and the same initial cash outflow, their NPVs can differ due to several key factors:

Key Factors Affecting NPV

1. Timing of Cash Flows:
   • The present value of cash inflows is affected by when those inflows occur. Cash flows received earlier are worth more than those received later due to the time value of money. For example, receiving RM 100 today is more valuable than receiving RM 100 in three years.
   • If Project A generates cash flows earlier than Project B, it will have a higher NPV because those early cash flows are discounted less.
2. Cash Flow Pattern:
   • The distribution of cash flows over time can vary significantly between projects. For instance, if one project has larger cash inflows in the early years and smaller inflows later, while another project has smaller early inflows but larger later inflows, their NPVs will differ even if the total cash inflow amounts are the same.
   • This means that even with identical total inflows, the sequence and size of those inflows can lead to different NPVs.
3. Discount Rate:
   • The NPV calculation uses a specific discount rate to account for the opportunity cost of capital. If the cash flows from one project are more sensitive to changes in the discount rate (for example, if they occur further in the future), this could also lead to differences in NPV.
   • A higher discount rate will reduce the present value of future cash flows more significantly.

Even though both projects have identical total cash inflows and initial outflows, their NPVs can differ due to variations in the timing and pattern of cash flows. The project with earlier or larger cash inflows will typically yield a higher NPV, reflecting its greater value when discounted back to present terms. This illustrates why simply comparing total cash inflows is insufficient for investment decision-making; the timing and distribution of those inflows are crucial for accurate NPV calculations.

(v) If the cost of capital increased to 15%, what impact would this have on your decision?

Answer:

If the cost of capital increases to 15%, this change would significantly impact the Net Present Value (NPV) calculations for both Project A and Project B.

Impact of Increased Cost of Capital on NPV

1. Reduction in Present Value of Cash Flows:
   • A higher discount rate reduces the present value of future cash inflows. This means that the cash flows from both projects will be discounted more heavily, leading to lower NPVs compared to when the cost of capital was 10%
     1
     4
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2. Recalculation of NPVs:
   • The NPVs for both projects would need to be recalculated using the new discount rate of 15%. Given that both projects already had differing NPVs at a 10% cost of capital, the increased rate would likely exacerbate this difference, potentially affecting the acceptability of each project.

Recalculation Example

Using the NPV formula:

$$NPV=\sum _{t=1}^n\frac{C{F}_t}{(1+r{)}^t}-C_0$$

where $r$ is now 15%.

Project A Cash Flows

• Year 1: RM25,000
• Year 2: RM125,000
• Year 3: RM175,000

Calculating NPV for Project A at 15%:

$$NP{V}_A=\frac{25,000}{(1+0.15{)}^1}+\frac{125,000}{(1+0.15{)}^2}+\frac{175,000}{(1+0.15{)}^3}-250,000$$

Calculating each term:

• Year 1: $\frac{25,000}{1.15}=21,739.13$
• Year 2: $\frac{125,000}{(1.15{)}^2}=94,736.84$
• Year 3: $\frac{175,000}{(1.15{)}^3}=102,056.63$

Summing these values:

$$NP{V}_A=21,739.13+94,736.84+102,056.63-250,000=-31,466.40$$

Project B Cash Flows

• Year 1: RM150,000
• Year 2: RM100,000
• Year 3: RM75,000

Calculating NPV for Project B at 15%:

$$NP{V}_B=\frac{150,000}{(1+0.15{)}^1}+\frac{100,000}{(1+0.15{)}^2}+\frac{75,000}{(1+0.15{)}^3}-250,000$$

Calculating each term:

• Year 1: $\frac{150,000}{1.15}=130,434.78$
• Year 2: $\frac{100,000}{(1.15{)}^2}=75,949.02$
• Year 3: $\frac{75,000}{(1.15{)}^3}=43,972.52$

Summing these values:

$$NP{V}_B=130,434.78+75,949.02+43,972.52-250,000=-4,643.68$$

Summary of Results at a Cost of Capital of 15%

Project	NPV (RM)	Decision
A	-31,466.40	Reject
B	-4,643.68	Reject

With an increased cost of capital to 15%, both projects yield negative NPVs:

• Reject both projects: Since both have negative NPVs at this higher discount rate.

This illustrates how sensitive project viability is to changes in the cost of capital; as the required return increases, even previously acceptable projects may become unviable due to diminished cash flow values in present terms.

Describe the process whereby the owners control the firm's management. What is the main reason that an agency relationship exists in the corporate form of organization? what kind of problems can arise?

Answer:

The process by which owners control a firm's management, the existence of agency relationships in corporate organizations, and the potential problems arising from these relationships are fundamental concepts in corporate governance and finance.

Process of Owner Control Over Management

1. Shareholder Voting:
   • Shareholders, as owners of the firm, have the right to vote on key corporate matters during annual general meetings (AGMs). This includes electing the Board of Directors, who are responsible for overseeing management and making strategic decisions on behalf of the shareholders.
2. Board of Directors:
   • The Board acts as an intermediary between shareholders and management. They are tasked with ensuring that management operates in the best interests of the shareholders. The Board sets policies, approves budgets, and monitors performance.
3. Management Accountability:
   • Management is held accountable to the Board and, by extension, to the shareholders. This accountability is enforced through regular reporting, performance evaluations, and compliance with regulatory requirements.
4. Incentives and Compensation:
   • To align the interests of management with those of shareholders, companies often implement incentive structures such as performance-based bonuses or stock options. This encourages managers to focus on increasing shareholder value.
5. Corporate Governance Mechanisms:
   • Effective corporate governance practices are established to ensure transparency and accountability. This includes internal controls, audits, and adherence to ethical standards.

Main Reason for Agency Relationships

The primary reason an agency relationship exists in the corporate form of organization is the separation of ownership and control. In many corporations, especially large ones, shareholders (the principals) do not manage the company directly; instead, they hire managers (the agents) to run the day-to-day operations. This separation leads to an agency relationship where managers are expected to act in the best interests of shareholders while managing their own interests.

Problems Arising from Agency Relationships

1. Agency Problem:
   • The core issue is that managers may prioritize their own interests over those of shareholders. This misalignment can lead to decisions that benefit management at the expense of shareholder value.
2. Moral Hazard:
   • Managers may take excessive risks or engage in activities that are not aligned with shareholder interests because they do not bear the full consequences of those risks (e.g., job security versus financial loss).
3. Information Asymmetry:
   • Managers typically have more information about the company's operations than shareholders do. This imbalance can lead to situations where managers make decisions that are not transparent or in line with shareholder expectations.
4. Cost of Monitoring:
   • Shareholders incur costs to monitor management's actions (e.g., audits, performance reviews). These costs can reduce overall profitability and shareholder returns.
5. Short-term Focus:
   • Managers may focus on short-term results to meet performance targets or secure bonuses rather than pursuing long-term strategies that would benefit shareholders over time.

The control mechanism established by owners through voting rights, board oversight, and incentive structures aims to mitigate agency problems arising from the separation of ownership and control in corporations. However, challenges such as misaligned interests, moral hazard, information asymmetry, monitoring costs, and a short-term focus can complicate this relationship and impact overall corporate performance. Effective corporate governance practices are essential for aligning management actions with shareholder interests and minimizing agency-related issues.

source: Corporate Finance First Semester Examination Academic Session 2011/1012 , Master Business Administration, Universiti Sains Malaysia