Please check the attached file to see if you can answer the problems

FIN 305 Assignment 1 Due by 5pm Fri, Jan 27th The goal of this assignment is to help you understand certain situations in which the \"traditional\" corporate finance theory objective function (maximizing firm value) can go awry. By awry, I mean that projects might be accepted rationally, even though \"traditional\" corporate finance theory might indicate that the projects should be rejected. You have learned a primary tenet of \"traditional\" corporate finance theory, the net present value rule (NPV), in previous courses (and I have discussed this during lectures). Simply stated, the \"NPV rule\" says that if the project has positive net present value, then the project should be accepted (you are accepting a project that increases firm value). If the NPV of the project is negative, then the project should be rejected (you do not want to accept a project that decreases firm value). If the NPV = 0, then accepting or rejecting the project is of equal value, namely zero. Instructions: Circle the correct answers below. Also, please feel free to work with your classmates and/ or visit me for assistance. 1) Agency Problem: Assume that a project costs $5 million to implement. With 20% probability, the project will be worth $18 million. With 80% probability, the project will be worthless. For simplicity, assume that there is no time value of money here (or, alternatively, that the discount rate is zero). a) What is the NPV of this project, and should it be accepted or rejected based on the NPV? $3.6 million, accept -$1.4 million, reject $4 million, accept b) Now, also assume that the manager would receive a private benefit (such as memberships, travel, prestige, perquisites, etc.) in an amount that is worth $100,000 to him/her. Assume that the manager is not at risk to lose his/her job and owns no stock in the company. Would the manager accept or reject the project? Accept Reject Indifferent c) What is minimum amount of manager's stock ownership to align shareholder and managerial incentives (for this project)? 10% 7.143% 5.556% 12.25% FIN 305 Assignment 1 2) Shareholder - Debtholder Problem: Assume that a firm is worth $1,000. Debtholders hold claims to the first $900, and equity has claim to the remainder. Equity holders have an opportunity to invest in a project that costs $500 today, and with 40% probability, the project will be worth $1,000 tomorrow. With 60% probability, the project will be worthless tomorrow. Again, for simplicity, assume that there is no time value of money here. Also, for simplicity, assume that if the value of the project equals zero, then the project will not be undertaken. a) What is the NPV of this project, and should it be accepted or rejected based on the NPV? -$100, accept -$100, reject $140, accept $140, reject b) What is the value of this project to shareholders, and would they rationally accept or reject? -$100, accept -$100, reject $140, accept $140, reject c) Assume that the debtholders had negotiated a covenant based on a leverage ratio (here, Debt / Equity ratio) in the initial contract. Typically, the covenant would dictate the maximum amount of leverage that a company can assume. If the company's leverage ratio exceeds this mandate, then the company is in technical default (which is not good!). What is the maximum D/E ratio that would have aligned shareholder and debtholder incentives for this project? 3.50 2.75 2.50 2.00 d) Assume that instead, the debtholders had negotiated a covenant based on the maximum amount of investment (so, they set a maximum on the amount of investment, such as the $500 in project costs). Assume that the probabilities and returns are proportionate (so, 40% probability that you double your money, and 60% chance that you lose your investment). What is the maximum amount of investment into this type of project that would allow shareholder and debtholder incentives to be aligned (should be less than $500 in this instance)? $150 $200 $250 $300 FIN 305 Assignment 1 e) Your answer in part (d) above assumed a covenant based on this type of investment (namely, double your money with 40% chance, lose your money with 60% chance). What if the investment were to be like a highly risky \"lottery ticket?\" For instance, with a miniscule chance of winning big, and an extremely high likelihood of losing your investment. What is the maximum amount of investment into this type of project that would allow shareholder and debtholder incentives to be aligned? $100 $150 $200 $250 3) Managerial Compensation Schemes - Stock Options: We discussed in lecture that often times, shareholders prefer to compensate managers (CEO's, CFO's, CMO's, etc.) with stock and/or stock options along with some sort of \"fixed\" salary. We discussed how this type of compensation scheme helps \"make managers more like shareholders,\" and this aligns incentives (and helps with the principalagent problem). We also talked about the \"moneyness\" and maturity of stock options. \"In the money\" means that the current stock price is above the strike price (the price at which the manager can purchase the shares). \"Out of the money\" means that the current stock price is below the strike price. \"At the money\" means that the current stock price is the same (or at least