External sources for financing Pearlparadise.com

Let’s use Portia as an ongoing example. Portia can consider using external financing, which refers to funds invested by outside investors and lenders. External financing is divided into equity and debt financing. Portia can either borrow money with the agreement to repay the borrowed sum plus interest or can obtain funds in exchange for equity, or use a combination of equity and debt financing.

Portia can consider debt as a source of external financing. Debt financing increases her financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, equity investors are not entitled to more than what is earned by the enterprise.

When borrowing from the bank, an entrepreneur has number of options. The following types of loans are generally available:

Lines of credit – this is when bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed, but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.

Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such arrangement is generally more expensive for the borrower.

Term loans – such loans are generally used for the financing of equipment. The loan is generally corresponds to the useful life of the equipment.

Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.

Portia can also consider equity financing. Private equity investors include venture capital firms and business angels. Venture capital firms raise a fund and then select portfolio of businesses in which to invest. Portfolios generally include start ups and existing businesses.

In exchange for investment, venture capital firms obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because the venture capital firm would like to have the senior claim on assets in case of liquidation but still wants to have an option to convert it to common stock if the business becomes successful.

Business angels, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. A very small percentage of start ups manage to get such funding. Therefore, entrepreneurs should have other options available as well.

There are also government supported financing options available to Portia which are specific to Portia’s location.

Further, Portia can use personal sources of funds. The “personal” sources could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.

Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.

Borrowing from friends and family is also very tricky and should be done with extreme care. If Portia’s business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. An agreed upon deal should be put in writing since memory is not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.

Overall, Portia has a number of the sources of external financing to choose from. Portia needs to evaluate upsides and downsides of each option and consider all options in light of the unique situation of the business to choose the best option or combination of options.



Growth of a Small Business

Entrepreneurs have different preferences towards the growth of their businesses. Some desire rapid growth, others pursue manageable and reasonable growth while others prefer not to grow their businesses at all but only to maintain the current size of the business.

Growth of a small business can be incredibly challenging if it is not planned for. One of the reasons for this is due to the fact that growth usually requires additional financing which has to be obtained before the additional profits appear as cash inflows.

This growth problem is further exacerbated due to the difficulty of obtaining external financing. Business may need additional financing to hire more personnel to handle increased sales and to buy extra inventory and raw materials. Therefore, the situation may occur where a rapidly growing business is profitable but has cash-flow problems. This is referred to as a “growth trap”.


Objectives and Benefits of a Business Plan

Business plan for a start up refers to the written plan of how the business will be established and developed. The biggest benefit of the business plan is that writing it forces an entrepreneur to consider all important areas of the business, which otherwise may be overlooked. Research regarding whether business plan contributes to success of the new venture shows mixed results. The key factor is not if businesses has a business plan but if such a plan was carefully prepared and if it is being implemented.

In certain circumstances it may not be needed to have a business plan. This can happen when it is vital to act immediately and there is just no time for planning or in situations when the business is very small and there are no plans for growth.

Objectives of a Business Plan

Most importantly, the goal of a business plan is to recognize and explain the new business opportunity.

Another objective is to present, in a written format, how an entrepreneur intends to take advantage of the business opportunity.

Business plans must provide descriptions of key success factors which will determine whether the business opportunity will be successful or not.

Therefore, part of the second objective of the business plan is to be a managerial tool to be used to ensure successful pursuit of the opportunity.

Yet another objective of a business plan is to allow entrepreneur to obtain funds necessary to establish a venture. Suppliers of funds usually include banks as well as potential investors.

Business plans shows to lenders of funds how well an entrepreneur thought about each aspect of the potential new business. Business plan also provides potential lenders with information that they require in making a decision about whether lending or investing funds into the venture is a suitable action.

Benefits of a Business Plan

Financing: Business plan helps entrepreneur to obtain financing for the new venture. Lenders and investors demand business plans from entrepreneurs before they would even consider lending or investing their money. In the past, business plans were mostly prepared by large businesses. In current times, business plans are prerequisites for entrepreneurs who seek funding from lenders and investors.

Indication of success: Business plan also provides an indication to the entrepreneur and other interested parties of whether a prospective new business will be a successful venture.

