Financial Theory and Corporate Policy (4 Edition) by Copeland Chapter 2: Investment Decisions: The Certainty Case

JAM May 2012 1.
01 FTCP 2 Page 1 of 9
Financial Theory and Corporate Policy (4
th
edition) by Copeland
Chapter 2: Investment Decisions: The Certainty Case

Introduction
In the investment decision, must decide how much to not consume today so as to enjoy
more consumption in the future
Should maximize expected utility over the planning horizon
Individuals, corporate managers, and public sector managers must all make the allocation
between current and future consumption
Initially interest rates are known and constant
Also assume there are no imperfections in capital markets
The firm objective is to maximize the wealth for its shareholders

Fisher Separation: The Separation of Individual Utility Preferences from the
Investment Decision
It is difficult to determine individual utility functions (how happy is happy?)
Assuming no market friction, individuals can delegate investment decisions to firm
managers
Managers should choose to invest until the rate of return equals the market-determined
rate of return
Maximizing shareholders wealth is equivalent to maximizing the present value of their
lifetime consumption
*
* 1
0 0
1
C
W C
r
= +
+

This implies the slope of the capital market line is (1+r)
The individual shareholders all prefer the same investment decisions at the firm (called
the unanimity principle)
The individuals can adjust for their risk/reward tolerance by borrowing or lending at the
risk-free rate

The Agency Problem
The shareholders wealth is the present value of cash flows discounted at the opportunity
cost of capital
Owners must find a way to monitor (at a cost) the behavior of managers
Owners must balance the monitoring costs with incentive-type compensation (e.g. stock
dividends)
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Shareholder Wealth Maximization
Dividends vs. Capital Gains
Shareholder wealth could be defined as the present value of future dividends
( )
0
1 1
t
t
t
s
Div
S
k
=
=
+

The above formula works if the dividends and discount rates are known with certainty
The effect of capital gains is effectively in the formula above
If the dividend stream is growing at a rate g,
1
0
s
Div
S
k g
=
-

The Economic Definition of Profit
Economic profits equal the mean rates of return in excess of the opportunity cost for
funds
To determine this, must know the timing of the cash flows and the opportunity cost
In this section, dividends include any cash flows that could be paid to shareholders; this
includes items such as capital gains, spin-offs to shareholders, and repurchase of shares
Assume you have an all-equity firm in a no-tax environment
The sources of funds are revenues (Rev) and sale of new equity (m shares at S dollars per
share)
The uses of funds are wages, salaries, materials, and services (W&S); investment (I); and
dividends (Div)
For each time period,
( )
t t t t t
t
Sources Uses
Rev m S Div W &S I
=
+ = + +

Assuming no new equity is issued,
( )
( )
( )
0
1 1
t t t
t
t t
t
t
t
s
Div Rev W &S I
Rev W &S I
S
k
=
= - -
- -
=
+

The accounting definition does not deduct gross investment; rather, it deducts a portion as
depreciation (dep)
( )
t t t
t
NI Rev W &S dep = - -
Can reconcile the two definitions by realizing the change in asset book value during the
year is the gross investment less the depreciation
( )
0
1 1
t t t
t t
t
t
s
A I dep
NI A
S
k
=
D = -
- D
=
+

The economic definition focuses on the actual timing of cash flows
Managers should not just try to maximize earnings per share, which is based on
accounting profits; rather, should maximize shareholder value
For example, FIFO (first-in, first-out) accounting method results in higher earnings per
share but lower cash flows because more is paid in taxes
So LIFO (last-in, first-out) is better for shareholder value even if it is worse for earnings
per share

Capital Budgeting Techniques
Problems for managers making investment decisions
1. Searching out new opportunities in the market
2. Estimating expected cash flows of projects
3. Evaluating projects according to sound decision rules
Criteria for essential property of maximizing shareholder value
1. All cash flows should be considered
2. Cash flows should be discounted at the opportunity cost of funds
3. Select from mutually exclusive projects the one that maximizes shareholders
wealth
4. Consider one project independently from others (value-additivity principle)
Summing the values of all the projects will compute the firm value
Widely used capital budgeting techniques
1. Payback method
2. Accounting rate of return (ARR)
3. Net present value (NPV)
This is the only method consistent with shareholder maximization
4. Internal rate of return

Cash flows for four mutually exclusive projects
Year A B C D PV Factor @10%
0 -1000 -1000 -1000 -1000 1.000
1 100 0 100 200 0.909
2 900 0 200 300 0.826
3 100 300 300 500 0.751
4 -100 700 400 500 0.683
5 -400 1300 1250 600 0.621

The Payback Method
Project A has the shortest payback method, only 2 years
However, this method does not consider all the cash flows and does not discount them
This violates the first two criteria for maximizing shareholder value