very similar to!) to strike price. Remember, call options like these give the holder (the manager) the right, but not the obligation to purchase shares at the strike price. If the price at maturity is below the strike price, then the holder would not exercise his/her option. If the stock price is above the strike price at maturity, then the holder would exercise his/her right to purchase for cheaper than market value. A firm's manager has several stock options (call options) with a strike price of $50/share. Assume that there are two mutually exclusive projects that can be undertaken (so, at most, only one project can be pursued). Project A will either increase the share value by $3/share, or decrease the share value by $2/share with equal odds (50% probability in either direction). Project B will either increase the share value by $8/share, or decrease the share value by $10/share with equal odds. For simplicity, assume that the manager is not at risk to lose his / her job based on these decisions, and that there is no other source of uncertainty with respect to this stock price. a) Which project (if any) would shareholders like to pursue? Project A Project B Neither b) If the current share price is $40/share (so, the manager's options are out of the money), which project results in more expected compensation to the manager? Project A Project B Neither c) If the current share price is $50/share (so, the manager's options are at the money), which project results in more expected compensation to the manager? Project A Project B Neither FIN 305 Assignment 1 d) If the current share price is $60/share (so, the manager's options are in the money), which project results in more expected compensation to the manager? Project A Project B Neither e) In this example, under which setting is shareholder and manager incentives aligned? Out of the Money At the Money In the Money None All First Principles Maximize the value of the firm The investment decision The hurdle rate should reflect the riskiness and the mix of debt and equity used to fund it 1 The return should reflect the magnitude and timing of the cash flows and side effects The financing decision The optimal mix of debt and equity that maximizes firm value The right kind of debt that matches the life of the assets The dividend decision How much How you you can choose to return to return cash investors to investors depends on depends on assets in whether they place and prefer growth dividends or opportunities buybacks Measures of Return - Earnings vs. Cash Flow Principles Governing Accounting Earnings Measurement Accrual Accounting: Show revenues when products and services are sold or provided, not when they are paid for. Show expenses associated with these revenues rather than cash expenses. Operating versus Capital Expenditures: Only expenses associated with creating revenues in the current period should be treated as operating expenses. Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization) To get from accounting earnings to cash flows: 2 you have to add back non-cash expenses (like depreciation) you have to subtract out cash outflows which are not expensed (such as capital expenditures) you have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital). Measuring Return - The Basic Principles 3 Use cash flows rather than earnings. You cannot spend earnings. Use \"incremental\" cash flows relating to the investment decision, i.e., cash flows that occur as a consequence of the decision, rather than total cash flows. Use \"time weighted\" returns, i.e., value cash flows that occur earlier more than cash flows that occur later. The Return Mantra: \"Time-weighted, Incremental Cash Flow Return\" But first... Understanding basics of financial statements Textbook Chapters 2 & 3 provide a good introduction for students needing additional help. Also, I have put the textbook's version of these slides on Angel. Review of the: 4 Balance Sheet Income Statement Statement of Cash Flows How to standardize and use financial statement information The Balance Sheet Corporate Finance decisions are either investment decisions or financing decisions Investment decisions involve the purchase and sale of any assets (show up on the left-hand side of the B/S) Financing decisions involve the choice of debt and equity used to fund the accumulation of assets (right-hand side of the B/S). Assets = Liabilities + Owners' Equity 5 The Balance Sheet (left-side) Total assets are a portfolio, and not necessarily homogenous 6 Current Assets: Cash and assets typically converted to cash within 12 months (inventory, accounts receivable, etc.) Fixed Assets: Has a relatively long life and typically classified as tangible (like property, plant and equipment) and intangible (patents, trademarks, etc.) Of great importance - the accounting balance sheet value may (at times drastically) deviate from the market value! The Balance Sheet (right-side) Total liabilities and owners' equity is a portfolio, and not necessarily homogenous 7 Current Liabilities: Typically those that are due within 12 months (accounts payable, notes payable, etc.) Long-Term Liabilities: Debt not due in the coming year Shareholders' Equity: The difference between the total value of the assets and the total value of the liabilities (includes the stock