c1 solution

7/30/2019 C1 Solution

1/12

Case1-Solution/expectedanswers

Part1

Questions1to5

Thecorrectanswersareasfollows:

1.Numberofsubsidiariesinthegroup 456

2.PercentageofcontrolMacKenzieInvestmentforFutureWorldhasover

SwordCom66%

3.MacKenzieInvestmentforFutureWorld'sdividendrightsinSwordCom 6.25%

4.MacKenzieInvestmentforFutureWorld'scashflowrightsinAZ-

Connect8.25%

5.MacKenzieInvestmentforFutureWorld'svotingrightsinAZ-Connect 66%

Explanations

MacKenzieInvestmentforFutureWorldiscomposedof:

6 first level subsidiaries, each of which has on average 3 subsidiaries (second level

subsidiaries). Each of the latter has on average 4 subsidiaries. Each of the third level

subsidiaries has 5 direct participations in other firms considered to be subsidiaries. The

groupisthuscomposedof=6+6*3+6*3*4+6*3*4*5=456subsidiaries.

SwordComisa4thlevelsubsidiaryfullycontrolledbySonCo(whichowns75%ofthevoting

rightsinSwordCom).SonCoisitselffullycontrolledbyPandoraGroupwhichowns70%of

thevoting rights inSonCo.Pandora isfully controlledbyMK-Tekwhichowns58%ofthe

votingrightsinPandora.Andfinally,MK-TekisfullycontrolledbyMKIFWwhichowns66%of

the voting rights inMK-Tek.Aswritten in technical document1 Voting rightswork asa

binomialtransfer.Whentheshareholderhasmorethan50%ofthevotingrightsinalevel

onesubsidiary,hecontrolsfullythedecisionsinthesecondlevelsubsidiaryinwhichthefirst

level subsidiaryhas amajoritystake. ThusMKIFWhas a66% ofcontrol overSwordCom

becauseMKIFWhas66%ofvotingrightsinMK-Tek.ForthesamereasonsMKIFWhasa66%

ofcontroloverAZ-Connect.


2/12

Therighttodividendiscomputedonthepercentageofownership.InthecaseofSwordCom,

MKIFWsdividendrightsisequalto50%*50%*50%*50%=6.25%

Similarly,MKIFWscashflowrightsinAZ-Connectamountto50%*50%*33%=8.25%

Question6

Correctanswersareasfollows:

Pyramidalstructuresareawayforshareholderstoeffectivelycontrolafirm[with/without]

baringthe[financial/operational/managerial]costofcontrol.A[cascade/shower/

nebula]ofparticipationsisattheheartofpyramidalstructures.

IntherealestatebranchoftheMKIFWGroup,forexample,theheadholding(MKIFW)owns

50%ofthesharesand60%ofthevotingrightsinMKRealEstate.MKRealEstateowns50%

ofthesharesofDrumpConstructionand75%ofitsvotingrights,andDrumpConstruction

owns50,001%ofthesharesandvotingrightsinMortarInc.ItthusfollowsthatMKIFWowns

[12.5%/60%/22.5%/25%]ofMortarInc,whileitcontrols[noneof/allof/onlyoneof]

the3companies.AsMortarInchasnodebt,itsdevelopmentmusthavebeenfinanced

predominantlyby[MKIFW/outsideinvestors].MKIFWhasarightfor[60%/75%/12.5%/

22.5%]ofthecashflowsgeneratedbyMortarInc.Sucha[difference/similarity]between

ownershiprightsandcontrolcreatesincentivesforthemajorityshareholdersto

[manipulate/accept/decrease]thepricesatwhichgoodsandservicesaresoldfromone

companytoanother.Theheadholdingofthepyramidalstructurehasindeedanincentiveto

maintainalowprofitabilityin[higher/lower]levelsubsidiariesandtoincreasetheprofitsof

[higher/lower]leveloneswheretheirparticipationandthentheiraccesstocashflowsis

[higher/smaller].AsfarasMKIFWisconcerned,suchasituation[cannot/may]happenas

theGroup'sproceduresmanual[is/isnot]subjecttovariousinterpretationswhenitcomes

toorganizingbusinessrelationsbetweenthefirmswithinthegroup.Theproceduresinthe

Group[should/shouldnot]berevisedsoastoavoidsuchcases.

