What Are Affiliated Companies?

Companies are affiliated when one company is a minority shareholder of another. In most cases, the parent company will own less than a 50% interest in its affiliated company. Two companies may also be affiliated if they are controlled by a separate third party. In the business world, affiliated companies are often simply called affiliates.

The term is sometimes used to refer to companies that are related to each other in some way. For example, Bank of America has many different affiliated companies including Bank of America, U.S. Trust, Landsafe, Balboa, and Merrill Lynch.

Companies may be affiliated with one another to get into a new market, to maintain separate brand identities, to raise capital without affecting the parent or other companies, and to save on taxes. In most cases, affiliates are associates or associated companies, which describes an organization whose parent has a minority stake in it.

Understanding Affiliated Companies

There are several ways companies can become affiliated. A company may decide to buy out or take over another one, or it may decide to spin off a portion of its operations into a new affiliate altogether. In either case, the parent company generally keeps its operations separate from its affiliates. Since the parent company has a minority ownership, its liability is limited, and the two companies keep separate management teams.

Affiliates are a common way for parent businesses to enter foreign markets while keeping a minority interest in a business. This is especially important if the parent wants to shake off its majority stake in the affiliate.

There is no single bright-line test to determine if one company is affiliated with another. In fact, the criteria for affiliation changes from country to country, state to state, and even between regulatory bodies. For instance, companies considered affiliates by the Internal Revenue Service (IRS) may not be considered affiliated by the Securities and Exchange Commission (SEC).

Affiliates Versus Subsidiaries

An affiliate is different from a subsidiary, of which the parent owns more than 50%. In a subsidiary, the parent is a majority shareholder, which gives the parent company’s management and shareholders voting rights. Subsidiary financials may also appear on the parent company’s financial sheets.

But subsidiaries remain separate legal entities from their parents, meaning they are liable for their own taxes, liabilities, and governance. They are also responsible for following the laws and regulations where they are headquartered, especially if they operate in a different jurisdiction from the parent company.

An example of a subsidiary is the relationship between the Walt Disney Corporation and sports network ESPN. Disney owns an 80% interest in ESPN, making it a majority shareholder. ESPN is its subsidiary.

SEC Rules Surrounding Affiliates

Securities markets around the world have rules that concern affiliates of the businesses they regulate. Here again, these are complex rules that need to be analyzed by local experts on a case-by-case basis. Examples of rules enforced by the SEC include:

• Rule 102 of Regulation M prohibits issuers, selling security holders, and their affiliated purchasers from bidding for, purchasing, or attempting to induce any person to bid for or purchase, any security which is the subject of a distribution until after an applicable restricted period has passed.
• Before disclosing nonpublic personal information about a consumer to a nonaffiliated third party, a broker-dealer must first give a consumer an opt-out notice and a reasonable opportunity to opt out of the disclosure.
• Broker-dealers must maintain and preserve certain information regarding those affiliates, subsidiaries, and holding companies whose business activities are reasonably likely to have a material impact on their own finances and operations.

Tax Consequences of Affiliates

In nearly all jurisdictions, there are important tax consequences for affiliated companies. In general, tax credits and deductions are limited to one affiliate in a group, or a ceiling is imposed on the tax benefits that affiliates may reap under certain programs.

Determining whether companies in a group are affiliates, subsidiaries, or associates is done through a case-by-case analysis by local tax experts.

What Is the Annual Equivalent Rate (AER)?

The annual equivalent rate (AER) is the interest rate for a savings account or investment product that has more than one compounding period. AER is calculated under the assumption that any interest paid is included in the principal payment’s balance and the next interest payment will be based on the slightly higher account balance.

The AER method means that interest can be compounded several times in a year, depending on the number of times that interest payments are made.

AER is also known as the effective annual interest rate or the annual percentage yield (APY).

