CORPORATE FINANCE (UKFF 3013)

JAN 2022 TRIMESTER

TUTORIAL 2 (WEEK STARTING 31 JAN 2022)
THE FINANCE FUNCTION (CHAPTER 1)

QUESTION 1
The declared objective of K Berhad is the maximisation of the wealth of its
shareholders. Recent financial and other information on K Berhad is as follows.

Income statement information

2016 2017 2018 2019 2020
RM’million RM’million RM’million RM’million RM’million
Turnover 127.0 142.2 159.3 178.4 200.00
Operating profit 25.4 26.2 27.0 27.8 28.6
Interest 2.4 2.4 2.0 1.8 1.8
Profit before 23.0 23.8 25.0 26.0 26.9
tax
Taxation 6.9 7.1 7.5 7.8 8.0
Earnings 16.1 16.7 17.5 18.2 18.8
Dividends 6.4 6.5 6.6 8.8 8.9
Retained 9.7 10.2 10.9 9.4 9.9
Earnings
Balance Sheet information
Non-current 109.6 115.8 125.5 145.5 150.6
assets
Current assets 35.0 40.6 41.8 48.0 50.0
Current 25.0 26.6 36.6 37.4 39.6
liabilities
Equity funds 79.6 89.8 100.7 146.1 156.0
Long-term debt 40.0 40.0 30.0 10.0 5.0
Other information
Shares 1.0 15.0 15.0 20.0 20.0
(millions)
Directors’ pay RM2.0m RM2.4m RM3.1m RM4.4m RM6.5m
Price/earnings ratio:
Company 10.0 10.0 10.0 9.9 9.5
Industry 10.5 10.7 10.9 10.9 11.5

The increased number of shares in 2016 was due to a 1 for 3 rights issue. None of the
directors of K Berhad own shares in the company.

Required:
Write a report which discusses the following issues with respect to K Berhad:
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(1) Whether shareholder wealth is being maximised

(2) Whether the company is suffering from agency problems

Support your discussion with financial analysis of the information provided.

SUGGESTED ANSWER
Financial analysis
2016 2017 2018 2019 2020
ROCE 21.2% 20.2% 20.7% 17.8% 17.8%
Net profit margin 20.0% 18.4% 17.0% 15.6% 14.4%
Return on equity 20.2% 18.6% 17.4% 12.5% 11.9%
EPS 107sen 111sen 117sen 91sen 94sen
EPS growth 3.7% 5.4% -22.2% 3.2%
Share price RM10.73 RM11.13 RM11.67 RM9.01 RM8.93
Share price growth 3.7% 4.9% -22.8% -1.0%
DPS 42.7sen 43.3sen 44.0sen 44.0sen 44.5sen
DPS growth 1.4% 1.6% nil 1.1%
Payout ratio 40% 39% 38% 48% 47%
TSR 7.8% 8.8% -19% 4%
Interest cover 11 11 14 15 16
Debt/equity (BV) 50% 44% 30% 7% 3%

Turnover growth 12% 12% 12% 12%

PBIT growth 3% 3% 3% 3%
Earnings growth 4% 5% 4% 3%
NCA growth 6% 8% 16% 3.5%
Directors’ pay growth 20% 30% 42% 48%
Current ratio 1.4 1.5 1.1 1.3 1.3

The agency problem arises when managers, as agents of the shareholders, act in sub-
optimal ways so that shareholder wealth is not being maximized.

The most obvious sign that K Berhad may be suffering from the agency problem is the
way in which the directors’ salaries have grown at rates which are much greater than any
other key indicator of corporate performance. Average growth in directors’ salaries has
been 35% per year and the growth rate has increased every year, with a 48% increase in
2020. Over the 4-year period, turnover has grown by 12% per year but ROCE has fallen
from 21.2% to 17.8%, net profit margin has fallen from 20.0% to 14.4%, and return on
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equity has fallen from 20.2% to 11.9%. K Berhad pays out in directors’ salaries more
than 70% of what it pays out in dividends.

Another sign of the agency problem is a preference by directors for equity finance rather
than debt finance, for reasons of job security and lower financial risk. K Berhad has
progressively reduced its long-term debt from 2016 and over the 4-year period, gearing
has fallen from 50% to 3% while interest cover has risen from 11 to 16.