Dualclasssharesare[thesynonymof/contraryto/inlinewith]theoneshareonevote

principlewhichisusuallyconsideredtobeagoodcorporategovernanceprinciple.When

firmswithdualclasssharesraisecapital,theirinitialshareholdersareprotectedfromapotential[relutive/dilutive/expensive]effectonthecontroltheyhaveonthecompany

Explanations

Thetextsimplyrephrasesthecontentoftechnicaldocuments.

Tech doc 1 states that The shareholding structure of the different subsidiaries of the

holding is complex. This subsidiary cascade has enabled the Group to grow quicker by

accepting other stakeholders at different levels. Such a cascade creates indeed a


3/12

discrepancybetweenownershipandcontrolanditbecomespossibletocontrola firmwith

muchlessmoneythanwhatwouldbenecessaryviaadirectcontrol.

As in previous questions, the computations on ownership have to be done through the

percentage of shares while control depends on the voting rights. MKIFW owns

50%*50%*50%=12.5% ofMortar. But ithas effective control over the three companies

thankstoits60%ofvotingrightsinMKRealEstatewhichhas75%votingrightsinDrump.

And Drump has more than 50% of the voting rights in Mortar Inc. There is indeed a

significant discrepancy between ownership and control which could be an incentive to

manipulate prices and organise cash flow transfers from one subsidiary to another. The

grouphasanincentivetotransferprofitstothehigherlevelsubsidiarieswhereitscashflow

rights are higher. Refer to the quotation ofPr. KuDair intechnical documentfor further

explanations.

Technicaldocument2(BookofInternalprocedures)statesthatInthehigherinterestofthe

Group, and to support a true integration between the subsidiaries, when two firms

belonging to the Grouphave business relations and exchangeproductsand services, the

prices atwhichsuch transactions are conducted should be fixedsoastobuildprivileged

relationsinsidetheGroup.Suchasentenceisparticularlyunclearandleavessomespace

fordoingalmostwhateverispossible.

Dualclasssharesseparateownershipandcontrol.Theyarethusbydefinitioncontrarytothe

one share one vote principle. They protect historical shareholders from diluting their

control on the company, as the latter remains unchanged when the firm issues shareswithoutvotingrights.

Question7

Correctanswersareinthetablebelow:

Right Wrong

AccordingtoMKIFW'sprocedures,afirmintheGroupcannot

investmorethan1,000,000Acesifitisnotincludedex-anteintheannualinvestmentplan

x

Dualclasssharesaredevicesenforcinggoodcorporate

governancepractices x

Son-Co'sinvestmentinSwordComwaswithcertainty

monitoredbyPandoraGroupbeforetheinvestmentwas

realizedinSon-Co'sannualinvestmentplan

x

Differencesbetweenvotingrightsanddividendrightscreatean

incentivetomoveprofitsfromonepartofaconglomeratetoanother x


4/12

1.Levelonesubsidiariesmaymakeunplannedinvestmentsofupto2millionAceswhichdo

nothavetobeincludedintheannualinvestmentplan

2.&4. The separation of ownership and control gives incentives for tunnelling within the

corporation,thus,thispracticedoesnotenforcegoodcorporategovernancepractices.

3.SonCosinvestmentsintoSwordComhavebeenlessthan500,000everyyear(Technical

document 3), so it is possible that these investments were not included in the annual

investmentplanandwerenotmonitoredandapprovedbyPandora.

Part2

Questions1&2

Correctanswersareinthetablesbelow:

Year1 Year2 Year3 Year4 Year5

DeterminetheNOIforthefirst5years 492,000 519,120 553,790 570,403 587,516

DeterminetheNetIncomeforthefirst5

years-19,600 -616 23,653 35,282 47,261

DeterminetheAvailablecashflowfor

thefirst5years180,400 199,384 223,653 235,282 247,261

Determinethepaymenttothebankinyear3 320,000 Aces

Determinetheterminalvalueofthebuildingattheendofyear5 7,119,307 AcesDeterminethevalueofthebuildingbasedontheDCFapproach 5,231,574 Aces

NPVforDrumpConstruction 2,747,889Aces

Explanations

Togettheresult,followcarefullythemethodologygiveninthetechnicaldocumentcalled

RealEstateFinanceinanutshell.