Writing a business plan allows entrepreneur to be certain that the prospective venture is really worth the entrepreneurs’ time and other resources. Writing a business plan also allows entrepreneurs to think through and decide on various key areas. A well written business plan is an indication that the entrepreneur researched the prospective venture well.

Identifies key success factors: Another benefit is the fact that it allows to identify key variables that will determine whether the business will succeed or not. This will ensure a more effective management of the business; as such variables can be closely monitored by interested parties.

Provides performance standards and milestones: It provides a roadmap that management can follow in implementing and establishing a new business. Business plans provide milestones and other performance standards against which actual performance can be measured.

Helps to build relationships: Well written business plan helps to build relationships with potential business partners, potential as well as current customers and suppliers. Many large companies will not even consider dealing with a small start up or small growing company unless a well written business plan is presented. Furthermore, the written plan can help small business to obtain trade credit from suppliers. Trade credit refers to suppliers providing product with agreement that payment will be made within certain period, usually 30 days or at the end of the month.

Helps to attract better employees: It allows potential employees to see that the company may have a chance to succeed and is a promising place to build a career.

Improves motivation of employees: Business plan helps to keep all employees informed and excited about where company is now, where it is going and how it is going to get there.


The Importance of Customer Relations Management

Whereas in the past companies could afford to ignore consumers’ needs and preferences, this is no longer the case. With options available to consumers due to such factors as increased competition and drastic changes and improvements in technology, consumers become increasingly more educated and demanding.

For example, Portia have to work really hard to keep consumers of Pearlparadise.com satisfied and to build long lasting relationships with them. Otherwise they will move to a competitor.

Since Portia’s business is a small business, Portia has an advantage compared to large competitors. This advantage arises because Portia can address each customer personally and superior higher customer service which will lead to greater customer satisfaction and loyalty.

It is crucial for Pearlparadise.com to keep current customers satisfied since acquisition of new customers is very costly. It costs about five times more to acquire a new customer in comparison to keeping an existing one. Current customers also tend to buy more from the enterprise and may refer their family and friends.

On average, businesses keep between 70-90 percent of customers each year. However, if retention of customers could increase by 5-10 percent per year, than businesses could double their profitability.

This statistics highlights how incredibly important it is for Portia to keep current customers satisfied. So think about this for a minute. While Portia wants to spend money on advertising, that is really a small part of the battle. Once people see Portia’s advertising, she needs to convert them into paying customers. Once Portia converts them into paying customers she then needs to ensure they are repeat clients, otherwise she needs to spend even more on advertising. If she does a poor job serving existing customers, they may write poor review of her business which will lead to even less effect from her advertising.

Moreover, customers are often willing to pay a premium for excellent customer service. Therefore, Portia could even increase her profit margin by providing higher customer service than that of her competitors.


Introducing Business Plan

There are three basic objectives of a business plan:

  • First, and most importantly, the goal of business plan is to recognize and explain the new business opportunity.  It forces you to crystallize your thinking before you share it with others.
  • Second, the objective is to present, in a written format, how an entrepreneur intends to take advantage of the business opportunity. Business plans need to describe which steps the entrepreneur intends to take to make his dream of a new business a reality. It should include various tools that the entrepreneur will be able to use in the management of the business opportunity, such as vision, mission, goals, budgets, financial forecasts and description of target markets. Business plans also must provide descriptions of key success factors where achievement of, or occurrence and non occurrence of, will determine whether the business opportunity will be successful or not. Therefore, part of the second objective of the business plan is to be a managerial tool to be used to ensure successful pursuit of the opportunity.
  • A third objective of business plan is to allow entrepreneurs to obtain funds necessary to establish a venture. Suppliers of funds usually include banks as well as potential investors. The business plan demonstrates to lenders of funds how well the entrepreneur thought about each aspect of the potential new business. Business plans also provide potential lenders with information they require in making a decision about lending or investing funds into the venture.

Another important main objective of the business plan is to identify factors that will determine if the business opportunity has good potential to be successful.


The business plan is a road map that allows entrepreneurs and other interested parties to see where prospective or current business is today, where it is going and how it is going to get there. In other words, it examines and identifies key areas that needed to be attended to as well as how it will be attended to and the performance standards which an entrepreneur expects to maintain, such as milestones.

