Question

1. You work as a Corporate Risk Analyst at JP Morgan. You clients Peter and Angela are planning to start a new company and have come to you for advice. Angela is worried that company’s managers may serve their own personal interests rather than maximizing the revenues of the company. Explain to Angela what this problem is called and prescribe one way of dealing with this problem.

2. Angela is unsure about the appropriate mix of debt and equity for the new firm. Explain to her the main criterion that corporations use to determine the appropriate debt-to-equity ratio.

3. Peter purchased bonds issued by Lipo Limited with a face value of 200,000 and a yield of 1.4 per cent per annum at the time of issue. The bonds pay a fixed coupon rate of 2.5 per cent per annum payable on a half-yearly basis. The bonds were issued with a term to maturity of seven years. Exactly one year has elapsed. Peter is concerned that Lipo is not progressing well and wants to sell his investment in the company. The bond is currently trading a yield of 1.8 per cent per annum. What is the current price of the bond? Show detailed calculations.

Answer 1

1) The problem of managers working serving their own personal interests rather than maximising the revenue of the comapny can be termed as self interest of the managers. These managers owe a duty of care and responsibility towards the shareholders as they are the ones investing funds into the firm expecting returns on behalf of it. They have ensured their trust in the management believing that the managers will work on their best interests.

There are many ways to deal with this problem, One of them is to maybe issue some shares to those in managerial positions as well. This would give the managers a sense of understanding as to increase revenues and hence profit so that they will also get an equal share of it on distribution. So when it is in their interest also , they are bound to be focussed on maximising the revenue of the firm.

2) In general a good debt to equity ratio is seen somehwere between 1 and 1.5.

But this is bound vary from industry to industry. As some industries are more focussed on debt financing whereas some others are a little less. So there could be a difference in average debt to equity ratio when you look at different industries.

Capital intensive industries have at times debt to equity ratio greater than 2.

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