NetOperatingIncomecalculation

Year 1 2 3 4 5 6

GrossIncomePotential 600,000 618,000 636,540 655,636 675,305 695,564

Occupancyrate 85% 87% 90% 90% 90% 90%

Totaloperatingexpenses 18,000 18,540 19,096 19,669 20,259 20,867

NOI 492,000 519,120 553,790 570,403 587,516 605,141


5/12

Tobeginthecomputations,onehastotakeintoaccountthefiguresgiveninthetechnical

documentcalledCharacteristicsofthetransaction.

TheGrossPotentialIncomeforthenextyear(Y1)is600,000andwillgrowat3%perannum(rentalpricegrowth),thus,thepotentialincomeinyear2is600,000*1.03=

618,000etc.tillyear6

Theoccupancyrateis85%forY1,87%forY2and90%thereafter Thenon-recoverableoperatingexpensesare18,000forY1andwillgrowat3%per

annum(sameasrentalgrowth),thus, totalexpensesfor year2are 18,000*1.03=

18,540etc.tillyear6

The net operating income is equal to (Potential Income x Occupancy rate Operating

expenses).

NetIncomecalculation Year 1 2 3 4 5

NOI 492,000519,120553,790570,403587,516

Depreciation 200,000200,000200,000200,000200,000

EBIT 292,000319,120353,790370,403387,516

PaidInterests 320,000320,000320,000320,000320,000

EBT -28,000 -88033,79050,40367,516

Taxes -8,400 -26410,13715,12120,255

NetIncome -19,600 -61623,65335,28247,261

Thebuildingisdepreciatedlinearlyover20years,thus,theannualdepreciationexpenses

equal4,000,000/20=200,000Aces.

Astheloanisaninterestonlyloan,thepaymenttothebankeveryyear(asinyear3),is

equaltotheamountborrowedtimestheinterestrate=4,000,000*8%=320,000Aces.

DrumpConstructionsprofitswillremainover12millionAcesoverthenextfiveyears,while

Mortar Inc.s profits will remain above 4 million Aces. Drump Construction will remain

profitableevenoncetheofficebuildinghasbeenbought.Thus,the30%taxrateappliesto

earningsfromthisbuilding.WhenEBTisnegative,thefirmhasataxsaving(negativetaxes)

onthesameyearofthenegativeEBT,thesavingisnotcarriedforwardbecausetheentire

company(Drump)willrealizethesavingfromthisprojectrightaway.


6/12

NetIncomeisequaltoNOIminusthedepreciation,interestexpensesandtaxes.

AvailableCashFlowcalculation

Year 1 2 3 4 5

NetIncome -19,600 -61623,65335,282 47,261

Depreciation 200,000200,000200,000200,000 200,000

Mortgagerepayment - - - - -

AvailableCashFlow 180,400199,384223,653235,282 247,261

TheAvailableCashFlowisequaltoNetIncome+depreciation-principalmortgagepayment.

Note that thisbuildinghasnotbeenboughtwithamortgage the companyhas takena

bankloantofinancetheconstructionofthebuilding.Thus,thebankloanrepaymentisnot

accounted for in the Available Cash Flow, but it has to be considered as an investment

expenseintheNPVcalculation.

Terminalvaluecalculation

WiththeNOIapproach,theterminalvalueisequalto:

!! =!"#!!!

! ! + !

Applyingthisformulaattheendofyear5withthefollowinginputs:

Y6NOI 605,141

CapitalisationRate(R) 10%

Depreciationrate(d) 0.50%

LongtermGrowthrate(G) 2%

givesafinalterminalvalueof7,119,307Aces.

BuildingsvalueandNPVcalculation

CashFlows Year 1 2 3 4 5

CFfromOperations

180,400

199,384

223,653

235,282 247,261

TerminalValue

7,119,307

Total 180,400

199,384

223,653

235,282 7,366,568

Costofcapital(discountrate) 10%

DiscountedCF 164,000 164,780 168,034 160,701 4,574,059

Valueofthebuilding 5,231,574Aces


7/12

CFfromInvestment -4,000,000

DiscountedCFfrominvestment -2,483,685

NPVforDrumpConstruction 2,747,889Aces

ThevalueofthebuildingbasedontheDCFapproachisthesumofthediscountedcashflows

and the discounted terminal value and amounts to 5,231,574 Aces. The cash flows are

discountedattheappropriatecostofcapitalwhichhereis10%.