The Accounting Rate of Return (ARR)
The ARR is the average after-tax profit divided by the initial cash outlay
Similar to the return on assets (ROA) and the return on investment (ROI)
Assuming the cash flows in the table above are profits, the average after-tax profit for
project A is:
1000 100 900 100 100 400
80
5
- + + + - -
= -
And the ARR is -80 / 1000 = -8%
Project B has the highest ARR at 26%
The problems for the ARR method is it uses accounting profits instead of cash flows and
does not consider the time value of money

Net Present Value (NPV)
The net present value is simply the present value of the free cash flows less the initial
investment
( )
0
1 1
N
t
t
t
FCF
NPV I
k =
= -
+

Using the table above, just multiply the product cash flows by the discount factors
Should accept projects that have a NPV greater than zero
Project C has the highest NPV of 530.85
If the projects are mutually exclusive, then only Project C is accepted
If the projects are independent but not mutually exclusive, then accept Projects B, C, and
D since they all have positive values

Internal Rate of Return (IRR)
The IRR is the rate which equates the present value of cash outflows and inflows
Solve for the rate that makes the NPV = 0
( )
0
1
0
1
N
t
t
t
FCF
NPV I
IRR =
= = -
+

Project D has the highest IRR of 25.4%
Should accept any project that has an IRR greater than the cost of capital
Of course can only accept one project if they are mutually exclusive

Comparison of Net Present Value with Internal Rate of Return
IRR and NPV can lead to different project choices
NPV is appropriate because it uses the market-determined opportunity cost of capital
The IRR method does not discount at the opportunity cost of capital

The Reinvestment Rate Assumption
The NPV approach assumes shareholders can reinvest at the market-determined
opportunity cost of capital
Under the IRR method, it is assumed shareholders can reinvest at the IRR

The Value-Additivity Principle
IRR does not adhere to the value-additivity principle
The results change when different projects are combined
NPV always follows the value-additivity principle

Multiple Rates of Return
There will be multiple IRR solutions when the sign changes more than once in a cash
flow stream
Could use the opportunity cost of capital to accumulate the positive cash flows in the
calculation to eliminate the multiple roots
This makes sense because the cash flows lent to the firm should be at a reasonable rate

Summary of Comparison of IRR and NPV
Problems with IRR
1. Does not obey value-additivity principle
2. Assumes funds invested in projects have opportunity costs equal to the IRR for
the project
3. Cash flows cannot be discounted at the market-determined cost of capital
4. Multiple roots can emerge if the sign of the cash flows change more than once

Cash Flows for Capital Budgeting Purposes
This section adds debt and taxes
Investment funds can be provided by creditors and shareholders
Debt holders expect to receive a stream of payments unless the firm is bankrupt;
shareholders get the residual value
Both creditors and shareholders should receive their expected risk-adjusted rates of return
Use the following assumptions in a simplified example
An initial investment of $1000 is required to buy equipment that will depreciate at
$200 per year for 5 years
The owners will borrow $500 at 10% interest
The cost of equity is 30%

The table below illustrates the pro forma income statement
Rev Revenue 1300
VC
FCC
dep.
Variable costs
Fixed cash costs
Noncash charges (depreciation)
600
0
200
EBIT Earnings Before Interest and Taxes 500
k
d
D Interest Expense 50
EBT Earnings Before Taxes 450
T Taxes @ 50% 225
NI Net Income 225

Assuming the residual cash flows continue forever,
Residual Cash Flow 225
750
30%
s
S
k
= = =
The present value of the bondholders wealth, B, is:
Interest Payments 50
500
10%
b
B
k
= = =
Thus, the market value of the firm, V, is:
V = B + S = 1250
Define the weighted average cost of capital (WACC) in the following manner:
( ) ( )( ) ( ) ( ) ( ) 1 0.10 1 0.5 0.4 0.30 0.6 20%
b c s
B S
k WACC k k
B S B S
t

= = - + = - + =

+ +

Cash flows for capital budgeting purposes is free operating cash flows minus taxes on
free operating cash flows
( ) ( )
( )( )
( )
1
1
c
c c
c
Rev VC FCC Rev VC FCC dep I
Rev VC FCC dep I
EBIT dep I
t
t t
t
D - D - D - D - D - D - D - D
= D - D - D - + D - D
= - + D - D

Notice the cash flows are independent of the capital structure (debt and equity mix); that
is taken into account in determining the WACC
Discounting at the WACC separates the investment decision of the firm from its
financing decision
Must assume the capital structure stays constant or the cost of capital would change each
period
The definition of cash flows includes working capital requirements

Relaxing the Assumptions
Will need to introduce uncertainty
Also must account for manager flexibility (e.g. could defer the start date, increase or
decrease the scale)
This means the NPV approach systematically undervalues every project

Recommended Problems
You can certainly work all the problems, but the ones below are particularly valuable in
your exam preparation.
1, 4, 5, 8, 9