QUESTION 2
What are some of the problems involved in the use of profit maximization as the goal of
the firm? How does the goal of maximization of shareholder wealth deal with those
problems?

SUGGESTED ANSWER
The goal of profit maximization is too simplistic in that it assumes away the problems of
uncertainty of returns and the timing of returns.

Rather than use this goal, we have chosen maximization of shareholders' wealth—that
is, maximization of the market value of the firm's common stock—because the effects of
all financial decisions are included. The shareholders react to poor investment or
dividend decisions by causing the total value of the firm's stock to fall and react to good
decisions by pushing the price of the stock upward. In this way all financial decisions
are evaluated, and all financial decisions affect shareholder wealth.

QUESTION 3
Explain ways in which the directors of a public listed company can be encouraged to
achieve the objective of maximisation of shareholder wealth.

SUGGESTED ANSWER
The directors can be encouraged to achieve the objective of maximising shareholder
wealth through managerial reward schemes and through regulatory requirements.

Managerial reward schemes

As agents of the company’s shareholders, the directors may not always act in ways
which increase the wealth of shareholders, a phenomenon called the agency problem.
They can be encouraged to increase or maximise shareholder wealth by managerial
reward schemes such as performance-related pay and share option schemes.
Through these methods, the goals of shareholders and directors may increase in
congruence. Performance-related pay links part of the remuneration of directors to some
aspect of corporate performance, such as levels of profit or earnings per share. One
problem here is that it is difficult to choose an aspect of corporate performance which is
not influenced by the actions of the directors, leading to the possibility of managers
influencing corporate affairs for their own benefit rather than the benefit of shareholders,
for example, focusing on short-term performance while neglecting the longer term.

Share option schemes bring the goals of shareholders and directors closer together to
the extent that directors become shareholders themselves. Share options allow directors
to purchase shares at a specified price on a specified future date, encouraging them to
make decisions which exert an upward pressure on share prices. Unfortunately, a
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general increase in share prices can lead to directors being rewarded for poor
performance, while a general decrease in share prices can lead to managers not being
rewarded for good performance. However, share option schemes can lead to a culture of
performance improvement and so can bring continuing benefit to stakeholders.

Regulatory requirements
Regulatory requirements can be imposed through corporate governance codes of best
practice and stock market listing regulations. Corporate governance codes of best
practice, such as the MCCG 2012/ MCCG 2017, seek to reduce corporate risk and
increase corporate accountability. Responsibility is placed on directors to identify, assess
and manage risk within an organisation. An independent perspective is brought to
directors’ decisions by appointing non-executive directors to create a balanced board of
directors, and by appointing non-executive directors to remuneration committees and
audit committees.

Stock exchange listing regulations can place obligations on directors to manage

companies in ways which support the achievement of objectives such as the
maximisation of shareholder wealth. For example, listing regulations may require
companies to publish regular financial reports, to provide detailed information on
directorial rewards and to publish detailed reports on corporate governance and
corporate social responsibility. ESG

QUESTION 4

Daily Clothing Bhd is a medium sized trading company situated in the Klang Valley. It
has been trading for ten years and is managed by its main shareholders who are the
original founders of the company. Most of the employees are also shareholders, having
been given shares as bonuses in previous years. The main business of the company is
the supply of commercial and industrial clothing. Its mission statement is ‘We maximise
our shareholder value through supplying good value clothing for our customers’. The
company also practices several codes of business ethics. The code of ethics also
covers environmental responsibility.

Since its incorporation, Daily Clothing Bhd has experienced rapid expansion via
generic growth. The company has had a very efficient credit controller who has
managed the credit control department efficiently by preparing the aging lists on a
weekly basis and collected payments from debtors on time. He introduced early
settlement cash discounts and managed to reduce bad debts. This improved the
liquidity of the company. During his tenure, the overdraft was within the required limit.