The NPV for DrumpConstruction from investing into this building is simply equal to the

Valueofthebuildingminusthepresentvalueoftherepaymentofthebankloan:(5,231,574

4,000,000/1.10^5)=2,747,889Aces.

ThecomputedNPVfortheprojectisavaluenotaprice.Thisvalueisthevaluetotheowner

ofthebuildingandsimplysummarizesallthevaluecreatedfromoperatingthebuilding.To

getthevalueoftheprojectitthuswouldbewrongtoremovetaxesoncapitalgainfromthe

terminal value. These taxeswouldbe paid if andonly if thebuilding is sold,which is an

additionalassumptionthatthebusinesscasedoesnotmake.

Question3&4

MKRealEstateowns25% (50%*50%)ofMortar Inc throughDrumpConstructionandhas

50%of the cash flow rights inDrumpConstruction. The transferof the buildingand the

connectedbankloanfromMortartoDrumpConstructionmeansa25%(50%-25%)increase

intheownershipofthebuildingandloan(theNPVoftheproject)toMKRealEstate.

The gain in value from the transfer of the building forMK-Real Estate is thus equal to

25%*2,747,889=686,972Aces.

TheminorityshareholdersofMortarInchavea50%participationinthecompany,thusalso

inthebuildingandtheloan.Withthetransfer,theywilllosetheownershipintheproject

(totalNPV)whichleadstoalossinvalueof50%*2,747,889= 1,373,944Aces.Asthepriceof

thebuildingisfarfromitsvalue(4millionvs5.23million),thisoperationmaybeconsidered

astunnelingdescribedbyasituationinwhichThemanagersofalowerlevelsubsidiarymay

beforcedtoselltheirproductstoahigherlevelparentcorporationsoastotransferthecashflowsand profits fromone company toanotheror whena subsidiary sellsanasset to

anotheratanunfairpriceaswritteninthetechnicaldocuments.


8/12

Part3

Question1

PercentagechangeinEPS -7.41%

According to the technical document Incentives for the executives, MK-Tek has 100

million outstanding shares. The stock option plan would create 8million new shares if

exercisedandtheexpectedprofitfornextyearis554millionAces.

Ifalloptionsareexercised,thetotalnumberofshareswouldjumpfrom100to108millions

whileMK-Teksprofitsremainunchangedat554millionAces.

Thus,EPSwoulddropfrom554/100=5.54Acespershareto554/108=5.13Acespershare

whichisadropof7.41%(5.13/5.54-1=-7.41%).

Question2


Right Wrong

Agencyproblemsstemfromthefactthatthemanagersactionsare

unobservabletotheshareholdersx

Executiveshaveaninterestinfixingahighthresholdfortheindicatorwhich

determinestheirbonus x

Abonusisaforwardlookingincentivedevice

x

Thethresholdforbonusesisknownasthestrikeprice xIfanexecutivemakesmoneywhenexercisinghis/heroptionsthenthe

optionisoutofthemoney x

ThecostoftheMKTek'sstockoptionplanisequaltotheprofitsmadeby

themanagementwhenexercisingtheiroptionsandsellingtheirshareson

themarket

x

Stockoptionsalwaysfavorlongtermdecisionmakingbythemanagement

x

Stockoptionsareabackwardlookingincentivedevice

x

AnswersstemfromthetechnicaldocumentIncentivesfortheexecutives.

1.EveniftheshareholdersownthefirmandnominatethemembersoftheBoard,which

controlsthemajordecisions,theycanneitherobservethebehaviorofthemanagersnor

controltheirdailyactionsanddecisions.

2.AsThekeyquestiontodeterminethebonusisthethresholdwhichmustbecrossedfor

anexecutivetogethis/herbonusexecutiveshaveclearincentivestofixalowthreshold.

3.Thedocstatesthatthebonusworksasacompensationforpastrealizedperformanceof

thecompany.


