Agency Problem

14. Agency Problem.

Suppose you own stock in a company, the current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock.  Your company’s management immediately begins to fight off this hostile bid. Is the management acting in the shareholders’ best interests? Why or why not

Solution

It could be both ways. The management could be acting in the shareholders best interest in the case where the bid is an inadequate and opportunistic one whereas they could also be acting in their own best interest and not that of the shareholders because hostile take-overs usually mean major management structure changes.

Chapter 2.

2. Accounting and Cash Flows

Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period?

Solution

According to financial accounting principles, revenues and their respective costs are “booked” when the revenue process is completed and not when the revenues are collected or the costs paid for.

3. Book Values versus Market Values

In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?

Solution

It is because without the book value there would be no way of knowing if a business is creating value for its stock holders. It can be known by comparing the book value from the balance sheet with the market capitalization.

4.  Operating Cash Flow

In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow. Explain what each is and why it is excluded in operating cash flow.

Solution

Depreciation is found in the net income but not in operating cash flow

Depreciation is the non cash expense a business incurs by devaluing its assets on account of age, wear and tear or obsolescence.

Depreciation is not included in the operating cash flow because it is a non cash expense and not an operating cost.

Interest is found in the net income but not in operating cash flow.

Interest is the fee levied by a lender on a borrower and is expressed as an annual percentage of the principal sum borrowed.

Interest is found in the net income but not the operating cost because it is a financing cost and not an operating cost.

6. Cash Flow from Assets

Suppose a company’s cash flow from assets is negative for a particular period, is this a good sign or a bad sign?

Solution

A healthy business will definitely have a positive cash flow from assets and a negative cash flow from assets should automatically trigger an alarm. But a negative cash flow from assets for an expanding business is not necessarily a bad sign since there are bound to be large capital spending resulting in a negative cash flow from assets for a certain period of time.