account, paid-in-capital, treasury stock and retained earnings) Of great importance - the accounting balance sheet value may (at times drastically) deviate from the market value! Net Working Capital It is often useful (and necessary) to know how much total capital is \"tied up\" in current assets and current liabilities A by-product of accrual accounting on financial statements Many firms fail because the required current assets (like accounts receivable and inventory) explode relative to the accounts payable Particularly young, fast-growing firms NWC = Current Assets - Current Liabilities 8 The Income Statement Income statements (or P&L) using GAAP follow the: While expenses are \"matched,\" they are not necessarily cash outlays (or cash inflows) Depreciation Taxes Many others... Additional line-item considerations 9 Revenue recognition principle Matching principle Product costs vs. Period costs Variable costs vs. Fixed costs A note on taxes... When computing a firm's total tax liability, the average tax rate applies Remember, as financial managers, we use the incremental cash flow considerations to guide our investment decisions (marginal tax rate) Important considerations include 10 Progressive nature of rates Net Operating Losses (NOL) Investment tax credits Mergers & Acquisitions On to Cash Flows Table 2.6 in the textbook 11 Examples... 12 The book and textbook slides (on Angel) have some simple examples I created a more challenging in-class example... Understanding Sources and Uses of Cash Remember, we care about cash flows (not accounting returns). It is imperative that we understand the proper adjustments to financial statements. Uses of cash Sources of cash 13 Assets increase - (purchase inventory, new property, etc.) Liabilities decrease - (paid off some debt, paid down your A/P, etc.) Assets decrease - (customers pay down you're A/R, sell a machine, etc.) Liabilities increase - (raised additional debt financing, you're stringing out your vendors longer, etc.) Statement of Cash Flows Divided into three primary areas Operating Activity Investing Activity Financing Activity IF all accounts are properly shown in the B/S and the I/S, then the SCF is easily obtained However, in practice, I have often noticed additional details in the SCF not found in the other statements 14 Depreciation Share-based compensation Capex and M&A activity Comparing Financial Statements In isolation, financial statements can be difficult to interpret Analysts and decision makers find it useful to compare financial performance across time and across peer firms 15 Common-Size Ratio Analyses Let's go through a simple Common-Size example... Can also be useful tools when analyzing financial projections Ratio Analyses 16 It is important to understand whether the signal obtained from a given ratio is useful for what is needed Many common ratios are easy to compute, but analysts must think critically about the ratio (the signal) Ratios are often useful, particularly when properly adjusted Anecdotally, I have found that intelligently utilizing ratios uncovered a previously unrecognized issue in the financial statements Extremely useful when creating defensible projections! Various Ratios used... Typical ratios are grouped into these buckets 17 Short-term solvency (liquidity) Long-term solvency (financial leverage) Asset management (turnover) Profitability Market value Short-term solvency Common Ratios: 18 Current Ratio = CA / CL Quick (or, Acid Test) Ratio = (CA - Inventory) / CL Cash Ratio = Cash / CL NWC-to-Total Assets = (CA - CL)/TA Interval measure = CA / (Ave Daily Opex) Who might care most about each ratio? How might we adjust these to meet certain needs? What does \"too low\" mean? What does \"too high\" mean? Long-term solvency Common Ratios: 19 Total Debt Ratio = (TA - TE) / TA Long-term Debt Ratio = LTD / (LTD + TE) Interest Coverage Ratio = EBIT / Intx Cash Coverage Ratio = (EBIT + Depr) / Intx Who might care most about each ratio? How might we adjust these to meet certain needs? What does \"too low\" mean? What does \"too high\" mean? Asset management Common Ratios: 20 Inventory Turnover = COGS / Inventory Receivables Turnover = Sales / AR Payables Turnover = COGS / AP Total Asset Turnover = Sales / TA Who might care most about each ratio? How might we adjust these to meet certain needs? What does \"too low\" mean? What does \"too high\" mean? Profitability measures Common Ratios: 21 Profit Margin = Net Income / Sales Return on Assets (ROA) = Net Income / TA Return on Equity (ROE) = Net Income / TE Who might care most about each ratio? How might we adjust these to meet certain needs? What does \"too low\" mean? What does \"too high\" mean? Market Value measures Common Ratios: 22 EPS = Net Income / Shares Outstanding PE Ratio = Price per share / EPS Price-to-Sales Ratio = Price per share / Sales per share MTB = Market Value per share / Book value per share EBITDA multiple = (MVE + BVD - Cash) / EBITDA Who might care most about each ratio? How might we adjust these to meet certain needs? What does \"too low\" mean? What does \"too high\" mean? Now that we understand Financial Statements, recall... Maximize the value of the firm The investment decision The hurdle rate should reflect the riskiness and the mix of debt and equity used to fund it 23 The return should reflect