Stakeholders interests

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MC Question 29

The following information relates to an investment project which is being evaluated by the directors of Fence Co, a listed company. The initial investment, payable at the start of the first year of operation, is $3·9 million.

Year 1 2 3 4
Net operating cash flow ($000) 1,200 1,500 1,600 1,580
Scrap value ($000) 100

The directors believe that this investment project will increase shareholder wealth if it achieves a return on capital employed greater than 15%. As a matter of policy, the directors require all investment projects to be evaluated using both the payback and return on capital employed methods. Shareholders have recently criticised the directors for using these investment appraisal methods, claiming that Fence Co ought to be using the academically-preferred net present value method.

The directors have a remuneration package which includes a financial reward for achieving an annual return on capital employed greater than 15%. The remuneration package does not include a share option scheme.

Which of the following statements about Fence Co is/are correct?

(1) Managerial reward schemes of listed companies should encourage the achievement of stakeholder objectives
(2) Requiring investment projects to be evaluated with return on capital employed is an example of dysfunctional behaviour encouraged by performance-related pay
(3) Fence Co has an agency problem as the directors are not acting to maximise the wealth of shareholders

A. 1 and 2 only
B. 1 only
C. 2 and 3 only
D. 1, 2 and 3

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Question 31c

PV Co, a large stock-exchange-listed company, is evaluating an investment proposal to manufacture Product W33, which has performed well in test marketing trials conducted recently by the company’s research and development division. Product W33 will be manufactured using a fully-automated process which would significantly increase noise levels from PV Co’s factory. The following information relating to this investment proposal has now been prepared:

Initial investment $2 million
Selling price (current price terms) $20 per unit
Expected selling price inflation 3% per year
Variable operating costs (current price terms) $8 per unit
Fixed operating costs (current price terms) $170,000 per year
Expected operating cost inflation 4% per year
The research and development division has prepared the following demand forecast as a result of its test marketing trials. The forecast reflects expected technological change and its effect on the anticipated life-cycle of Product W33.
Year 1 2 3 4
Demand (units) 60,000 70,000 120,000 45,000

It is expected that all units of Product W33 produced will be sold, in line with the company’s policy of keeping no inventory of finished goods. No terminal value or machinery scrap value is expected at the end of four years, when production of Product W33 is planned to end. For investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year and a target return on capital employed of 30% per year. Ignore taxation.

Required:
(c) Discuss how the objectives of PV Co’s stakeholders may be in conflict if the project is undertaken. (5 marks)

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MC Question 8

Which of the following statements are correct?

(1) Share option schemes always reward good performance by managers

(2) Performance-related pay can encourage dysfunctional behaviour

(3) Value for money as an objective in not-for-profit organisations requires the pursuit of economy, efficiency and effectiveness

A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

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MC Question 8

Which of the following actions is LEAST likely to increase shareholder wealth?

A. The average cost of capital is decreased by a recent financing decision
B. The financial rewards of directors are linked to increasing earnings per share
C. The board of directors decides to invest in a project with a positive net present value
D. The annual report declares full compliance with the corporate governance code

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Question 1c

Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of an investment project with an expected life of four years, as follows:

Year  1 2 3 4
Sales Revenue ($000) 1250 2570 6890 4530
Costs ($000) 500 1000 2500 1750

These forecast cash flows are before taking account of general inflation of 4•7% per year. The capital cost of the investment project, payable at the start of the first year, will be $2,000,000. The investment project will have zero scrap value at the end of the fourth year. The level of working capital investment at the start of each year is expected to be 10% of the sales revenue in that year.

Capital allowances would be available on the capital cost of the investment project on a 25% reducing balance basis. Darn Co pays tax on profits at an annual rate of 30% per year, with tax being paid one year in arrears. Darn Co has a nominal (money terms) after-tax cost of capital of 12% per year.

Required:

Explain ways in which the directors of Darn Co can be encouraged to achieve the objective of maximisation of shareholder wealth. (6 marks)

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Question 3a

Zigto Co is a medium-sized company whose ordinary shares are all owned by the members of one family. It has recently begun exporting to a European country and expects to receive €500,000 in six months’ time. The prospect of increased exports to the European country means that Zigto Co needs to expand its existing business operations in order to be able to meet future orders.

All of the family members are in favour of the planned expansion, but none are in a position to provide additional finance. The company is therefore seeking to raise external finance of approximately $1 million. At the same time, the company plans to take action to hedge the exchange rate risk arising from its European exports.

Zigto Co could put cash on deposit in the European country at an annual interest rate of 3% per year, and borrow at 5% per year. The company could put cash on deposit in its home country at an annual interest rate of 4% per year, and borrow at 6% per year. Inflation in the European country is 3% per year, while inflation in the home country of Zigto Co is 4·5% per year.

The following exchange rates are currently available to Zigto Co:

Current spot exchange rate 2·000 euro per $
Six-month forward exchange rate 1·990 euro per $
One-year forward exchange rate 1·981 euro per $

Required:

Discuss the reasons why small and medium-sized entities (SMEs) might experience less conflict between the objectives of shareholders and directors than large listed companies.

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