Recently, the credit controller resigned and migrated to another country. After his
resignation, the company’s credit control department was poorly managed by an
inexperienced and inefficient newly recruited credit controller. The ineffective credit
control has had serious effect on the company’s overdraft. The company too was fined
for discharging washing detergents into a local river without any treatment. At the
recent board meeting, discussions were held on the liquidity of the company and the
breach of environmental ethics. It was also highlighted that the board had insisted the
management to reduce its overdraft urgently.
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One of the board members suggested that the company should consider factor finance
as an alternative source of funds for working capital management and at the same time
improve the liquidity of the company. Prior to the meeting, the member had made
enquiries about factor services from a reputable company. He pointed out that the
factor company would take over
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the administration of Daily Clothing Bhd’s receivables on a non-recourse basis for an

annual fee of 1% of turnover. The factoring will enable the transfer of collection and
maintenance of receivables to the factor company. The existing administrative
employees can be transferred to other departments, so that there will be no
redundancy costs. If the factor company is engaged, Daily Clothing Bhd could save
RM15,000 per year in administration costs.

In addition, the factor company is willing to advance 80% of the book value of
receivables at an annual interest rate of 2% above Daily Clothing Bhd’s current
overdraft rate. The advance financing could reduce the bank overdraft and improve
cash flow of the company. The factor company, through its expertise and wide
experience, is expected to reduce the average receivables period to 20 days.

Immediately after the meeting, the credit controller was instructed to prepare a detailed
report on the current working capital management together with the necessary
remedial action that is required and present it at the next board meeting.

Extracts from the financial statements of Daily Clothing Bhd for 2018, and the
forecasted financial statements for 2019, are given below.

Income statement extracts for years ending 30 September

2018 2019
RM’000 RM’000
Sales (all on credit) 16,625 11,725
Cost of sales (14,963) (10,404)
Operating profit 1,662 1,321
Finance costs (interest payments) (175) (125)
Profit before taxation 1,487 1,196

Statements of Financial Position

2018 2019
RM’000 RM’000
Non-current assets 5,600 5,400
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Current assets:
Inventory 2,202 1,230
Trade receivables 2,188 875
Cash - 90
9,990 7,595
Capital and reserves:
Share capital 2,625 2,625
Reserves 2,815 2,330
5,440 4,955
Current liabilities:
Trade payables 1,600 500
Overdraft 1,410 600
Non-current liability:
8% Bonds 1,540 1,540
9,990 7,595
The company pays interest on its overdraft at approximately 6% per annum before
tax. Average ratios for the business sector in which Daily Clothing Bhd operates are
as follows:

Current ratio: 1.90

Quick ratio: 1.00
Inventory days: 40 days
Receivables days: 30 days
Payables days: 60 days
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REQUIRED:
(a) Discuss how Daily Clothing Bhd’s financial objective might be achieved and measured.

SUGGESTED ANSWER
Daily Clothing Bhd’s mission is to maximise shareholder value. Shareholder value is
linked to dividend payment as well as capital gain. To increase dividend, the company
needs to identify and undertake investments which give positive net present values. If
the company accepts investments with positive NPVs, free cashflows for the company
will increase. A positive NPV represents an investment return that is greater than that
required by a company’s providers of finance, offering the possibility of increased
dividends being paid to shareholders from future cash flows. When there is ample cash
available and high dividends are paid, demand for the shares will increase and the
market value of the company, theoretically at least, increases by the amount of the
NPV. Shareholder’s wealth is therefore increased if positive NPV projects are accepted
and, again theoretically, shareholders wealth will be maximised if a company invests in
all projects with positive NPVs.

(b) Advise the directors of Daily Clothing Bhd on the benefit(s) the other stakeholders will
receive if the company’s financial objective is achieved.

SUGGESTED ANSWER
When Daily Clothing Bhd’s financial objective is achieved, it will benefit other
stakeholders either directly or indirectly. The stakeholders are:
 Customers
 Suppliers
 Government
 Employees
 Lenders
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Customers – When Daily Clothing is financially successful, it would be able to invest

in new technology equipment and facilities. This will improve the quality of the clothing.
Suppliers- If the company is financially sound, it would be able to pay the suppliers on
time and at the same time purchase more materials.
Government –When Daily Clothing Bhd earns more profit, it will pay more tax.
Additionally, employment opportunities offered would help to reduce unemployment.
Employees- Managers and supporting staff would feel a greater sense of job security
and increased job satisfaction and enhanced motivation.
Lenders- If the company is financially sound; the credit risk will be low.