the magnitude and timing of the cash flows and side effects The financing decision The optimal mix of debt and equity that maximizes firm value The right kind of debt that matches the life of the assets The dividend decision How much How you you can choose to return to return cash investors to investors depends on depends on assets in whether they place and prefer growth dividends or opportunities buybacks Ratios and projections 24 Remember, in the corporate finance investment decision, we are primarily concerned with future cash flows and risk Analysts (either implicitly or explicitly) assume certain ratios along with sales forecasts to generate pro-forma financial statements From these financial statements, we can project the cash flows to or from investors We can reasonably stress-test our assumptions to generate different scenarios (base case, worst case, etc.) First Principles Maximize the value of the firm The investment decision The hurdle rate should reflect the riskiness and the mix of debt and equity used to fund it 1 The return should reflect the magnitude and timing of the cash flows and side effects The financing decision The optimal mix of debt and equity that maximizes firm value The right kind of debt that matches the life of the assets The dividend decision How much How you you can choose to return to return cash investors to investors depends on depends on assets in whether they place and prefer growth dividends or opportunities buybacks Objective in Decision Making In traditional corporate finance, the objective in decision making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. Assets Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Expected Value that will be created by future investments 2 Liabilities Assets in Place Debt Growth Assets Equity Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible Residual Claim on cash flows Significant Role in management Perpetual Lives Is maximizing stock price too \"narrow\" an objective? Maximizing stock price is not incompatible with meeting employee needs/objectives. In particular: Employees are often stockholders in many firms Firms that maximize stock price generally are profitable firms that can afford to treat employees well. Maximizing stock price does not mean that customers are not critical to success. In most businesses, keeping customers happy is the route to stock price maximization. Maximizing stock price does not imply that a company has to be a social outlaw. 3 Why do we focus on maximizing shareholder wealth? Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously. The objective of stock price performance provides some very elegant theory on: Allocating resources across scarce uses (which investments to take and which ones to reject) how to finance these investments how much to pay in dividends 4 The classical objective function STOCKHOLDERS Hire & fire managers Board Annual Meeting BONDHOLDERS/ LENDERS Lend Money Maximize stockholder wealth Managers Protect bondholder Interests Reveal information honestly and on time Public goods SOCIETY All costs can be traced to firm Markets are efficient and assess effect on value FINANCIAL MARKETS 5 What can go wrong? STOCKHOLDERS Have little control over managers BONDHOLDERS Lend Money Managers put their interests above stockholders Managers Bondholders can get ripped off Delay bad news or provide misleading information Significant Social Costs SOCIETY Some costs cannot be traced to firm Markets make mistakes and can over/under react FINANCIAL MARKETS 6 Stockholder Interest vs. Management Interest In Theory: The stockholders have significant control over management. The two mechanisms for disciplining management are the annual meeting and the board of directors. Specifically, we assume that Stockholders who are dissatisfied with managers can not only express their disapproval at the annual meeting, but can use their voting power at the meeting to keep managers in check. The board of directors plays its true role of representing stockholders and acting as a check on management. In Practice: Neither mechanism is as effective in disciplining management as theory posits. 7 The Annual Meeting as a Disciplining Mechanism 8 The power of stockholders to act at annual meetings is diluted by three factors Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings. Incumbent management starts off with a clear advantage when it comes to the exercise of proxies. Proxies that are not voted becomes votes for incumbent management. For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet. Annual meetings are also tightly scripted and controlled events, making it difficult for outsiders and rebels to bring up issues that are not to the management's liking. What about institutional investors? 9 The Board of Directors as a Disciplining Mechanism Directors are paid well: In 2010, the median board member at a Fortune 500 company was paid $212,512, with 54% coming in stock and the remaining 46% in cash. If a board member was a non-executive chair, he or she received about $150,000 more in compensation. Spend more time on it than they used to: A board member worked, on average, about 227.5 hours a year (and that is being generous), or 4.4 hours a week, according to the National Associate of Corporate Directors. Of this, about 24 hours a year are for board meetings. Those numbers are up from what they were a decade ago. Even those hours are not very productive: While the time spent on being a director has gone up, a significant portion of that time was spent on making sure that they are legally protected (regulations & lawsuits). And they have many loyalties: Many directors serve on three or more boards, and some are full time chief executives of other companies. 