Solutions to Recommended Problems
1. First calculate the net income:
Revenue 140,000
Variable and fixed costs
Depreciation
100,000
10,000
Earnings Before Interest and Taxes 30,000
Interest Expense 0
Earnings Before Taxes 30,000
Taxes @ 40% 12,000
Net Income 18,000

( )( )
( )( ) ( )( )
1
140, 000 100, 000 1 0.4 0.4 10, 000 28, 000
c c
CF Rev VC FCC dep I t t = D - D - D - + D - D
= - - + =

( ) ( )( ) 1 30, 000 1 0.4 10, 000 0 28, 000
c
CF EBIT dep I t = - + D - D = - + - =

( )
10
1
28, 000
100, 000 58, 200
1.12
t
t
NPV
=
= - =

4. Calculate the net cash flows and discount back at 12% to find the net present value
At time t = 0 (buy new machine, sell old machine, take tax loss on sale)
( )( ) 100, 000 15, 000 40, 000 15, 000 0.4 75, 000 - + + - = -
In years 1 to 8 (increase in earnings, tax savings from new depreciation amount)
( ) ( ) ( ) ( )
( )[ ]
8
1
100, 000 12, 000 40, 000 0
1.12 31, 000 1 0.4 0.4
8 8
4.968 18, 600 2400 104, 328
t
t
-
=
- -
- + -

= + =

In year 8 (salvage value of new machine)
( ) ( )
8
1.12 12, 000 4, 847
-
=
Note there is no tax effect because this portion of the investment was never
deducted for tax purposes; only 88,000 was deducted over the life of the new
machine
NPV = -75,000 + 104,328 + 4,847 = 34,175

5. Note the financing of the project is irrelevant.
( )( ) ( ) ( )
10, 000
3000 1 0.4 0.4 2.991 10, 000 2, 223.40
5
NPV

= - + - = -

8. The financing information in this project is also irrelevant.
The annual cash flows are increased due to the revenue increase, cost reduction, and
tax savings from the depreciation:
[ ]( ) ( )
1200
200 360 1 0.4 0.4 496
3

+ - + =

( )
3
1
1.10 496 1200 33.55
t
t
NPV
-
=

= - =

9. First calculate the cash flow difference with and without the proposal
( ) ( )
( )( ) ( ) ( )
1
0 290 0 1 0.5 0.5 180 235
c c
CF Rev VC FCC dep t t = D - D - D - + D
= - - - - + =

Then calculate the NPV at the weighted average cost of capital
( )
5
1
1.10 235 900 9.12
t
t
NPV
-
=

= - = -

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Financial Markets and Corporate Strategy by Greenblatt & Titman
Chapter 18: How Managerial Incentives Affect Financial Decisions
(Study Note FET-162-08)

Introduction
Learning Objectives
1. Distinguish between managerial incentives and shareholder incentives
2. Understand how differences affect ownership structure, capital structure, and
investment policies
3. Describe ways to design compensation contracts that minimize managerial-
shareholder incentive problems

Purposes of Chapter
1. View how financial decisions are actually made in light of incentive problems
2. View how financial decisions should be made in light of incentive problems

Why might management decisions not maximize firm value?
1. Managers take advantage of position and benefit at shareholders expense
For example, Armand Hammer used Occidental funds to build a museum for his
personal art collection
2. Managers serve more than just shareholders (e.g. employees)

18.1 The Separation of Ownership and Control
Most large corporations are effectively controlled by management that own a very small
stake in the company

Whom Do Managers Represent?
1. Investors (e.g. equity holders and debt holders)
2. Customers and suppliers
3. Employees
Managers spend more time with the last two groups relative to investors

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What Factors Influence Managerial Incentives?
1. Length of time on job
Longer time increases loyalty to those who the manager frequently interacts (e.g.
customers and employees)
2. Proportion of company stock owned by management
Only a fraction of the perquisites (e.g. corporate jet) is paid by the manager

How Management Incentive Problems Hurt Shareholder Value
Share prices normally increase when entrenched executives leave
New CEOs can make the tough decisions that benefit shareholders even if employees are
hurt

Why Shareholders Cannot Control Managers
For most companies, CEOs own a very small fraction of the company (less than 1%)
The ownership of outside shareholder is too diffuse to make a change
Free-rider problem: individual investors are not inclined to discipline management even
though it would be in the best interest of the shareholders as a group
Proxy fights are very expensive and the cost must be borne by the individuals that wage
them
These individuals are only getting a fraction of the benefit; the other shareholders are
getting a free ride

Why is Ownership so Diffuse if it Leads to Less Efficient Management?
Investors must balance the desire to have a diversified portfolio with the need to
control management
An investor that sacrifices diversification for control would benefit other
shareholders, but only the investor would bear the lack of diversification cost

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Can Financial Institutions Mitigate the Free-Rider Problem?
Large institutional investors (like mutual funds) could control a significant stake in a
company and still be diversified
Mutual funds and insurance companies in the US are precluded by law from owning
more than 5% of the stock of any individual firm
Pension funds have begun to exert more influence, but there is still some reluctance in
private ones
Companies dont want other private pension plans to monitor their actions, so
they provide the same courtesy to other companies with their pension plan
Public pension funds are even more aggressive at monitoring managers of
corporations because they do not have concerns about other plans monitoring them