(c) Untreated discharge into a local river causes damage to the environment. Will
environmental risk affect Daily Clothing Bhd’s value?

Daily Clothing Bhd was fined for an untreated discharge into a local river. This is
considered as an environmental accident and the risk for the environmental damage is
clearly material to shareholder value and is likely to remain so while the company
continues its business activities.
The shareholders will evaluate the extent and nature of the risk and assess whether
the risk profile of the business matches their own attitudes to or appetite for the
environmental risk. In a portfolio of shares, some investors will want to blend the
environmental risks and returns, and knowing about a company’s environmental risks
is important in making these judgements.
The environmental risk information will allow the shareholders to judge how the risk
might affect the company’s value and hence the potential volatility and attractiveness
of the share. The penalty imposed on the company is capable of affecting returns,
costs or both. When the shareholders are aware of the environmental pollution and if
the environmental risk is material, the shareholders would have discounted the share
price accordingly. The shareholders will also evaluate the new risk controls put in
place by the management because these measures could be vital in restoring investor
confidence. In particular, they should reassure shareholders that the accident should
not re-occur, or that if it were to re-occur, further controls would be in place to offset
the worst of the damage.
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QUESTION 5
The following details relates to F Berhad’s, a multinational public listed company on
Bursa Malaysia. They operate in various sectors. The breakdown of activities by
percentage of total annual turnover are provided:
Department stores 30%
Clothing 24%
Building materials 20%
Hotels and catering 16%
Electronics 10%

Additional information on the company is:

Current share price: RM2.34
Average annual share price growth over past five years: 5%
Multinational sector average annual share price growth over past 5 9%
years
Level of gearing based on market values (debt/debt + equity) 23%
Multinational sector gearing level based on market values (debt/debt 52%
+ equity)

The Board of Directors of the company were given share options by its remuneration
committee five years ago. In one year’s, time, the share options will allow each
director to buy 100,000 shares in the company at a price of RM2.00. The directors’
average annual salary currently stands at RM200,000 on a five-year rolling contract
basis, while average salaries in the multinational sector are RM150,000 and tend to
be a three-year rolling contract.

REQUIRED:

(a) Using the information above to illustrate your answer, critically discuss the extent to
which F Berhad can be said to be suffering from an agency problem.
(b) Discuss how the issues you have identified in part (a) can be addressed to reduce
the agency problem.

SOLUTION

(a) Agency implies that managers (as agents) maximise their own wealth rather
than that of their shareholders (the principals) due to asymmetry of
information, differing objectives and divorce of ownership and control.
Hence, we need to look for clear signs that agency problems are present.

The first thing to note is that F Berhad has diversified its activities across a
range of different industries. This is often justified in the name of reducing risk for
shareholders, but shareholders should have already diversified themselves
through the portfolios they hold. Companies tend to diversify their activities for
managerial motives, such as to increase job security by diversifying unsystematic
risk.

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Second, F Berhad is maintaining a gearing ratio significantly below the

industrial average. This is another example of the agency problem as
shareholders prefer higher levels of debt because of the cheaper cost of debt
finance and are prepared to accept higher levels of financial risk because they
have a diversified portfolio. Managers, however, prefer equity finance as too
high a level of financial risk could jeopardise their job security.

A more obvious example of the agency problem is that the directors’ average
salaries are above the industry norms and they have five-year contracts,
contravening corporate governance directives like the Greenbury Report.
Managers are likely to become complacent with contracts of such length.

There is also a problem with the use and terms of the share options. Given
the historical growth rate in share price of 5 per cent, the company’s share
price five years ago when the directors were given the share options would
have been approximately £1.83. For the share price to climb above £2 in less
than five years represents a very unchallenging target If managers were to
exercise the options in a year’s time, their gain would be:
(2.34 × (1.05) – 2.00) × 100,000 = £45,700 This is a big reward for
underperforming the sector share price growth rate of 9 per cent.

