1.

Three instances where serious principal-agent problems arise are as follows:

between shareholders and managers where former are principals and latter are agents.
The shareholders are interested in maximizing returns, while the managers want stability
of business so they tend to take up lesser risk. Since both of them pursue their personal
interests, conflict may arise in the firm.
between majority and minority shareholders. The majority shareholders are the
controlling owners whereas the minority shareholders are the non-controlling owners
of the firm, hence the latter may feel the risk of not being able to exercise their rights in
the firm. Here the minority shareholders are the principal, whereas the majority
shareholders are agents.
between the firm itself (or the owners) and the contractual parties. The firm, acts as an
agent and needs to assure the contractual parties (the principal in this case) that there will
no opportunistic behavior from its end.
These misgivings leads to inability of the involved parties to act collectively, thus giving rise to
agency costs. Being a member of the board of the company, I would do my best to minimize the
costs and maximize profits for my firm. For this I will have to put in place appropriate
safeguards to prevent such problems from arising. Therefore, I will strategize at the regulatory as
well as governance level to promote trust and fairness in the company. The regulatory
mechanism will ensure that the agents actions are directed by the firms policies and governance
principles will establish control over the principals.

2. The four methods for investment appraisal are as follows:

Net Present Value (NPV)
Internal Rate of Return (IRR)
Accounting Rate of Return (ARR)
Payback period

To understand each of the above mentioned methods we take an example of a project with
following set of cash flows and assume a 10% expected rate of return
Years
Cash flow

100,000

30,000

45,000

25,000

50,000

35,000

The NPV is the amount of cash inflows in excess of gas outflows discounted at a rate of expected
return. In this case NPV will be calculated as follows
NPV = ((30,000/(1+0.1)^1) + (45,000/(1+0.1)^2) + (25,000/(1+0.1)^3) + (50,000/(1+0.1)^4) +
(35,000/(1+0.1)^5) -(100,000/(1+0.1)^0))
NPV = 39,231
When NPV > 0, we accept the project

IRR is the rate of return at which NPV equals zero. We calculate IRR as follows:
((30,000/(1+ r)^1) + (45,000/(1+ r)^2) + (25,000/(1+r)^3) + (50,000/(1+r)^4) + (35,000/(1+r)^5)
-(100,000/(1+r)^0)) = 0
Solving for r we get 24% (approximately), which exceeds the expected rate of return. Hence as
per IRR as well, this project is profitable.

ARR is the ratio of excess inflows and initial investment. This method does not consider
discounted cash flows and is given by:
(30,000+45,000+25,000+50,000+35,000)-(100,000)

100,000
Therefore we get, ARR = 85%.

Payback is the simplest method which calculates the number of years in which the project will
recover the initial investment. This method does not take into account the discounted values.
Years

Cash flow

-100,000

30,000

45,000

25,000

50,000

35,000

Cumulative
cash flow

-100,000

30,000

75,000

100,000

150,000

185,000

Investment
outstanding

-100,000

-70,000

-25,000

Hence we see that project payback period is three years. Generally, the lesser the payback period,
the better the project is considered. However, there are no set standards for accepting or rejecting
a project on the basis of this method. One main drawback of this method is that it doesn't
consider cash flows after the payback period is complete.

References:

Armour J., Hansmann H., & Kraakman R. (2009) Agency problems, legal strategies and
enforcement The Social Science Research Network Electronic Paper Collection, pp 1-19