10 Other issues with directors CEOs pick directors: A 1992 survey by Korn/Ferry revealed that 74% of companies relied on recommendations from the CEO to come up with new directors and only 16% used an outside search firm. While that number has changed in recent years, CEOs still determine who sits on their boards. While more companies have outsiders involved in picking directors now, CEOs exercise significant influence over the process. Directors don't have big equity stakes: Directors often hold only token stakes in their companies. Most directors in companies today still receive more compensation as directors than they gain from their stockholdings. While share ownership is up among directors today, they usually get these shares from the firm (rather than buy them). And some directors are CEOs of other firms: Many directors are themselves CEOs of other firms. Worse still, there are cases where CEOs sit on each other's boards. 11 Assessing Boards Calpers, the California Employees Pension fund, suggested three tests in 1997 of an independent board: Are a majority of the directors outside directors? Is the chairman of the board independent of the company (and not the CEO of the company)? Are the compensation and audit committees composed entirely of outsiders? Over the past few decades, there have been an increasing number of services aimed at assessing the strength of firms' corporate governance standards Sarbanes-Oxley Act 12 Assessing Boards yourself Look at the board of directors for your firm. How many of the directors are inside directors (Employees of the firm, exmanagers)? Is there any information on how independent the directors in the firm are from the managers? Are there any external measures of the quality of corporate governance of your firm? Yahoo! Finance now reports on a corporate governance score for firms, where it ranks firms against the rest of the market and against their sectors. Is there tangible evidence that your board acts independently of management? Check news stories to see if there are actions that the CEO has wanted to take that the board has stopped him or her from taking or at least slowed him or her down. 13 Managerial behaviors When managers do not fear stockholders, they will often put their interests over stockholder interests Greenmail: The (managers of ) target of a hostile takeover buy out the potential acquirer's existing stake, at a price much greater than the price paid by the raider, in return for the signing of a 'standstill' agreement. Golden Parachutes: Provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover. Poison Pills: A security, the rights or cash flows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill. Shark Repellents: Anti-takeover amendments are also aimed at dissuading hostile takeovers, but differ on one very important count. They require the assent of stockholders to be instituted. Overpaying on takeovers: Acquisitions often are driven by management interests rather than stockholder interests. 14 Overpaying on takeovers The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover. The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms. Stock prices of bidding firms decline on the takeover announcements a significant proportion of the time. Many mergers do not work, as evidenced by a number of measures. The profitability of merged firms relative to their peer groups, does not increase significantly after mergers. An even more damning indictment is that a large number of mergers are reversed within a few years, which is a clear admission that the acquisitions did not work. 15 An example in value destruction Kodak enters bidding war In late 1987, Eastman Kodak entered into a bidding war with Hoffman La Roche for Sterling Drugs, a pharmaceutical company. The bidding war started with Sterling Drugs trading at about $40/share. At $72/share, Hoffman dropped out of the bidding war, but Kodak kept bidding. At $89.50/share, Kodak won and claimed potential synergies explained the premium. 16 Kodak wins!!!! Stockholders' Interests vs. Bondholders' Interests In Theory: there is no conflict of interests between stockholders and bondholders. In Practice: Stockholder and bondholders have different objectives. Bondholders are concerned most about safety and ensuring that they get paid their claims. Stockholders are more likely to think about upside potential 17 Examples of conflict A dividend/buyback surge: When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash. Risk shifting: When a firm takes riskier projects than those agreed to at the outset, lenders are hurt. Lenders base interest rates on their perceptions of how risky a firm's investments are. If stockholders then take on riskier investments, lenders will be hurt. Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off. 18 Firms and Financial Markets In Theory: Financial markets are efficient. Managers convey information honestly and in a timely manner to financial markets, and financial markets make reasoned judgments of the effects of this information on 'true value'. As a consequence A company that invests in good long term projects will be rewarded. Short term accounting gimmicks will not lead to increases in market value. Stock price performance is a good measure of company performance. In Practice: There are some holes in the 'Efficient Markets' assumption. 19 Managerial Disclosure Information management (timing and spin): Information (especially negative) is sometimes suppressed or delayed by managers seeking a better time to release it. When the information is released, firms find ways to \"spin\" or \"frame\" it to put themselves in the best possible light. Outright fraud: In some cases, firms release intentionally misleading information about their current conditions and future prospects to financial markets. 20 Evidence of delaying bad news 21 Some Critiques of Market Efficiency Investor irrationality: The base argument is that investors are irrational and prices often move for not reason at all. As a consequence, prices are much more volatile than justified by the underlying fundamentals. Earnings and dividends are much less volatile than stock prices. Manifestations of irrationality Reaction to news: Some believe that investors overreact to news, both good and bad. Others believe that investors sometimes under react to big news stories. An insider conspiracy: Financial markets are manipulated by insiders. Prices do not have any relationship to value. Short termism: Investors are short-sighted, and do not consider the long-term implications of actions taken by the firm 22 Are markets too focused on the near-term? Focusing on market prices will lead companies towards short term decisions at the expense of long term value. I agree with the statement I do not agree with this statement Allowing managers to make decisions without having to worry about the effect on market prices will lead to better long term decisions. I agree with this statement I do not agree with this statement Neither managers nor markets are trustworthy. Regulations/laws should be written that force firms to make long term decisions. I agree with this statement I do not agree with this statement 23 Are markets short-term? Some evidence that they are not Value of young firms: There are hundreds of start-up and small firms, with no earnings expected in the near future, that raise money on financial markets. Why would a myopic market that cares only about short term earnings attach high prices to these firms? Current earnings vs Future growth: If the evidence suggests anything, it is that markets do not value current earnings and cash flows enough and value future earnings and cash flows too much. After all, studies suggest that low PE stocks are under priced relative to high PE stocks Market reaction to investments: The market response to research and development and investment expenditures is generally positive. 24 What about market crises? Markets are the problem: Many critics of markets point to market bubbles and crises as evidence that markets do not work. For instance, the market turmoil between September and December 2008 is pointed to as backing for the statement that free markets are the source of the problem and not the solution. The counter: There are two counter arguments that can be offered: 25 The events of the last quarter of 2008 illustrate that we are more dependent on functioning, liquid markets, with risk taking investors, than ever before in history. As we saw, no government or other entity (bank, Buffett) is big enough to step in and save the day. The firms that caused the market collapse (banks, investment banks) were among the most regulated businesses in the market place. If anything, their failures can be traced to their attempts to take advantage of regulatory loopholes (badly designed insurance programs... capital measurements that miss risky assets, especially derivatives) Firms and Society In Theory: All costs and benefits associated with a firm's decisions can be traced back to the firm. In Practice: Financial decisions can create social costs and benefits. A social cost or benefit is a cost or benefit that accrues to society as a whole and not to the firm making the decision. Environmental costs (pollution, health costs, etc..) Quality of Life' costs (traffic, housing, safety, etc.) Examples of social benefits include: creating employment in areas with high unemployment supporting development in inner cities creating access to goods in areas where such access does not exist 26 Social costs and benefits are difficult to quantify... Cannot know the unknown: They might not be known at the time of the decision. In other words, a firm may think that it is delivering a product that enhances society, at the time it delivers the product but discover afterwards that there are very large costs. (Asbestos was a wonderful product, when it was devised, light and easy to work with... It is only after decades that the health consequences came to light) Eyes of the beholder: They are 'person-specific', since different decision makers can look at the same social cost and weight them very differently. Decision paralysis: They can be paralyzing if carried to extremes. 