Question

The executives of a corporation are supposed to be managing a company on behalf of shareholders yet they may choose to increase the size of the business in order to justify higher salaries for themselves in what we often call empire building.

1. If the empire building also increases value for the shareholders can this still be called an agency cost?

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Accounting policies are usually made to ensure accounting principles are met and people reading the financial statements are better informed. There was a new rule that required that when stock options were given to employees they be expensed based on their current market value. Prior to the rule, stock options were awarded without any cost on the financial statements only with disclosure because the price was so low and there was uncertainty about whether they would ever be exercised.

2. Do you think that expensing the cost of the stock options is better than disclosure given that approximately half the time those stock options expire worthless? (2

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In the recent bankruptcy and reorganisation of Virgin Australia Airlines all prior shareholders received nothing. There is one argument that the pandemic is the reason for the collapse but another side is that the airline expanded to new markets and tried to become a full-service airline instead of the original low-cost airline that it started out as. From a finance perspective, other airlines with less debt have not gone bankrupt.

3. Most airlines have a high level of debt, do you think that this should preclude the current executive team from continuing on at Virgin Australia with the new owners? Why or why not?

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Your much older brother has finally started working full time and he approaches you about deciding how to invest his money and choose a superannuation plan. He told you he plans to copy your plan.

4. Explain why this is not a good idea.

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The recent stock market rally during COVID has been concentrated on technology stocks. One suggestion is that with all the working from home and closed casinos, people are shifting their gambling to the stock market. A counter argument is that technology stocks represent the future.

5. Do you think the stock market rally is temporary or will be sustained? Support your answer.

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Answer 1

Question 1) Yes that is still considered an agency problem as their is a conflict of interest b/w the management and the shareholders. Right now the value of the shareholders is also increasing so no one has an issue, but if it led to a decline in share value, there would be a huge issue with the share holders

Question 2) No it is not a wise approach, because in some cases these stock options can amass to great value in the millions, and that can casue the statements to skew (if they were to be expensed) and hence not a very wise option

Question 3) This should not cause a problem, as most airlines have higher levels of debt. As far as the management at Virgin is concerned, they had thrown good money behind a lot of bad projects, and that is one the reasons for the above average extra debt. Hence the new owners should bring in a new management which will have better capital allocation policies

Question 4) It is not a good idea because each person has different financial goals, you being younger have a much more aggresive growth plan whereas your brother should have different priorities given his older age

Question 5) The tech sector has heated up a lot post Covid, where stocks have gone up 4-5X. usually when such high multiple re- ratings occur, they must be backed by earnings. So as companies announce their results, and if their earnings are backing the narrative of high tech growth, then we can see further gains, but if the earnings of the companies are under stress, then i think the rally will end