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CORPORATE FINANCE (UKFF 3013)
JUNE 2022 TRIMESTER
TUTORIAL 2 (WEEK STARTING 20 JUN 2022)
THE FINANCE FUNCTION (CHAPTER 1)
QUESTION 1
R Berhad is a long-established petrochemical manufacturer, producing rare chemical products
in the east coast. The company’s products are marketed in USA, Europe and the Pacific
regions.
One of the company’s code of ethics is environmental responsibility. Last year, the company
was fined for an untreated discharge into a local river.
Over the years, the company’s share price has performed well. Now, there is concern that
price and cost competition from new entrants into the domestic market will have a significant
impact on the firm’s profitability and the dividends. R Berhad borrowed heavily to finance its
working capital requirements for local and overseas businesses. The management is
evaluating different foreign currency hedging methods to minimise its currency risk on the
payments to its overseas suppliers. The hedging methods that are available to R Berhad are
leading, lagging, forward and money markets.
The company is now considering expanding into other businesses through mergers or
acquisition. The finance director has proposed that the company acquire 100% of the equity of
D Berhad, an oil refinery company. The acquisition will be financed via a bond issue that will
not significantly impact upon the company’s existing credit rating and its capital structure. The
cost of capital is 7%.
Required:
A. Untreated discharge into a local river causes damage to environment. Environmental risk is
material to shareholder value. Discuss.
B. Agency conflicts may arise because of the differences in the interests of the owners and
managers. Explain the reasons for agency conflicts.
SUGGESTED ANSWER
(a)
R Berhad was fined for an untreated discharge into a local river. This is considered as
environmental accident and the risk for the environmental damage is clearly material to
shareholder value and is likely to remain so while the company continues to manufacture
petrochemical products.
The shareholders will evaluate the extent and nature of the risk and assess whether the risk
profile of the business matches their own attitudes to or appetite for the environmental risk. In a
portfolio of shares, some investors will want to blend the environmental risks and returns, and
knowing about a company’s environmental risks is important in making these judgements.
The environmental risk information will allow the shareholders to judge how the risk might
affect the company’s value and hence the potential volatility and attractiveness of the share.
The penalty imposed on the company is capable of affecting returns, costs or both. When the
shareholders are aware of the environmental pollution and if the environmental risk is material,
the shareholders would have discounted the share price accordingly. The shareholders will
also evaluate the new risk controls put in place by the management because these measures
could be vital in restoring investor confidence. In particular, they should reassure shareholders
that the accident should not re-occur, or that if it were to re-occur, further controls would be in
place to offset the worst of the damage.
CORPORATE FINANCE (UKFF 3013)
JUNE 2022 TRIMESTER
TUTORIAL 2 (WEEK STARTING 20 JUN 2022)
THE FINANCE FUNCTION (CHAPTER 1)
(b)
A manager has an interest in receiving benefit from his or her position as a manager. These
include all the benefits that come from status, such as a company car, use of a company
airplane, lunches, attendance at sponsored sporting events, and so on. Managers may work
less hard than they would if they were the owners of the company. The effect of ‘lack of effort’
could be lower profit and lower share price.
The interest of middle managers and the interest of senior managers might well be different,
especially if senior management are given pay incentives to achieve higher profits, but the
middle managers are not.
The remuneration of directors and senior managers is often related to the size of the company,
rather than its profits. This gives managers an incentive to grow the company, and increase its
sales turnover and assets, rather than to increase the returns to the company’s shareholders.
Management are more likely to went to re-invent profits in order to make the company bigger,
rather than pay-out the profits as dividends.
Shareholders are concerned about the long-term financial prospects of the company, because
the value of their shares depends on expectations for the long –term future, in contrast,
managers might only be interested in the short-term. These is partly because they might
receive annual bonuses based on short-term performance, and partly because they might not
expect to be with the company for more than a few years. Managers might therefore have an
incentive to increase accounting return on capital employed (or return on investment), whereas
shareholders have a greater interest in long term share value.
QUESTION 2
What are some of the problems involved in the use of profit maximization as the goal of
the firm? How does the goal of maximization of shareholder wealth deal with those
problems?
SUGGESTED ANSWER
The goal of profit maximization is too simplistic in that it assumes away the problems of
uncertainty of returns and the timing of returns.
Rather than use this goal, we have chosen maximization of shareholders' wealth—that
is, maximization of the market value of the firm's common stock—because the effects of
all financial decisions are included. The shareholders react to poor investment or
dividend decisions by causing the total value of the firm's stock to fall and react to good
decisions by pushing the price of the stock upward. In this way all financial decisions
are evaluated, and all financial decisions affect shareholder wealth.
QUESTION 3
Explain ways in which the directors of a public listed company can be encouraged to
achieve the objective of maximisation of shareholder wealth.
SUGGESTED ANSWER
The directors can be encouraged to achieve the objective of maximising shareholder
wealth through managerial reward schemes and through regulatory requirements.
Managerial reward schemes
CORPORATE FINANCE (UKFF 3013)
JUNE 2022 TRIMESTER
TUTORIAL 2 (WEEK STARTING 20 JUN 2022)
THE FINANCE FUNCTION (CHAPTER 1)
As agents of the company’s shareholders, the directors may not always act in ways
which increase the wealth of shareholders, a phenomenon called the agency problem.
They can be encouraged to increase or maximise shareholder wealth by managerial
reward schemes such as performance-related pay and share option schemes.
Through these methods, the goals of shareholders and directors may increase in
congruence. Performance-related pay links part of the remuneration of directors to some
aspect of corporate performance, such as levels of profit or earnings per share. One
problem here is that it is difficult to choose an aspect of corporate performance which is
not influenced by the actions of the directors, leading to the possibility of managers
influencing corporate affairs for their own benefit rather than the benefit of shareholders,
for example, focusing on short-term performance while neglecting the longer term.
Share option schemes bring the goals of shareholders and directors closer together to
the extent that directors become shareholders themselves. Share options allow directors
to purchase shares at a specified price on a specified future date, encouraging them to
make decisions which exert an upward pressure on share prices. Unfortunately, a
general increase in share prices can lead to directors being rewarded for poor
performance, while a general decrease in share prices can lead to managers not being
rewarded for good performance. However, share option schemes can lead to a culture of
performance improvement and so can bring continuing benefit to stakeholders.