27 A test of your social consciousness Put your money where your mouth is... Assume that you work for Disney and that you have an opportunity to open a store in an inner-city neighborhood. The store is expected to lose about a million dollars a year, but it will create much-needed employment in the area, and may help revitalize it. Would you open the store? Yes No If yes, would you tell your stockholders and let them vote on the issue? Yes No If no, how would you respond to a stockholder query on why you were not living up to your social responsibilities? 28 So, this is what can go wrong STOCKHOLDERS Have little control over managers BONDHOLDERS Lend Money Managers put their interests above stockholders Managers Bondholders can get ripped off Delay bad news or provide misleading information Significant Social Costs SOCIETY Some costs cannot be traced to firm Markets make mistakes and can over/under react FINANCIAL MARKETS 29 Traditional Corporate Finance theory breaks down when... Managerial self-interest: The interests/objectives of the decision makers in the firm conflict with the interests of stockholders. Unprotected debt holders: Bondholders (Lenders) are not protected against expropriation by stockholders. Inefficient markets: Financial markets do not operate efficiently, and stock prices do not reflect the underlying value of the firm. Large social side costs: Significant social costs can be created as a by-product of stock price maximization. 30 When traditional Corporate Finance theory breaks down, then what? A non-stockholder based governance system: To choose a different mechanism for corporate governance, i.e., assign the responsibility for monitoring managers to someone other than stockholders. A better objective than maximizing stock prices? To choose a different objective for the firm. Maximize stock prices but minimize side costs: To maximize stock price, but reduce the potential for conflict and breakdown: 31 Making managers (decision makers) and employees into stockholders Protect lenders from expropriation By providing information honestly and promptly to financial markets Minimize social costs Alternative Governance system Germany and Japan developed a different mechanism for corporate governance, based upon corporate cross holdings. In Germany, the banks form the core of this system. In Japan, it is the keiretsus Other Asian countries have modeled their system after Japan, with family companies forming the core of the new corporate families At their best, the most efficient firms in the group work at bringing the less efficient firms up to par. They provide a corporate welfare system that makes for a more stable corporate structure At their worst, the least efficient and poorly run firms in the group pull down the most efficient and best run firms down. The nature of the cross holdings makes its very difficult for outsiders (including investors in these firms) to figure out how well or badly the group is doing. 32 Different Objective Function Firms can always focus on a different objective function. Examples would include maximizing earnings maximizing revenues maximizing firm size maximizing market share maximizing EVA The key thing to remember is that these are intermediate objective functions. To the degree that they are correlated with the long term health and value of the company, they work well. To the degree that they do not, the firm can end up with a disaster 33 Maximize Stock Price, subject to The strength of the stock price maximization objective function is its internal self correction mechanism. Excesses on any of the linkages lead, if unregulated, to counter actions which reduce or eliminate these excesses In the context of our discussion, 34 managers taking advantage of stockholders has led to a much more active market for corporate control. stockholders taking advantage of bondholders has led to bondholders protecting themselves at the time of the issue. firms revealing incorrect or delayed information to markets has led to markets becoming more \"skeptical\" and \"punitive\" firms creating social costs has led to more regulations, as well as investor and customer backlashes. Stockholder activism Activist Institutional investors have become much more active in monitoring companies that they invest in and demanding changes in the way in which business is done. They have been joined by private equity funds like KKR and Blackstone. Activist individuals like Carl Icahn specialize in taking large positions in companies which they feel need to change their ways (Blockbuster, Time Warner, Motorola & Apple) and push for change. Vocal stockholders, armed with more information and new powers: At annual meetings, stockholders have taken to expressing their displeasure with incumbent management by voting against their compensation contracts or their board of directors 35 Threat of Hostile Takeover The typical target firm in a hostile takeover has a return on equity almost 5% lower than its peer group had a stock that has significantly under performed the peer group over the previous 2 years has managers who hold little or no stock in the firm In other words, the best defense against a hostile takeover is to run your firm well and earn good returns for your stockholders Conversely, when you do not allow