The AER is the actual interest rate that an investor will earn for an investment, a loan, or another product, based on compounding. The AER reveals to investors what they can expect to return from an investment (the ROI)—the actual return of the investment based on compounding, which is more than the stated, or nominal, interest rate.

Assuming that interest is calculated—or compounded—more than once a year, the AER will be higher than the stated interest rate. The more compounding periods, the greater the difference between the two will be.

Formula for the AER


$\begin{aligned} &\text{Annual equivalent rate}=\left(1 + \frac{r}{n}\right)^n-1\\ &\textbf{where:}\\ &n=\text{The number of compounding periods (times per year interest is paid)}\\ &r = \text{The stated interest rate}\\ \end{aligned}$​Annual equivalent rate=(1+nr​)n−1where:n=The number of compounding periods (times per year interest is paid)r=The stated interest rate​

How to Calculate the AER

To calculate AER:

1. Divide the stated interest rate by the number of times a year that interest is paid (compounded) and add one.
2. Raise the result to the number of times a year that interest is paid (compounded)
3. Subtract one from the subsequent result.

The AER is displayed as a percentage (%).

Example of AER

Let’s look at AER in both savings accounts and bonds.

For a Savings Account

Assume an investor wishes to sell all the securities in their investment portfolio and place all the proceeds in a savings account. The investor is deciding between placing the proceeds in Bank A, Bank B, or Bank C, depending on the highest rate offered. Bank A has a quoted interest rate of 3.7% that pays interest on an annual basis. Bank B has a quoted interest rate of 3.65% that pays interest quarterly, and Bank C has a quoted interest rate of 3.7% that pays interest semi-annually.

Therefore, Bank A would have an annual equivalent rate of 3.7%, or (1 + (0.037 / 1))¹ – 1. Bank B has an AER of 3.7% = (1 + (0.0365 / 4))⁴ – 1, which is equivalent to that of Bank A even though Bank B is compounded quarterly. It would thus make no difference to the investor if they placed their cash in Bank A or Bank B.

On the other hand, Bank C has the same interest rate as Bank A, but Bank C pays interest semi-annually. Consequently, Bank C has an AER of 3.73%, which is more attractive than the other two banks’ AER. The calculation is (1 + (0.037 / 2))² – 1 = 3.73%.

With a Bond

Let’s now consider a bond issued by General Electric. As of March 2019, General Electric offers a noncallable semiannual coupon with a 4% coupon rate expiring Dec. 15, 2023. The nominal, or stated rate, of the bond, is 8%—or the 4% coupon rate times two annual coupons. However, the annual equivalent rate is higher, given the fact that interest is paid twice a year. The AER of the bond is calculated as (1+ (0.04 / 2 ))² – 1 = 8.16%.

Annual Equivalent Rate vs. Stated Interest

While the stated interest rate doesn’t account for compounding, the AER does. The stated rate will generally be lower than AER if there’s more than one compounding period. AER is used to determine which banks offer better rates and which investments might be attractive.

Advantages and Disadvantages of the AER

The primary advantage of AER is that it is the real rate of interest because it accounts for the effects of compounding. In addition, it is an important tool for investors because it helps them evaluate bonds, loans, or accounts to understand their real return on investment (ROI).

Unfortunately, when investors are evaluating different investment options, the AER is usually not stated. Investors must do the work of calculating the figure themselves. It’s also important to keep in mind that AER doesn’t include any fees that might be tied to purchasing or selling the investment. Also, compounding itself has limitations, with the maximum possible rate being continuous compounding.

Special Considerations

AER is one of the various ways to calculate interest on interest, which is called compounding. Compounding refers to earning or paying interest on previous interest, which is added to the principal sum of a deposit or loan. Compounding allows investors to boost their returns because they can accrue additional profit based on the interest they’ve already earned.

One of Warren Buffett’s famous quotes is, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” Albert Einstein reportedly referred to compound interest as mankind’s greatest invention. 