Changes in Corporate Governance
Changes in the mid-1980s that made managers more responsive to shareholders include:
1. Active takeover market
2. Increased usage of executive incentive plans
3. More active institutional shareholders
The SEC changed two rules in the early 1990s to encourage this
Fuller disclosure of executive compensation packages
Made it easier for shareholders to get information about other
shareholders; this reduced the cost of proxy fights
Board members are becoming more effective at monitoring management
1. Smaller number of members with greater percentage of outsiders
2. Receive more compensation in stock options to align incentives
CEOs are now more likely to lose their jobs for poor performance

Corporate Governance Problems Differ Across Countries?
Some countries, like the US and UK, provide strong legal protection for outside
shareholders
Other countries, like Russia, have very weak protection
The countries with strong protection have more active markets

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18.2 Management Shareholdings and Market Value
The ownership in many corporations is quite concentrated
Many of the large shareholders are the company founders (e.g. Michael Dell)

The Effect of Management Shareholdings on Stock Prices
A person like Bill Gates may choose not to sell his Microsoft stock for tax reasons or to
avoid sending bad signals to the market
Executives in the industries with the greatest potential incentive problems retain the
largest ownership
The market expects the entrepreneur will work harder if he or she retains a larger
ownership position

Management Shareholdings and Firm Value: The Empirical Evidence
One study showed higher management concentration was good up to a point (5%), but
then it hurt the value of the corporation
This is tough to measure because market-to-book ratios are affected by many factors
Closed-end mutual funds often trade at a significant discount to the net asset value
(NAV)
This indicates investors dislike the large shareholders; negative effects of
management ownership outweigh the positive benefits

18.3 How Management Control Distorts Investment Decisions
The Investment Choices Managers Prefer
1. Making Investments that fit the Managers Expertise
This makes it harder to fire and replace the manager
Mangers want to become entrenched and irreplaceable
2. Making Investments in Visible/Fun Industries
Media companies are more fun to manage than chemical companies
3. Making Investments that Pay Off Early
Managers are focused on short-term results even if the decisions hurt the long-run

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4. Making Investments that Minimize the Managers Risk and Increase the Scope of the
Firm
Managers want to avoid bankruptcy to keep their jobs
This also explains why managers prefer large empires
Unsystematic risk matters to managers even though it does not matter to shareholders,
so managers prefer diversified structure
Managers also prefer less debt
Managers also like larger companies because pay is correlated with size

Outside Shareholders and Managerial Discretion
Outside shareholders can reduce management discretion though fixed assets and other
technologies
Flexibility is more valuable in uncertain environments, so outside shareholders may be
better off monitoring the managers rather than restricting the decisions
The cost of discretion is greater when manager and shareholder interest do not coincide

18.4 Capital Structure and Managerial Control
Increasing debt may motivate the manager simply trying to avoid bankruptcy and keep
job

The Relation between Shareholder Control and Leverage
Companies managed by individuals with a strong interest in the stock price tend to have
higher leverage

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How Leverage Affects the Level of Investment
Using debt to limit the firms ability to invest in the future may be beneficial; it avoids
poor investments by management
Large debt limits managements ability to use corporate resources
Selecting the Debt Ratio that Allows a Firm to Invest Optimally
Shareholders should use more debt if management has a tendency to overinvest
In Example 18.3 on page 641
A firm is financed with initial investment of $100
In one year, the firm can invest an additional $100 in a project that has the
following potential payoffs in different states of the economy:
Good Medium Bad
Value with additional investment $250 $175 $125
Value without additional investment 50 50 50
Incremental value added 200 125 75

The $100 additional investment in the bad state of the economy should not be
made because it will lose $25
To prevent management from making the second investment in the bad economy
state, could structure the initial $100 investment to restrict future choices
For example, the initial investment could be $70 of senior debt and $30 of
subordinate debt
The value with the additional investment (the first row in the table above)
must first pay back the $70 of senior debt
Then only if there are sufficient funds could it support the additional $100
investment
In the bad state of the economy, there would only be $55 remaining, which is
clearly not enough to support the $100 additional investment
Thus, management is prevented from investing in a negative NPV project
This restriction will only work if the internal cash flows of the company are not
sufficient to cover the additional investment

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A Monitoring Role for Banks
Banks could monitor the firm position much better than diffuse debt holders
Many debt holders would have the same free-rider problem discussed above
The bank could review the prospects before deciding to lend additional funds
This is a more flexible option compared to Example 18.3 above
However, if banks have too much influence it could make management too conservative
for the likes of equity holders
Borrowing from a bank can be done discretely; this is advantageous if the firm is trying
to keep proprietary secrets from its competitors

