# Tag Archives | board of directors

Joey owns a small chemical plant called Chemco. Chemco, despite the effects of the recent recession, is doing fine. They are doing so well, in fact, that they have excess cash. Chemco decides to look for a suitable investment for the free cash flow of the company.

The next day Joey attends his trade organization meeting. At this meeting he meets the CEO of Chemicalventures, his main competitor to Chemco. They resolve to set aside their differences and meet for lunch. At this lunch meeting, Joey finds out that Billy has decided to sell Chemicalvenutres and wonders if Chemco would be interested in purchasing Chemicalventures. Billy assures Joey that the investment will be worth his time and effort.

Joey, the next day, contacts his board of directors. The board of directors of Chemco is interested in the idea as long as it is financed with debt. First, however, they require the financials of the company as well as the adjusted present value of the deal.

Joey talks to Billy, who sends the company financials over to Joey. Joey begins his preliminary research by Googling “adjusted present value calculator”. Unsatisfied with what he sees, Joey sends the Chemicalventures financials over to his top financial analyst.

The analyst performs this calculation based on the Chemicalventures financials:

If…

Investment = \$500,000

Cash flow from equity = \$25,000

Cost of equity = 20%

Cost of Debt = 7%

Interest on debt = 7%

Tax = 35%

And the deal is financed half with equity and half with debt.

Then…

NPV = -\$500,000 + (\$25,000 / 20%) = -\$375,000 PV = (35% x \$250,000 x 7%) / 7% = \$87,500

-\$375,000 + \$87,500 = -\$287,500 –> Bad Deal

Joey is pleased to find these results because they have saved him from making a poor business decision. He contacts Billy to tell him that, unfortunately, Chemco can not purchase Chemicalventures.

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# Agency Costs Definition

The agency costs definition is the internal costs incurred from asymmetric information or conflicts of interest between principals and agents in an organization.

In a corporation, the principals would be the shareholders and the agents would be the managers. The shareholders want the managers to run the company in a way that maximizes shareholder value. Conversely, the managers may want to run the company in a way that maximizes the managers’ own personal power or wealth, even if it lowers the market value of the company. These divergent interests can result in agency costs. There are three common types of agency costs: monitoring, bonding, and residual loss.

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## Types of Agency Costs

When the principals attempt to monitor or restrict the actions of agents, they incur. Learn about the types of agency costs below:

### Monitoring Costs

For example, the board of directors at a company acts on behalf of shareholders to monitor and restrict the activities of management. This is to ensure that behavior maximizes shareholder value. The cost of having a board of directors is therefore, at least to some extent, considered an agency monitoring cost. Costs associated with issuing financial statements and employee stock options are also monitoring costs.

### Bonding Costs

Furthermore, an agent may commit to contractual obligations that limit or restrict the agent’s activity. For example, a manager may agree to stay with a company even if the company is acquired. The manager must forego other potential employment opportunities. Consider that implicit cost an agency bonding cost.

### Residual Losses

Residual losses are the costs incurred from divergent principal and agent interests despite the use of monitoring and bonding.

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## Activity Based Cost Allocation

Implementing Activity Based Costing

# Activity Based Cost Allocation

Let’s dig into activity based cost allocation. But first, we need to note that not all the allocation methods are based on the “cause and effect” concept. This is important because CEOs and other managers need to know what the real cost of a product or service is. Once that is known, two other considerations need to be addressed:

## Allocating Costs to Maximize Profits

The first question you need to ask is whether or not on any of the products or services have a negative income (after allocated fixed manufacturing costs). If so, the next question if whether or not eliminating/discontinuing those products or services will result in loss of profit. In other words, is any of your client’s other income a result of carrying that product or service? Or is there some other product or service that can replace that income source and increase profitability? If so, then eliminate the product or service so that you can increase the overall profitability.

If the answer is “no,” then you need to take a different approach. This approach involves assigning/allocating costs based on the ability to bear costs or some other equitable method. The goal for these methods is to keep the Board happy; so, the firm does not show any products or services that are losing money.  In addition, these methods need to find another way to maximize profit by incentivizing the sales staff to sell certain products. Accomplish this by allocating overhead in such a way that each sales person’s bonus or commission is tied to the products or services that maximize profit for the firm.