If you work for a large corporate you can use business plan approach to get a buy in for a new project or to explain an existing initiative. You will be surprised at how useful it is to write a business plan. It is powerful because it forces you to think through all aspects of the project. Like a true entrepreneur, it makes you accountable for everything.

The content of the business plan should cover five key factors.

  • It should provide a big picture of the opportunity. This refers to the external factors or context of the opportunity such as regulatory environment, which is beyond the entrepreneur’s control
  • It should also address a management team with their qualifications and experiences
  • It should clearly describe the business opportunity
  • It should also present financial structure
  • It should indicate the resources needed for success of the venture

Structures of a business plan will differ from case to case. Generally, business plans can either be very brief, just covering main key areas and projections. Such plan is called dehydrated business plan and focuses on market issues such as pricing, distribution channels and competition. However, when people in business refer to the business plan, they are usually referring to in depth, all inclusive, business plan which are called comprehensive business plans.

Comprehensive business plan may include the sections discussed below.

It should start with the cover page, which should specify:

  • the name of the prospective venture and entrepreneur
  • the address
  • Contact details of the business venture and entrepreneur
  • It should also include the date when the business plan was completed and a disclaimer advising that information in the business plan is confidential and cannot be used without permission
  • Each copy should be numbered to keep track of the copies and for general transparency as it will indicate to investors, lenders and other parties how many copies were already handed out

Cover page is followed by the table of contents. This part of the business plan is created for convenience of the investors, lenders or any other parties that would be reading the business plan. Just as in any book, table of contents in the business plan sequentially lists each section and subsection and provides a page number where this section or subsection can be found. This allows anybody who is reading a business plan to find any section or subsection that they would like to examine in a fast and easy manner.

Executive summary should follow. This is generally the most important part of the business plan. This is because many people who will be reading this business plan will read executive summary first and will only read business plan in-depth if the executive summary generated enough excitement.

The executive summary brings together key points from each section of the business plan. It is an overview of the entire business plan and should be written last and be no longer than two or three pages. It should describe opportunity, explain the business concept, explain which market or markets will be targeted, provide an industry overview as well as the competitive advantage the new venture intends to deploy/create. Economics of the business opportunity should be provided and the management team should be briefly described. Lastly, if external funding from investors is required, main points from the offering section should be included regarding how much of external funding from investors is required as well as how this money will be allocated.

In writing the executive summary two strategies can be used, synopsis and narrative. Synopsis provides conclusion of each section of the business plan. It is very straightforward and dry. It is about getting right to the point regarding each section of the business plan. Synopsis is easier to prepare but it may not create enough excitement in the target audience to entice them to continue explore the business opportunity.

A narrative executive summary creates excitement, generates enthusiasm and sense of urgency. It tells a story about business opportunity and requires certain degree of writing talent. Narrative executive summaries are especially relevant if there is something really special about the new venture, such as if a new market or new innovative product is to be explored. An example can be if the business intends to become the first direct life insurance provider in Ukraine. Alternatively, a narrative is relevant if the business is to be led by a well respected entrepreneur or a businessman, which again makes the new venture more special than an ordinary start up.

An industry, target customer and competitor analysis can be presented next. The main purpose of these sections is to present business opportunity as well as to illustrate that there is a profitable and big enough market to be served.

Industry analyses should describe the industry within which the prospective business will be established. This should include industry size, growth, trends and main players. Then the industry should be broken down into main segments. Lastly you should describe the niche from which the entrepreneur would specifically like to focus on or start from.

Target customers should describe in detail the target customer market or markets. It should illustrate factors that confirm that this target market is being underserved.

It should include customer profiles. Customer profile usually includes demographic characteristics of customers, such as their age and gender. It can also include psychological, behavioural and sociological information. Customer profile also includes information regarding transactions history, responses to marketing stimuli and on contacts with customer.

Based on customer analysis, the competitor analysis should be presented which should include profiles of main competitors. Such profile should include SWOT analysis, which is an analysis of the strengths, weaknesses, opportunities and threats of the competitors. More detailed competitor analyses may also be presented.

Company description section may follow which focuses on the type of business, its objectives, where it will be located and which form of organization will be selected.

Vision and mission statements may follow. The vision statement is a statement of the dream of the organization. What the organization inspires to be and to accomplish. The mission statement describes how the organization plans to accomplish its mission. It is more detailed. The mission statement is written based on the vision statement.

