Question

1. Corporate Cash Flows Question:

a) Describe the cash determination principle, and discuss the application of two popular parameters (expected level and variance) of cash flows. [8 Marks]

b) Describe the Discounted Cash Flows (DCF) model and the associated Consistency Principle.

2. Corporate Governance Question:

a) Describe the general function played by the board of directors in a corporation and its relationships to the general shareholders and management (including their common interests and interest conflicts). [5 Marks]

b) Describe the theory of agency problem and its application in discussing the major corporate governance issues (on the methods or tools of controlling or reducing the negative effects of the agency problem). [5 Marks]

c) Discuss how a CEO’s compensation package may influence a firm’s value

Answer 1

A. Cash flow determination is the most important step in investment analysis. The principles for cash determination are:

1. Net Present value Rule

2. Inflow and outflow of cash.

3. Revenue and capital expenditures.

4. Depreciation.

An investment have the following components of cash flows:

1. Initial investment - It is the total outlay or the original value of an asset. It is equal to gross investment plus increase in net working capital.

2. Net cash flows-Generating annual cash flows from operations after the initial cash outlay has been made.

3. Terminal cash flows- It includes the salvage value which is the market price of an investment at the time of its sale.

Now we will discuss about the two popular parameters of cash flows I.e. expected levels and variance. These two parameters are basically depends upon the risk and return of an asset.

Expected levels describe the expected return and variance is the volatility of rates which are caused by the fluctuations in returns. Thus returns is defined as the dividend yield plus capital gain rate and the expected rate of return on an asset is the sum of the products of possible rates of return and their possibilities. This is the average rate of retun which may deviate from the possible outcomes which can be measured by variance.

B. Discounted cash flows model- it is a type of financial model used for the business valuation, project or investment valuation, bond valuation, equity valuation, or valuation of the thing that produces cash flow. It enables the discounting of the expected returns back to the present value with the help of weighted average cost of capital.the very first stes in DCF model is to calculate the weighted average cost of capital which is the weighted average of the cost of debt and cost of equity. This model analyses whether the company's stock is overvalued or undervalued. If the stock trades below its fair value that it tends to be undervalued and if it trades above its fair value then it tends to be overvalued.

Components of DCF Model:

1. Cash flow- Unlevered free cash flow

2. Terminal value

3. Discount rate- It is the weighted average cost of capital that represents the required rate of return.

4. Time period

2. A. Board of directors are responsible for taking all the important decisions of the business. General functions played by the board of directors in the corporation:

a. Approving investments, deals and transactions.

b. Assesing, drafting and monitoring financial statements.

c. Formulating financial and strategic policies in the areas of corporate governance, corporate social responsibility, risk, investments and renumeration,

d. Approving goals and strategic guidelines.

e. Managing and supervising overall business activities.

f. Protecting the general intrest of the business.

g. Creating shareholders benefit value.

h. Approving budget and plans.

I. Appointment and removal of executive officers.

j. Defining the company's structure.

Shareholders are the owner of the company whereas boards of director supervises, regulate and manage the overall business activities. Board oversee the decisions taken by the shareholders of the company, so that there will be no conflicts of interesti between them.

B. The conflict between the intrests of shareholders and managers is referred to as agency problems which results into agency costs. Agency costs are the costs incurred by the shareholders to monitor the actions of managers and control their behavior. When managers own the company, the agency problems got vanished. The following ways through which an agency problems can be taken off.

1. When managers own the company.

2. If shareholders give ownership rights to managers.

3. If shareholders offer incentives to managers to act in their intrests.

4. Monitoring by other stakeholders, board of directors may also reduce the agency problems.