Question

Question 1

As companies grow in size, it is inevitable for the shareholders to hire management to run the operations of the business. The entire team of management, starting from the CEO and other top-level management, all the way to the middle and bottom level management are expected to perform towards the growth of the business. Since the shareholders of large companies are scattered across geographies, they appoint certain members as representatives who are elected to represent them on the company board. The board of directors of a company, along with the Chairman, are expected to keep the actions of the management in check.

Explain the above in context of agency theory and corporate governance. What can companies do to ensure adequate corporate governance?

Question 2

Mr. Morris had $100,000 in his account. Using this fund, he made a portfolio of two NYSE listed stocks – Johnson and Johnson (J&J) and IBM on 01 Jan 2019 in the ratio of 60:40, i.e. 60% funds in J&J & 40% funds in IBM. The daily stock data of both stocks can be found on market websites such as finance.yahoo.com. Download daily data for 1 year from 1 Jan 2019 – 1 st Jan 2020. Using the stock data of the two stocks, you are required to explain the below concepts and then compute for the given stocks:

a. Annual return of both J&J and IBM.

b. Annualized standard deviation of returns of both J&J and IBM

c. Correlation coefficient of returns of J&J and IBM. What does this correlation coefficient signify about the correlation of the two stocks and corresponding decision from an investor?

d. Portfolio return of the portfolio of two stocks.

e. Portfolio risk (standard deviation) of the portfolio of two stocks.

f. Critically analyze your investment decision in these two companies . Given an option, would you like to invest in any other company? Or would you like to have a different ratio of investment in the two?

Question 3

Your firm’s geologists have discovered a small oil field in New York’s Westchester County. The field is forecasted to produce a cash flow of C1 $2 million in the first year. You estimate that you could earn an expected return of r 12% from investing in stocks with a similar degree of risk to your oil field. Therefore, 12% is the opportunity cost of capital. What is the present value? The answer, of course, depends on what happens to the cash flows after the first year. Calculate present value for the following cases:

a. The cash flows are forecasted to continue for 20 years only, with no expected growth or decline during that period

b. The cash flows are forecasted to continue for 20 years only, increasing by 3% per year because of inflation

c. Evaluate the cashflows in a and b and explain which one you will choose and why

Answer 1

AGENCY THEORY: Agency theory focuses on the relationship between the agents and principals in the business. It basically solves the issues and/or cater to the interests arising between agents nd principaqls. Agents acts and takes decisions on behalf of the principals.The issues being talked about are basically due to their different risk perspectives and business goals. In finance, the agency relationship exists between shareholders and executives of a corporation where the top executives are elected to act in the interest of the true owners of the company ofetn called as shareholders..

AGENCY THEORY IN CORPORATE GOVERNANCE: Agency theory in corporate governance relates to a particular type of agency relationship that exists between the shareholders and directors/management of a company. The shareholders as principals, elect the executives to act and take decisions on their behalf with an aim to represent the views of the shareholders and conduct operating activities in their interest. Despite this clear rationale of electing the board of directors, there are a lot of instances when complicated issues come up and the executives, knowingly or unknowingly, take decisions that do not reflect shareholders’ best interest. In the dynamic business environment, agency theory of corporate governance has garnered a lot of attention and is seen and evaluated from different points of view.

Agency theory in corporate finance is gaining momentum for all the right reasons. With markets getting volatile as ever, it becomes imperative that both, the interests of the shareholders and the company are taken care of. The shareholders should trust the management of the company and go an extra mile to understand their day-to-day business decisions. Similarly, the management should also keep the interests of the true owners of the company in their mind. A clear communication should be sent out explaining the rationale behind major business decisions to help shareholders understand and appreciate changes if any. A robust corporate policy can help to keep differences at bay.

Steps taken by companies to ensure adequate Corporate Governance can be as follows:

• Understand good governance as a value and not limited to compliance
• Appoint competent Board Members
• Monitor Organisational performance regularly
• The CEO is the responsibility of the Board
• Prioritise Risk Management
• Important information should reach the Board regularly and at correct time
• Evaluate Board Performance consistently
• A competent Chairperson of the Board
• Routine evaluation