A product or service plan may be presented next. This includes description of such areas as why the product or service which the company intends to provide will be better than that of competitors. If the product or service fills a particular gap in the market – it should be indicated as such. It also should be described if any secondary target markets are available. The prospective venture’s competitive advantage should be indicated as well as if this competitive advantage will be sustainable or is it very easy to copy.

Working model, photos of the product or product prototype as well as drawings may be included. Alternatively it can indicate where such information may be found in the appendices. Investors are interested in products that already were developed and shown in practice that they can work well and is useful and meet particular needs of the target market.

It should also be pointed out if company has any specific advantages, such as patent protection and innovative characteristics of the product or service. Product or service strategy for growth should also be included.

The Marketing plan can follow. This plan points out how the new business intends to promote its product or service. This refers to how customers will be persuaded and informed about the existence as well as benefits of the product or service.

The plan should include the pricing strategy and descriptions of which distribution channels will be used. It should be indicated what would be credit and pricing policies, which selling approach or approaches are intended. The plan must describe any types of sales promotions, advertising and how customers will be found and enticed to buy the product.

The marketing plan should include sales forecasts, which are developed based on other information provided in the marketing plan. The plan should describe if there are any warranties that will be provided. If business intends to have product updates than this also should be indicated.

The Operations and development plan can be presented next. This part of the business plan explains how the product will be manufactured or service provided. This section should indicate if the operations process will contribute to a competitive advantage. For example, this could be the case if the operation process is expected to be cheaper than that of competitors. The operations and development plan descries operational aspects of the business such as how much space the business will require, if the business will require a special location and which equipment is necessary for the operation of the business. The business plan should indicate what will be bought, built, owned and operated and/or outsourced and why. Lastly, it is important to point out how quality standards will be maintained, how and from whom raw materials are intended to be obtained, if business plasn to use subcontractors and which approach the new venture intends to use to control its inventory.

The management team section of the plan can follow. This is an important section because investors often look at the quality and calibre of the management team before they even look at what the new venture’s product of service will be.  Investors want to see a well balanced management team which consists of members with complementing skills. Investors want to see that all crucial skills and experience are present in the proposed management team. For example, investors and lenders may be looking to make sure that businesses have management with relevant skills, education and experience in areas such as finance, marketing, production and management.

Next, critical risks should be discussed. Investors, lenders and other interested parties understand that any business venture has critical risks. What they want to see is if the entrepreneur is aware of it and if entrepreneur has a plan how to manage, control or eliminate such risks. One example of critical risks includes lack of market acceptance which occurs when customers do not buy product or service as anticipated. Another example of critical risk is that competitors may respond by putting success of the new venture in jeopardy. For example, if the new venture is going to compete with a very large established company that produces the same kind of product, a large competitor may take action to ensure that the emerging new competitor is eliminated. For example, a very large company may temporarily lower its prices. The new venture will not be able to offer such low prices and may go out of business. Yet another example of critical risks can be unexpected government regulation which may have adverse effects on the new venture. New ventures generally have better protection from competitor response risk if they target a niche in which larger businesses are not so interested. Another way for the new venture to protect itself from competitor responses is to have a competitive advantage which is very difficult to imitate.

An offering section can follow. This section is relevant if the entrepreneur requires external financing from investors. This section describes how much money the venture will require from investors and at which times. It is advisable to present investors with sources and uses table which describes where money will come from, such as from equity or debt and for what purposes money will be used.

The Financial plan can be presented next. This is a very important section. It provides financial forecasts of the new venture in the form of pro forma statements. It should include annual pro forma income statements, balance sheets and cash flow statements for a minimum of three and up to five years. This section should also include monthly cash budgets for the first year and quarterly cash budgets for the second and third years. Assumptions based on which the pro forma financial statements have been prepared as well as clarifications of how the pro forma statements were determined should be indicated.

Specific attention should be paid to statements of cash flows. Without cash inflows the business will not be able to survive even if it is profitable according to income statement. It indicates sources of cash and for which main investments, such as equipment or property, it will be used for.

Appendices should conclude business plan. This section contains supporting documents. It can contain details on information that is briefly discussed in the main body of the business plan. For example, in the case of the management team section, brief descriptions of the management team’s skills, education and experience should be supplemented with detailed resumes of each member of the management team which should be presented in the appendices. Appendices also may contain photographs of the product and facilities, copies of signed contracts with important customers and/or research documents, patent filings etc.