A Monitoring Role for Private Equity
Private equity suppliers (e.g. venture capital firms) could also provide monitoring
services
They are likely to provide more monitoring because
1. They have substantial equity stake
2. Their investment is not liquid, so interested in long-term viability of firm
3. They have the needed expertise

18.5 Executive Compensation
Stockholders are the principals and management is the agent hired by the principals
The Agency Problem
The tenant farmer (the agent) and the owner of the farm (the principal)
The farmer compensation should be tied to the output, but not too much because
outside influences (e.g. weather) can dramatically affect the crop and is not
controllable by the farmer
Two Components of an Agency Problem
1. Uncertainty the agent cannot control
2. Lack of information for the principal (cannot monitor the agent all the time)
Measuring Inputs versus Measuring Outputs
The principal can either closely measure the agent input (labor intensity) or indirectly
monitor the agent by measuring the output
In the mid-1970s it was popular to measure the input; however, it was difficult to
measure the quality of the input even if the quantity was objective
Now there is a tendency to monitor the output

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Designing Optimal Incentive Contracts
Managers should not be penalized for factors outside their control
So should not tie the managers to the overall stock return; rather, should compare to
the stock return of other firms in the industry
Minimizing Agency Costs
Agency costs are the difference between actual firm value and hypothetical value if
the management and shareholder incentives were in sync

Is Executive Pay Closely Tied to Performance?
The Jensen and Murphy Evidence
In a 1990 article they argued executive compensation is not tied to performance
enough
More Recent Evidence
Subsequent evidence hints Jensen and Murphy underestimated the sensitivity
They failed to capture the future CEO compensation relationship to performance
Positive actions taken by the CEO are immediately reflected in the stock price on a
present value basis; the investors assume the positive results will continue into the
future
It is more important to compare cumulative compensation to cumulative stock gains
over many years
Cross-Sectional Differences in Pay-for-Performance Sensitivities
The performance sensitivities differ greatly by industry
Industries that have more potential agency problems tie the pay more to performance
Higher performance sensitivities is observed at smaller companies
Growth firms in volatile industries have smaller pay-for-performance sensitivities;
too much of the performance is outside the managers control

Is Pay-for-Performance Sensitivity Increasing?
It has increased over the past 20 years, mainly through stock options

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How Does Firm Value Relate to the Use of Performance-Based Pay?
Empirical studies tend to show performance-based pay does improve financial results
However, the positive correlation does not imply causation
Managers may be inclined to accept performance-based pay if they expect high returns in
the short term
Thus, the implementation of performance-based pay could be a form of market signaling

Is Executive Compensation Tied to Relative Performance?
Relative performance compensation tie the managers pay to performance relative to a
benchmark
Stock options are the dominant form of performance-based compensation, and they are
not based on relative performance
Bonuses are easier to tie to relative benchmarks
Relative benchmarks could encourage too much competition within the industry

Stock-Based versus Earnings-Based Performance Pay
Stock-Based Compensation
Advantageous because ties managers directly to shareholder desire
Disadvantages include:
1. Stock prices change for reasons outside the managers control
2. Stock prices change due to changing expectations, not just realizations
This penalizes managers if the market has a favorable opinion of them in
advance
Earnings-Based Compensation
Advantageous because numbers are available for separate business units and privately
held firms
Disadvantages include:
1. Difficult to determine the appropriate measure
2. Accounting numbers can have quirks
Value-Based Management
Based on economic cash flows
Adjusts for the amount of capital used

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Compensation Issues, Mergers, and Divestitures
Stock-based compensation is not as useful at motivating heads of business units since
their actions are not as impactful on the stock price
Spin-Offs and Carve Outs
Spin-offs create a new company by distributing shares to the existing shareholders
Carve outs create a new company through an IPO
Both of these could be done to better motivate the division heads
Mergers
Mergers combine separate firms into a single entity
Many divestitures undo past mergers

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Financial Markets and Corporate Strategy by Greenblatt & Titman
Chapter 19: The Information Conveyed by Financial Decisions

Introduction
Learning Objectives
1. Understand how financial decisions are affected by well-informed managers
2. Indentify situations in which managers may want to distort accounting information
3. Explain how dividend choice, capital structure, and real investments affect stock price
4. Interpret empirical evidence regarding stock price reaction to financing and investing
decisions

Introduction
The stock market reacts greatly to dividend changes and other financial restructurings
Managers often have inside information that cannot be disclosed to investors
The information could give the company a competitive advantage or the management
team may simply want to hide unfavorable news
Investors strive to interpret indirect news from management called signals
These actions (e.g. management purchasing shares) often speak louder than words
Managers often want to maximize the short-term stock price simply to boost their own
pay
Must distinguish between decisions that create value and decisions that simply signal
positively to shareholders

