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FE2118 exam questions 2008/09

Section A
Question 1
Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interest of the owners, rather than their own. 1) What strategies are available to shareholders to help ensure that managers are motivated to act this way? (50 marks) It is OK for the students to answer this part of the question broadly, i.e., to mention that there are four ways (monitoring, incentives, market discipline and corporate governance) to make sure that the managers act in the best interest of the owners. But this question mainly asks for the strategies such as monitoring and providing incentives to motivate the managers.

The shareholders may insist on monitoring closely the actions of the managers and the way in which the resources of the business are used. Details are needed.

The shareholders may introduce incentive plans for managers that link their remuneration to the performance of the business such as the bonus scheme (related to the profits) and share options (dependent on share performance). Details are needed.

2) Critically comment on the available strategies with reference to the current economic and financial conditions. (50 marks) The strategy of monitoring the manager behaviour is fine in theory, but can be difficult to implement and is costly. Many businesses are now extremely large and their shareholders, who may individually own only a very small proportion of the shares of the business, will normally find it difficult to act collectively with other shareholders. However, if they try to monitor manager behaviour on an individual basis, the costs will be high in relation to the benefits. In such a situation, doing nothing may be a better option for a shareholder.

The strategy of providing incentives to managers can also be difficult to design and implement and can be costly.

The advantage of the bonus scheme is that the profit of the business can be increased. However, this scheme emphasises short-term profits at the expense of long-term profitability or performance of the business. Although investment decisions, e.g., investment in research and development and quality control, often have a negative-profit impact in the short run, a positive impact could be expected in the long run. But this scheme may discourage the vital investment decision-making. At the same time, it encourages the use of ‘creative accounting’ methods to manipulate year-end results. For example, companies have sold properties and regarded the gains made as part of trading profit. Another trick is to issue new shares and invest the proceeds in the bank, and the interest accrued is shown as an increase in the year’s profits.

The share option scheme is a long-term compensation arrangement, which is dependent on the company’s share performance. Managers can buy a given number of shares at a given price over a set period of time. Such options only have value when the actual share price exceeds the option price. This offers managers, who take up the scheme, the incentive to take actions consistent with wealth-creation over a longer time period. While in theory, the scheme is attractive, it is often difficult for managers to see a clear relationship between their efforts and share prices. For example, inefficient managers could be rewarded in times of a generally rising stock market, as in the early 1980s. But mangers who have worked hard may be penalised for the decrease in share prices during the downturn of the general economic and financial markets.

Reward students who relate the answer to the FT articles we discussed in the seminars.

Question 2
1) Salford Engineers Limited has discovered that it is holding 120 days’ stock. Explain what you consider to be the most important factors when determining whether this is the optimum level of stock holding for the company. (50 marks) The optimum level of stock holding...
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