Finding the Market Price Ratio of Exchange

When the acquiring company knows the ratio of exchange, it can be used to find the market price ratio of exchange. The market price rate of exchange is found as follows:

(MP of acquiring company * ratio of exchange)/ MP of the target company

Where: MP refers to the market price per share.

The market price ratio of exchange indicates how much of market price per share of the acquiring firm is exchanged for every $1.00 of the market price per share of the target company.

It is normal for the market price ratio of exchange to be above 1. This is an indication that the acquiring company pays a premium above the market price to acquire a target company.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s market price is $60 and BCD’s market price is $55. However, during merger negotiations, ABC agreed to a 1.5 ratio of exchange where it valued BCD’s shares at $90.

Find the market price per share in the ABC/BCD merger.



This means that ABC gives $1.6 of its market price in exchange for every dollar of the BCD’s market price.

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Types of Corporate Restructuring

Mergers and Consolidations

Consolidation is a type of corporate restructuring and occurs when two or more organizations come together to form a completely new corporation. This new corporation typically include all assets and liabilities of the combined separate companies. Consolidations usually occur between organizations of similar size.

Merger is also a type of corporate restructuring and occurs when two or more organizations merge into one. Organizations that merged into one usually maintain the identity of most important organization.

Merger often involves one or more smaller organizations merging into a larger organization and becoming part of that larger organization. Merging involves absorption of assets and liabilities of all firms merged. Mergers also can be called acquisitions, buyouts or takeovers.

Within a merger, the acquiring company (generally larger and more important company) usually will approach a target company (smaller and less important company) to arrange a merger.

Sometimes, however, the target company may approach acquiring company. The key outcome that the acquiring company seeks from a merger is synergy, leverage, key staff, technology or even preventing a competitor from acquiring a particular company.

Government and mergers

Governments regulate mergers. The main concern of the government is to ensure that competition is not eliminated. This concern is especially relevant if one direct competitor attempts to acquire another direct competitor. Such a merger could result in higher prices for consumers and lower output of combined organizations (fewer product or service options or inferior customer service). If such a situation occurs then population may end up worse off than it was before the merger.

Mergers, of course, also may provide social benefits. Such benefits include economies of scale and scope, better utilization of resources, higher output and improved quality.

Therefore, government usually prohibits only those mergers in which anticompetitive disadvantages outweigh social benefits.

Hostile and Friendly mergers (takeovers)

Hostile merger (hostile takeover) usually occurs when the acquiring company approaches target company but management of the target company or the board of directors of the target company do not support the proposal for acquisition. In such a situation, the target company may take actions to make it harder or impossible for the hostile merger to take place by executing hostile merger defence strategies.

Acquiring company then attempts to obtain the required amount of shares in the market place via tender offers. Tender offers refer to formal offers made to the shareholders in the market place to obtain a certain amount of shares at a given price which is above the current market price.

The acquiring company may also undertake a creeping tender offer by silently purchasing enough shares in the market place before making their intentions known.

Hostile mergers (hostile takeover) also occurs if the acquiring company approached shareholders directly without firstly approaching the management and board of directors of the target company.

Another way a hostile merger can occur is if the acquiring company engages in a proxy fight by trying to obtain support of enough shareholders to replace management with new management which will endorse the takeover.

Certainly hostile mergers are more difficult to undertake. The acquiring company may struggle to obtain a loan if it needs to borrow to finance a hostile takeover as banks usually are not supportive of hostile takeovers.

The acquiring company is also at greater risk under a hostile takeover because it cannot undertake an in depth due diligence of the target company and will have to rely completely on the publicly available information to make a decision to acquire a target company. Nevertheless, hostile takeovers also take place.

Friendly merger (friendly takeover) involves a situation where the acquiring company approaches the management of the target company with the proposal for acquisition. If management supports such an acquisition and if the board of directors sees a merger to be in best interests of shareholders, then the board makes such a recommendation to the shareholders. If shareholders approval is obtained then a friendly merger occurs and it is completed by the acquiring company obtaining shares in the target company.

Motives for mergers

Any action undertaken by business must be based on achieving the main objective of the enterprise which is the wealth maximization of the owners of the enterprise.