9/12

4.Thestrikepriceisthepriceatwhichoptionsmaybeexercised.Ithasnothingtodowith

thethresholdforbonuses.

5.Tomakemoneywhileexercisingoptions,thesharepricemustbehigherthanthestrike

price,thustheoptionhastobeinthemoney.

6.ThecosttoshareholdersofthestockoptionplanislinkedtoapotentialdilutionofEPS,

thecostmaybeevenhigheriftheplanleadstobaddecisiontakenbythemanagementof

thefirm.

7.&8.Toincreasestockprices,executiveofafirmmayhowevertakebaddecisionsforthe

future prospects of the firm like forgoing researchand developmentexpenses, or taking

decisions which are not favorable to the shareholders such as cropping the dividend

payments to support the growth of the stock price by retaining excess cash thus stock

optionmayfavorshorttermdecisionswhicharenotfavorabletothelongtermprospectsofthefirm.Inanycasesthesedecisionareforwardlooking,andstockoptionsbeingbasedon

futurestockvaluesareforwardlookingtoo.

Question3


Computetheaveragecompensationofthetop12executivesatMK-

Tek4.28

million

Aces

Consideringtheexercisepriceforlastyear'soptionsis68acesper

share,computetheaveragestockoptiongainforeachmanager384,000 Aces

Computethisaveragegainasapercentageoftheaveragetotal

patrimonyofthetop12executives2.345%

Computethechangeinthepreviousmeasure(averagestockoption

gainasapercentageofaveragetotalpatrimony)ifthestockprice

increasesby1Ace.

0.586%

Yes No

IsMK-Tek'sstockoptionplananefficientincentivedeviceforits

managers? x


10/12

Togettheseresultsonehastocomputetheaveragerevenues,theaveragetotalpatrimony

andthegainfromexercisingtheoptions.

Top 12executives

Compensation

Patrimony

TotalpatrimonyMain

residence

Other

RE

Assets

Securities Miscellaneous

A 6 6.40 2.20 11.20 0.60 20.4

B 5.8 7.50 2.60 10.70 0.90 21.7

C 5.4 8.80 2.80 10.90 1.20 23.7

D 4.2 5.50 1.90 9.80 1.50 18.7

E 4.1 3.20 1.40 9.40 1.70 15.7

F 4.05 4.70 1.20 9.50 0.80 16.2

G 4 3.60 1.30 9.30 1.1015.3

H 3.9 3.30 1.90 9.20 0.90 15.3

I 3.8 3.10 0.90 8.60 1.40 14.0

J 3.6 2.10 0.80 8.20 0.50 11.6

K 3.4 2.40 1.60 8.50 0.40 12.9

L 3.1 2.60 0.80 7.30 0.30 11.0

Mean 4.28 4.43 1.62 9.38 0.94 16.375

Stockoptiongainpermanager

Numberofstock-optionspermanager(1option=1share) 96,000

Strikeprice

68

Currentstockprice 72

Gainperoption(72-68) 4

Totalgainpermanager(4*96,000) 384,000

Theaveragegainasapercentageoftheaveragetotalpatrimonyofthetop12executivesis

thus384,000/16,380,000=2.345%.

Incaseofa1Aceincreaseinthestockprice,themarginalgainisequalto1*96,000whichdividedbytheaveragepatrimony(16.375millionAces)gives0.568%changeintheaverage

gainaspercentageofpatrimony.

FromthesetwofigureswecanconcludethatMK-Teksstockoptionplanisnotaneffective

incentivedeviceforitsmanagersasaccordingtoarecentstudybyPr.KuDair,whenthe

valueofthegainonstocksislessthan10%ofthetotalwealthforatopmanager,thenstock

optionsare avery limiteddevice tomotivatethatmanagerand toalignhis/her interests

withtheonesoftheshareholders.


11/12

Question4


Yes No

ZoeCallun,CFOofMacKenzieInvestmentforFutureWorld x

DougChan,FounderofMymusic x

MarkPo,FounderofWelovetennis.com x

HubertdelaTour,FounderofLarion x

WandaRodesandGaryUsher x

PatClon,CEOofFujiKo x

SebastianHunt,FounderofPayfriends.com x

According to technical documents, An outside member (or independent member) is a

memberoftheboardwhohashadnointerestinthecompanyoverthelastfiveyears.An

employeeoraformeremployeecannotbeconsideredasanindependentboardmember.