19.1 Management Incentives When Managers Have Better Information Than
Shareholders
Should the manager strive to maximize the current market value of the firms which is
based on public information or the true value of the firm (the intrinsic value) based on
private information?
Long-term shareholders prefer the maximization of intrinsic value
Short-term shareholders prefer the maximization of the current value
At times they even want management to conceal bad news

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Conflicts between Short-Term and Long-Term Share Price Maximization
Reasons for management concern of current stock prices
1. May plan to issue equity or sell some of own stock
2. Prevent acquisition at a low price
3. Boost management compensation
4. Need higher price to attract customers and outside stakeholders
Managers want to increase the weighted average of the current and intrinsic value; must
determine these weights based on the particular circumstances
Good decisions can reveal unfavorable information and bad decisions can reveal
favorable information
This means stock price reactions do not necessarily imply the decision was good or bad

19.2 Earnings Manipulation
Managers often increase reported earnings in the current year at the expense of future
years
Depreciation and inventory methods can be used to manage earnings
Some of the methods are disclosed, but other estimates left to manager discretion are
hidden from shareholders

Incentives to Increase or Decrease Accounting Earnings
Earnings are manipulated most when it is most advantageous
For example, earnings will be increased prior to a stock issue
Sometimes the earnings will be lowered (e.g. prior to union negotiations or plea for
government assistance)

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19.3 Shortsighted Investment Choices
Savvy investors rarely take the reported earnings at face value
Sometimes cash flow numbers are more reliable

Managements Reluctance to Undertake Long-Term Investments
Some investments will not generate significant profits for many years
Analysts are skeptical about management claims of future profits; they are more
concerned about the current year profits
This causes reluctance for managers to invest in long-term projects
A manager only concerned about maximizing intrinsic value would still undertake good
long-term investments

What Determines a Managers Incentive to be Shortsighted?
The weights assigned to the current value and intrinsic value determine the
shortsightedness

19.4 The Information Content of Dividend and Share Repurchase Announcements
Empirical Evidence on Stock Returns at the Time of Dividend Announcements
Stock prices increase about 2% on announcement of a dividend increase; the jump is
greater if no previous dividends have been paid
Stock prices drop about 9.5% when dividends are cut or omitted
However, this does not mean increased dividends are good for intrinsic value
maximization

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A Dividend Signaling Model
Operating Cash Flow = Investment Expenditures Change in Equity + Dividends
A company must use the internal cash flows for investments or give it back to
shareholders
Information Observed by Investors
Assume investors cannot observe the operating cash flows and investment
expenditures
They can observe the dividends paid and amount of capital raised
The Information Content of a Dividend Change
Increased dividends could mean higher operating cash flow (which is good) or
reduced investment expenditures (which is bad)
Dividend Signaling and Underinvestment
If the manager is focused on the current stock price, will likely forgo some
investment opportunities to increase the current dividends
Often this will hurt the intrinsic value of the company
Do Positive Stock Price Responses Imply That a Decision Creates Value?
Not necessarily
As mentioned above, increased dividends could actually mean the company is not
making proper investments
Also, dividend cuts could be viewed negatively by the market when it is the prudent
decision for management to make worthwhile investments
Share Repurchases versus Dividends
Share repurchases are equivalent to dividends, ignoring transaction costs and taxes
Studies have shown stock prices react favorably to share repurchase announcements
A greater stock price reaction is observed for tender offers compared to purchases
made in the open market
This occurs because tender offers are usually larger in size and at a premium
Simultaneous dividend cuts and share repurchases should be a wash in the market
However, the market may view the share repurchase as a one-time event and the
dividend cut as permanent
Share repurchases are more tax efficient for the investor
There is very limited empirical evidence on simultaneous dividend cuts and share
repurchases

JAM May 2012 1.03 SN 163 Page 5 of 9
Dividend Policy and Investment Incentives
Investors and analysts rarely know details about the investment opportunities of the firm
Can Dividend Cuts Signal Improved Investment Opportunities?
Management must convince the shareholders the investments are worthwhile
Sometimes the shareholders will believe management, other times they will not
Dividend Cuts and the Incentive to Overinvest
Managers may overinvest simply to see the firm grow rather than add value for the
shareholders
Studies have shown companies with better investment opportunities (measured by the
ratio of the market value to the book value) have smaller market reactions to dividend
cuts and dividend increases
This could simply show people who invest in growth stocks (high MV to BV ratio)
are not interested in dividends

Dividends Attract Attention
There is more incentive for management to attract attention when it feels the firm is
undervalued
Stock dividends and stock splits also usually increase the share price even though they do
not affect the firms cash flows
This could be due solely to the attention the announcement solicits

19.5 The Information Content of the Debt-Equity Choice
Two key pieces of information in the debt/equity choice
1. Managers will avoid debt if think it will be difficult to repay; therefore, debt
issues express the management confidence in future cash flow
2. Managers would be reluctant to issue equity if they thought the shares were
underpriced; therefore, equity issues may signal overpriced shares