The main objective of a merger should be the same as the main objective of the firm. Namely, the maximization of the owners’ wealth by improving the share value.

There are two driving forces for mergers, which should be consistent with the main objective. They include strategic and financial reasons.

Under a strategic merger the performance of firms after the merger is higher than performance of firms before merger. The strategic merger involves economies of scale due to combining two or more firms to achieve greater productivity and profitability.

Financial mergers are conducted due to a perception by the acquiring company that the target company can be managed and structured better after acquisition. In this way the acquiring company anticipates to unlock unrealized value from the target company. Such mergers rely significantly on debt to finance acquisition. A leveraged buyout (LBOs) is an example of financial mergers. Strategic mergers are more prevalent than financial mergers.

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Corporate Restructuring

Corporate restructuring is the process of reorganizing the ownership, legal, operating or any other structures of the company. It may involve expansion or contraction of the operations of the business.

There are various types of corporate restructuring such as mergers, consolidations and leveraged buyouts (LBOs). Successfully restructured organization should result in an increase of the owners’ wealth and more effective operations.

Restructuring can be necessary in various situations. Some of the reasons are as follows.

  • If company was the target of a leveraged buyout than it is likely to be restructured by the new owner and sold for a profit after the restructuring is successfully completed.
  • Restructuring can also be necessary in situations when the organization became too large, to the point that the structure established for the organization earlier can no longer support the operations of the organization.
  • If an organization grows to be too large for its current structure, restructuring may allow the organization to make its operations more efficient. For example, some parts of the organization can be converted into subsidiaries to obtain tax advantages and to ensure more effective management of the operations.
  • Another situation which may require restructuring is an organization struggling to survive. Such a situation can occur for various reasons such as the downturn in the economy, market entry of an unexpectedly strong competitor or revolutionary changes in technology which make some of the business’s product offerings obsolete. Contraction of the operations of such an organization may be necessary to ensure that the business can continue its existence and start rebuilding itself from the size it can currently sustain.

There are of course many more reasons why an organisation can be restructured. In general, restructuring implies the organization will continue its operations in one way or another.



Purchase versus Lease Decision

When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

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Agency problem and agency costs

Agency costs refer to costs which arise due to an agency problem. Agency problem, which is also called principal–agent problem or agency dilemma, occurs when an agent acts on behalf of the principal. The problem arises because agents’ interests and priorities may be different from that of the principal.

Agency costs are costs that a principal incurs to decrease or eliminate the agency problem by providing agent with incentive to act in the best interests of the principal as well as by monitoring the agent’s actions to ensure the agent is acting honestly and in the best interests of the principal.

In the context of an organization

In the context of an organization, agency costs refer to the costs of eliminating or decreasing the agency problem which arises due to management (agent) acting on behalf of shareholders (principal).

Agency problem, in the context of an organization, refers to the tendency of management to pursue its own needs as a first priority, which may be at the expense of the needs of the shareholders.

Agency costs include costs which arise due to maintenance of corporate governance structure of the organization. The goal is to give the management incentive to treat the needs of shareholders as a priority as well as ensuring honest dealings of management and monitoring management’s performance.

A typical example of agency costs occurs when rewards of management are tied to shareholders’ wealth maximization or performance of the company.

As an example, to tie rewards of management to the shareholders’ wealth maximization management may be given portion of shares of the company. Therefore, management becomes shareholders as well and their needs and interests become more aligned with other shareholders.

Alternatively, management is given stock options which will allow purchasing stock at the market price set at the time when stock options are granted at some point in the future. This gives management an incentive to be interested in shareholders’ wealth maximization since management will be able to benefit from it personally by buying appreciated shares at some point in the future at the price set at the time stock options were granted (at the lower price).

To tie rewards of management to the performance of the company, management may be evaluated based on their ability to achieve certain measures such as EPS. Performance shares or cash bonus may be given to reward management for meeting specific performance measures.

The other ways which help to decrease the agency problem in organisations is the pressure that shareholders place on the management and negative implications which will materialize if management cannot meet shareholders’ expectations.

Another factor that helps to decrease the agency problem in organisations is the threat of takeover by an individual, group or company which believes that company could be managed better. It serves as impetus for management to work harder in meeting shareholders’ needs.

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