(b) Given the company appears to have major agency and corporate governance
problems, these could be reduced by some of the following actions:
• get managers to refocus the business in one area of specialisation and realise
economies of scale and operation;
• instruct managers to increase the level of debt finance as the current level of
gearing is unlikely to minimise the company’s cost of capital;
• restructure share options so that gains are achievable if managers stretch
themselves;
• monitor managers to ensure they are not maximising their own wealth. The degree
of success depends on the monitoring method used and the structure of the
company’s shareholders as someone must pay for monitoring to take place;
• reduce salaries back in line with industry averages and tie part of the salary to a
performance-related variable (e.g. company share price relative to the sector).
Introduce one-year rolling contracts to keep managers on their toes;
• examine the constitution of the remuneration committee and the backgrounds of
nonexecutive directors, and make appropriate changes where necessary.
Ultimately, the shareholders might want to exercise their right to vote out directors at
the AGM if they think that their performance has been poor.

QUESTION 6
R Berhad is a long-established petrochemical manufacturer, producing rare chemical
products in the east coast. The company’s products are marketed in USA, Europe
and the Pacific regions.
One of the company’s code of ethics is environmental responsibility. Last year, the
company was fined for an untreated discharge into a local river.
Over the years, the company’s share price has performed well. Now, there is
concern that price and cost competition from new entrants into the domestic market

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will have a significant impact on the firm’s profitability and the dividends. R Berhad
borrowed heavily to finance its working capital requirements for local and overseas
businesses. The management is evaluating different foreign currency hedging
methods to minimise its currency risk on the payments to its overseas suppliers. The
hedging methods that are available to R Berhad are leading, lagging, forward and
money markets.

The company is now considering expanding into other businesses through mergers
or acquisition. The finance director has proposed that the company acquire 100% of
the equity of D Berhad, an oil refinery company. The acquisition will be financed via
a bond issue that will not significantly impact upon the company’s existing credit
rating and its capital structure. The cost of capital is 7%.

Required:
A. Untreated discharge into a local river causes damage to environment. Environmental
risk is material to shareholder value. Discuss.

B. Agency conflicts may arise because of the differences in the interests of the owners
and managers. Explain the reasons for agency conflicts.

SUGGESTED ANSWER
(a)
R Berhad was fined for an untreated discharge into a local river. This is considered
as environmental accident and the risk for the environmental damage is clearly
material to shareholder value and is likely to remain so while the company continues
to manufacture petrochemical products.

The shareholders will evaluate the extent and nature of the risk and assess whether
the risk profile of the business matches their own attitudes to or appetite for the
environmental risk. In a portfolio of shares, some investors will want to blend the
environmental risks and returns, and knowing about a company’s environmental
risks is important in making these judgements.

The environmental risk information will allow the shareholders to judge how the risk
might affect the company’s value and hence the potential volatility and attractiveness
of the share. The penalty imposed on the company is capable of affecting returns,
costs or both. When the shareholders are aware of the environmental pollution and if
the environmental risk is material, the shareholders would have discounted the share
price accordingly. The shareholders will also evaluate the new risk controls put in
place by the management because these measures could be vital in restoring
investor confidence. In particular, they should reassure shareholders that the
accident should not re-occur, or that if it were to re-occur, further controls would be in
place to offset the worst of the damage.

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(b)
A manager has an interest in receiving benefit from his or her position as a manager.
These include all the benefits that come from status, such as a company car, use of
a company airplane, lunches, attendance at sponsored sporting events, and so on.
Managers may work less hard than they would if they were the owners of the
company. The effect of ‘lack of effort’ could be lower profit and lower share price.
The interest of middle managers and the interest of senior managers might well be
different, especially if senior management are given pay incentives to achieve higher
profits, but the middle managers are not.
The remuneration of directors and senior managers is often related to the size of the
company, rather than its profits. This gives managers an incentive to grow the
company, and increase its sales turnover and assets, rather than to increase the
returns to the company’s shareholders. Management are more likely to went to re-
invent profits in order to make the company bigger, rather than pay-out the profits as
dividends.
Shareholders are concerned about the long-term financial prospects of the company,
because the value of their shares depends on expectations for the long –term future,
in contrast, managers might only be interested in the short-term. These is partly
because they might receive annual bonuses based on short-term performance, and
partly because they might not expect to be with the company for more than a few
years. Managers might therefore have an incentive to increase accounting return on
capital employed (or return on investment), whereas shareholders have a greater
interest in long term share value.

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