Question 1 (10 marks) What is the main reason that an agency relationship exists

Question

Question 1 (10 marks) What is the main reason that an agency relationship exists in the corporate form of business organisations? What kinds of agency problems may arise and how are they resolved? Question 2 (20 marks) You have just purchased a life insurance policy that requires you to make 40 semiannual payments of $350 each, where the first payment is due in 6 months. The insurance company has guaranteed that these payments will be invested to earn you an effective annual rate of 8.16 percent, although interest is to be compounded semiannually. At the end of 20 years (40 payments), the policy will mature. The insurance company will pay out the proceeds of this policy to you in 10 equal payments, where the first payment to be made one year after the policy matures. If the effective interest rate remains at 8.16 percent, how much will you receive during each of the 10 years?

Explanation / Answer

The relationship between stockholders and management is called an agency relationship.it exists when principal hires agent to express their interests.

The agency problem arises due to the separation of ownership and control of business firms.

Let us understand with an example

Suppose we hire an agent to sell car and agree to pay a flat fee when he or she sells the car. The agent's tries only to sell car to get incentive and his motive is not to get the best price.

The above problem can be resolved by offering commission rate of 10 percent of the sales price instead of a flat fee.Then this problem might not exist. So agency compensated is major factor that affects agency problems.

Given an effective annual rate of 8.16%, the periodic rate can be calculated as: i PER = (1.0816) 1/2 - 1.0 = 4%

FV = [$350][FVIFA 4%,40 ] = $33, 259

PV = $ 33,259 , I=8.16, N=10

This amount is then to be paid out over a 10-year period.

Since the first payment begins one year later, you may continue to treat this as a regular annuity.

This implies that: $33,259 = [PMT][PVIFA 8.16%,10 ] = [PMT][6.6619247] => [PMT] = [$33,259]/[6.6619247] = $4,992.40

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