People who have been connected to the firm through business relations are not

independenteitherAsZoeCallun,DougChan,MakPoandSebastianHuntallhaveorhad

interestsinsubsidiariesofMKIFW,theycannotbeconsideredasindependent.Wandaand

GaryareemployeesofMKIFWandareconsequentlynotindependenteither.DelaTourand

Clon are the only really independent boardmembers: both Larion and Fujiko are 100%

familyownedandplayersinindustriesoutsideMKIFWsscope.

Question5Resultsareasfollows:

TheBoardofMKIFW[is/isnot]abidingbytherecommendationsoftheShweps

Commission.Asthekeymissionofanyboardisto[validate/monitor/agreewith]thetop

management'sdecisions,theboardissupposedtoworkinthe[shortterm/average/best]

interestoftheshareholders.Whenthenumberofindependentdirectorsis[nothighenough

/toohigh],itiseasyfortheCEOto[capture/reinforce/serve]theboard'smonitoring

duties.The[longlastingness/absence/depth]ofbusinesstieswiththefirmisakeycriteria

tobeconsideredasanindependentdirector.Butoneshouldwonderwhetherthisis

sufficientornot.Imagineadirectorsittingontheboardfor10yearsormorewiththesameCEO,onecouldclearly[doubt/confirm]thatnopersonallinkshavebeenbuiltwiththeCEO.

Independencehasthus[notonly/only]todealwiththenominationprocess.Consequently,

a[verylongterm/shortterm/openended]mandateisrecommendfortheindependent

directors.

ItisclearfromthepreviousquestionthatMKIFWdoesnotabidebytherecommendations

of the Scwheps commission which requires that at least 80% of board members are

independent.AsstatedinthetechnicaldocumentonMKIFWsboardofdirectorsAmong

thekeyresponsibilitiesoftheBoardishiringandevaluatingthefirmsexecutives,sothe

boardmonitorsthemanagementand even exert commandover themanagement. The


12/12

definition of independence set up by the Schweps Commission stresses the necessary

absence of business relations with the firm. Long lasting relations may create friendship

betweenmanagersandboardmembersanddecreasetheeffectivenessofcontrol.

Question6


EachsubsidiaryoftheGroupgathersitsBoardofdirectorsonaverage 1.184 timesayear

TheaveragelengthofaBoardmeetinglastyear

was 124.44 minutes

ForafirmwithinMKIFWabidingbytheGroup'srecommendations,

eachcompulsorysubjectisinpracticeatpresentaddressedon

averagefor

18.89 minutes

Howmuchtime,accordingtotheSchwepsCommission,shouldbe

devotedattheminimumtoeachsubjectontheagendainaBoard

meetingwith10members?

40.00 minutes

Yes No

Basedonthesemeasures,canweconsiderthattheBoardsofthe

subsidiariesintheMacKenzieInvestmentforFutureWorldGroup

havethemeanstoproperlyexerttheirresponsibilities? x

Explanations

AsThedifferentBoardsofdirectorsofthecompanieswithintheGroupmet540timeslastyear,spendingatotalof1,120hoursinthemeetingsandasMKIFWhas456subsidiaries

then

Each subsidiary of the Group gathered its Board of directors on average540/456=1.184timesayear.

TheaveragelengthofaBoardmeetinglastyearwas1,120/540*60=124.44minutestheGroupsrulesrecommendtodevoteatleast30minutesformiscellaneousissuesand

questionswhilethereare5compulsorysubjectsontheagendaoftheboardmeeting.This

leaves 124.44-30=94.44 minutes to be spent on the compulsory subjects, and thus

94.44/5=18.89foreachsubject.

The Schweps Commission recommends that in order tobe effective and to really exert

commandoverthemanagement,eachboardmembershouldhaveatleast4to5minutesto

commentanddiscusseachpointontheagendaofaboardmeeting,thus,aboardwith10

membersshouldspendatleast4*10=40minutesoneachsubjectontheagenda.Sincethis

is waymore than the average practice inMKIFW, the boards do nothave themeans to

properlyexerttheirresponsibilities.

c1 solution

Documents