A Signaling Model Based on the Tax Gain/Financial Distress Trade-Off
When issuing debt, management must weigh the tax benefits with the cost of financial
distress
Management that expects large future cash flows will favor debt financing
Management may even increase leverage when it reduces the intrinsic value just to pump
up the current stock price
In order for this to be a credible market signal firms with poor prospects must find it
difficult to issue debt
JAM May 2012 1.03 SN 163 Page 6 of 9
The Credibility of the Debt-Equity Signal
Sometimes a firm will take on more debt than desired just to send a strong market
signal
Investors must take into account the motives of management
For example, the CEO would like to increase the stock price right before a sale of his
or her personal shares
The investors must determine if management (in particular the CEO) has a long-term
or short-term agenda

Adverse Selection Theory
Adverse selection is displayed when individuals choose among various medical or dental
insurance plans
Managers have the greatest incentive to sell stock when it is a lemon (overpriced)
Adverse Selection Problems When Insiders Sell Shares
An entrepreneur must consider the following when deciding how many shares to sell:
1. Diversification benefits
2. Tax costs
3. Whether the shares are undervalued or overvalued
Investors watch carefully the buying and selling by insiders
The big inside investors must convince the market that selling shares is not a bad
signal for the company stock
Adverse Selection Problems When Firms Raise Money for New Investments
Firms may pass up good investments just to avoid issuing equity
This is especially true if the current stock price is below the intrinsic value
Using Debt Financing to Mitigate the Adverse Selection Problem
With debt financing, a company should take on a new project provided it has a
positive NPV
Management does not have to worry about the current stock price be undervalued
Management may still pass up good investments if it increases the risk of bankruptcy
too much
Adverse Selection and the Use of Preferred Stock
Preferred stock has fixed payments like a bond but avoids the financial distress risk
because missing payments does not cause bankruptcy
Preferred stock may be a good option for firms that are experiencing temporary
financial problems
JAM May 2012 1.03 SN 163 Page 7 of 9
Empirical Implications of the Adverse Selection Theory
1. The reluctance of managers to issue equity when the stock price is undervalued
explains why the stock price drops when equity is issued
2. Also explains why managers prefer the following order for financing projects:
a. Retained earnings
b. Debt
c. Equity

19.6 Empirical Evidence
What is an Event Study?
Examine stock price responses to announcements
The stock price often moves a few days before the announcement because information is
leaked to the public
Also, sometimes the stock price reacts slowly to the news over several days
Therefore, many studies average the total return or excess return over several days
Excess return calculations adjust for the market returns, which is most important for
small samples

Event Study Evidence
Capital Structure Changes
Leverage-increasing events (e.g. stock repurchase, exchange debt for preferred) tend
to increase stock prices and leverage-decreasing events (e.g. conversion-forcing call,
common stock sale) tend to decrease stock prices
Issuing Securities
In general raising capital is viewed negatively by the market
It implies the company has generated insufficient internal capital
The negative reaction is much more severe for equity issues because it also implies
management thinks the stock is overpriced
Debt issues get almost a neutral market reaction because the market likes the increase
in leverage

JAM May 2012 1.03 SN 163 Page 8 of 9
Explanations for the Event Study Results
The empirical findings above are consistent with the adverse selection theory
Equity issues are most subject to adverse selection (management knows the stock
price is overvalued) and short-term bank debt is least subject to adverse selection
Management is enticed to buy back shares when the stock price is undervalued
Managers also are willing to take on debt when they expect the future profits to be
sufficient to cover the cash flow needs
Summary of the Event Study Findings
Stock prices react favorably to
1. Distributing cash to shareholders
2. Increasing leverage
Stock prices react negatively to
1. Raising cash
2. Decreasing leverage
Differential Announcement Date Returns
Announcements of equity issues will be perceived less negatively if investors realize
the company cannot easily issue debt
The empirical evidence supports this conclusion
Postannouncement Drift
The market often underreacts to important information
Studies have shown the market underreacts to dividend initiations and omissions
It also underracts to equity issues and share repurchases
Investors may place too much confidence in their own analysis of the firms value
before the announcement

JAM May 2012 1.03 SN 163 Page 9 of 9
How Does the Availability of Cash Affect Investment Expenditures?
The borrowing capacity and availability of cash affect a firms ability to invest
Too much debt financing can hurt the companys credit rating, which could affect its
ability to attract customers
Empirical Evidence in the United States
Studies have shown companies limit investments based on cash flows
This is especially true for companies that pay lower dividends
Empirical Evidence in Japan
A keiretsu family is a group of firms with interlocking ownership structures
It makes it difficult for another firm to take them over
The family is usually held by a large bank that can supply the capital needs
Therefore, investment decisions are not greatly impacted by cash flow

JAM May 2012 1.04 SN 170 Page 1 of 7
The New Corporate Finance
Where Theory Meets Practice (Third Edition) by Chew
Chapter 31: Theory of Risk Capital in Financial Firms