hostile takeovers, this is the firm that you are most likely protecting (and not a well run or well managed firm) 36 In response, boards have changed characteristics Boards have become smaller over time. The median size of a board of directors has decreased from 16 to 20 in the 1970s to between 9 and 11 in 1998. The smaller boards are less unwieldy and more effective than the larger boards. There are fewer insiders on the board. In contrast to the 6 or more insiders that many boards had in the 1970s, only two directors in most boards in 1998 were insiders. Directors are increasingly compensated with stock and options in the company, instead of cash. In 1973, only 4% of directors received compensation in the form of stock or options, whereas 78% did so in 1998. More directors are identified and selected by a nominating committee rather than being chosen by the CEO of the firm. In 1998, 75% of boards had nominating committees; the comparable statistic in 1973 was 2%. 37 In response, how about legislation? Every corporate scandal creates impetus for a legislative response. The scandals at Enron and WorldCom laid the groundwork for Sarbanes-Oxley. You cannot legislate good corporate governance. The costs of meeting legal requirements often exceed the benefits Laws always have unintended consequences In general, laws tend to be blunderbusses that penalize good companies more than they punish the bad companies. 38 Is there a payoff for good corporate governance? In the most comprehensive study of the effect of corporate governance on value, a governance index was created for each of 1500 firms based upon 24 distinct corporate governance provisions. Buying stocks that had the strongest investor protections while simultaneously selling shares with the weakest protections generated an annual excess return of 8.5%. Every one point increase in the index towards fewer investor protections decreased market value by 8.9% in 1999 Firms that scored high in investor protections also had higher profits, higher sales growth and made fewer acquisitions. The link between the composition of the board of directors and firm value is weak. Smaller boards do tend to be more effective. On a purely anecdotal basis, a common theme at problem companies and is an ineffective board that fails to ask tough questions of an imperial CEO. 39 Bondholders' defense against Stockholder excesses More restrictive covenants on investment, financing and dividend policy have been incorporated into both private lending agreements and into bond issues. New types of bonds have been created to explicitly protect bondholders against sudden increases in leverage or other actions that increase lender risk substantially. Two examples of such bonds Puttable Bonds, where the bondholder can put the bond back to the firm and get face value, if the firm takes actions that hurt bondholders Ratings Sensitive Notes, where the interest rate on the notes adjusts to that appropriate for the rating of the firm More hybrid bonds (with an equity component, usually in the form of a conversion option or warrant) have been used. This allows bondholders to become equity investors, if they feel it is in their best interests to do so. 40 The Financial Market response While analysts are more likely still to issue buy rather than sell recommendations, the payoff to uncovering negative news about a firm is large enough that such news is eagerly sought and quickly revealed (at least to a limited group of investors). As investor access to information improves, it is becoming much more difficult for firms to control when and how information gets out to markets. As option trading has become more common, it has become much easier to trade on bad news. In the process, it is revealed to the rest of the market. When firms mislead markets, the punishment is not only quick but it is savage. 41 Society's response If firms consistently flout societal norms and create large social costs, the governmental response (especially in a democracy) is for laws and regulations to be passed against such behavior. For firms catering to a more socially conscious clientele, the failure to meet societal norms (even if it is legal) can lead to loss of business and value. Finally, investors may choose not to invest in stocks of firms that they view as socially irresponsible. 42 The counter-reactions STOCKHOLDERS 1. More activist investors 2. Hostile takeovers Protect themselves BONDHOLDERS 1. Covenants 2. New Types Managers of poorly run firms are put on notice. Managers Firms are punished for misleading markets Corporate Good Citizen Constraints SOCIETY 1. More laws 2. Investor/Customer Backlash Investors and analysts become more skeptical FINANCIAL MARKETS 43 The Modified Objective Function For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected: Maximize Stock Price: This will also maximize firm value For publicly traded firms in inefficient markets, where bondholders are protected: Maximize stockholder wealth: This will also maximize firm value, but might not maximize the stock price For publicly traded firms in inefficient markets, where bondholders are not fully protected Maximize firm value, though stockholder wealth and stock prices may not be maximized at the same point. For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not) 44