When you are borrowing money (in the form of loans), you want to minimize the effects of compounding. On the other hand, all investors want to maximize compounding on their investments. Many financial institutions will quote interest rates that use compounding principles to their advantage. As a consumer, it is important to understand AER so you can determine the interest rate you are really getting.

What Is an Agency Problem?

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In corporate finance, an agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize their own wealth.

Understanding Agency Problems

The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as possible, they are given the responsibility to perform in whatever situation results in the most benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example, the plumber may make three times as much money by recommending a service the agent does not need. An incentive (three times the pay) is present, causing the agency problem to arise.

Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal’s or client’s best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court’s assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

Minimizing Risks Associated With the Agency Problem

Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.

Regulations

Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients’ interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest.

For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client’s best interest.

Incentives

The agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal’s best interests. For example, a manager can be motivated to act in the shareholders’ best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing, or the threat of takeovers.

Principals who are shareholders can also tie CEO compensation directly to stock price performance. If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem. However, if the CEO was compensated based on stock price performance, the CEO would be incentivized to complete the takeover. Stock prices of the target companies typically rise as a result of an acquisition. Through proper incentives, both the shareholders’ and the CEO’s interests would be aligned and benefit from the rise in stock price.

Principals can also alter the structure of an agent’s compensation. If, for example, an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.

Real-World Example of an Agency Problem

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. The company’s executives used fraudulent accounting methods to hide debt in Enron’s subsidiaries and overstate revenue. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings.

In the four years leading up to Enron’s bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron became the largest U.S. bankruptcy at that time with its $63 billion in assets. Although Enron’s management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.

What Is Agency Theory?

Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents.

Understanding Agency Theory

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect the principal financially are made by the agent, differences of opinion, and even differences in priorities and interests, can arise. Agency theory assumes that the interests of a principal and an agent are not always in alignment. This is sometimes referred to as the principal-agent problem.

By definition, an agent is using the resources of a principal. The principal has entrusted money but has little or no day-to-day input. The agent is the decision-maker but is incurring little or no risk because any losses will be borne by the principal.

Financial planners and portfolio managers are agents on behalf of their principals and are given responsibility for the principals’ assets. A lessee may be in charge of protecting and safeguarding assets that do not belong to them. Even though the lessee is tasked with the job of taking care of the assets, the lessee has less interest in protecting the goods than the actual owners.

Areas of Dispute in Agency Theory

Agency theory addresses disputes that arise primarily in two key areas: A difference in goals or a difference in risk aversion.

For example, company executives, with an eye toward short-term profitability and elevated compensation, may desire to expand a business into new, high-risk markets. However, this could pose an unjustified risk to shareholders, who are most concerned with the long-term growth of earnings and share price appreciation.

Another central issue often addressed by agency theory involves incompatible levels of risk tolerance between a principal and an agent. For example, shareholders in a bank may object that management has set the bar too low on loan approvals, thus taking on too great a risk of defaults.

Reducing Agency Loss

Various proponents of agency theory have proposed ways to resolve disputes between agents and principals. This is termed “reducing agency loss.” Agency loss is the amount that the principal contends was lost due to the agent acting contrary to the principal’s interests.

Chief among these strategies is the offering of incentives to corporate managers to maximize the profits of their principals. The stock options awarded to company executives have their origin in agency theory. These incentives seek a way to optimize the relationship between principals and agents. Other practices include tying executive compensation in part to shareholder returns. These are examples of how agency theory is used in corporate governance.

These practices have led to concerns that management will endanger long-term company growth in order to boost short-term profits and their own pay. This can often be seen in budget planning, where management reduces estimates in annual budgets so that they are guaranteed to meet performance goals. These concerns have led to yet another compensation scheme in which executive pay is partially deferred and to be determined according to long-term goals.

These solutions have their parallels in other agency relationships. Performance-based compensation is one example. Another is requiring that a bond is posted to guarantee delivery of the desired result. And then there is the last resort, which is simply firing the agent.