Introduction
Primarily focused on principals in business parties that engage in asset-related (e.g.
lending) and liability-related (e.g. deposit taking) activities
Distinguishing features of principal financial firms
1. Credit-sensitivity of customers
Because customers can be major liabilityholders
Customers prefer high credit quality
2. High cost of capital
Because of opaqueness to customers and investors
The detailed asset holdings and business activities are not publicly disclosed
Changes can occur quickly and cannot be easily monitored by customers and
investors
This causes high agency and information costs
3. Profitability is highly sensitive to cost of capital
Because operate in competitive financial markets
Must correctly charge for the capital commitments
Difficult to allocate capital to business units

What is Risk Capital?
Smallest amount to insure value of the firms net assets against a loss
Net assets are the gross assets less the customer liabilities
The riskiness of the net assets depends on riskiness of gross assets and customer
liabilities
Risk capital differs from both regulatory capital (based on accounting standard) and cash
capital (cash required to execute transaction)

JAM May 2012 1.04 SN 170 Page 2 of 7
Measuring Risk Capital
Hypothetical Example
New firm (Merchant Bank) with no initial assets
Only deal is one-year $100 million bridge loan paying 20% interest
The risk-free rate is 10%
Three potential scenarios
1. Anticipated Return of $120 million
2. Disaster Return of $60 million
3. Catastrophe Return of $0

Possibilities with No Customer Liabilities
1. Risk Capital and Asset Guarantees
Finance with risk-free note that pays $110 million at maturity
For $5 million Merchant Bank can buy insurance that guarantees a return of $110
million on the bridge loan
The price of the loan insurance is the risk capital
Accounting Balance Sheet
Assets Liabilities
Bridge Loan $100 Note (default free) $100
Loan Insurance 5 Shareholder Equity 5
Risk-Capital Balance Sheet
Assets Liabilities
Loan Insurance 5 Risk capital 5

The payoff scenarios are as follows:
Scenario Bridge Loan Loan Insurance
Bridge Loan +
Loan Insurance Note Shareholder
Anticipated 120 0 120 110 10
Disaster 60 50 110 110 0
Catastrophe 0 110 110 110 0

JAM May 2012 1.04 SN 170 Page 3 of 7
2. Risk Capital and Liability Guarantees
Rather than purchasing insurance on the bridge loan, the parent of Merchant Bank
could guarantee the note
Assets Liabilities
Shareholder Equity 0
Risk-Capital Balance Sheet
Assets Liabilities
Note Guarantee
(from parent)
G Risk capital G
Since economically it is the same as purchasing insurance on the bridge loan, G must
equal $5 million
The shareholder payoffs are the same
3. Liabilities with Default Risk
Now Merchant Bank will finance by issuing a liability with some default risk
The risky note is only worth $95 million since $5 million must be subtracted for the
default risk
Risky Note = Default-free Note Note Insurance
The economic effect and shareholder payoffs are again the same
Assets Liabilities
Bridge Loan $100 Note (risky) $100 D
Shareholder Equity D

Assets Liabilities
Asset insurance
(from note holder)
5 Risk Capital 5
The accounting balance sheet for the above three examples could be different, but the
risk-capital balance sheets are all very similar

JAM May 2012 1.04 SN 170 Page 4 of 7
Possibility with Fixed Customer Liability
Assume a firm has risky assets worth $2.5 billion
The price of complete insurance for the asset portfolio is $500 million
The firm has issued one-year guaranteed investment contracts (GICs) promising 10% on
the face value of $1 billion
Junior debt with a face value of $1 billion and promised return of 10% is used with $500
million of equity to fund the balance
Partial insurance on the investment portfolio has been purchased for $200 million; it will
cover the first $300 million of losses
Insurance on the entire $2.5 billion portfolio is valued at $500 million; this is the value of
an at-the-money put option on the risky asset portfolio
Assuming the GIC has a market value of $990 million (11% yield) and the junior debt
has a market value of $900 million (22% yield), the accounting balance sheet looks like:
Assets Liabilities
Investment portfolio $2,500 GICs (par $1,000) $990
Third-party insurance 200 Debt (par $1,000) 900
Equity 810

Total Assets 2,700 Total Liabilities 2,700

The risk-capital balance sheet of the firm is as follows:
Assets Liabilities
Investment portfolio $2,500 Cash Capital (default free)
Customers (GICs) $1,000
Asset Insurance Debtholders 1,000
Equityholders (residual) 190 Equityholders 500
Insurance Co. (third-party) 200 Total Cash Capital 2,500
Debtholders (disaster) 100
Customers (catastrophe) 10 Risk Capital (Equityholders) 500
Total Insurance 500

Total Assets 3,000 Total Capital 3,000

The debtholder and customer asset insurance is simply the par value minus the market
value (1000 900 = 100 and 1000 990 = 10)
The equityholder asset insurance is just the plug to make the total equal $500, which
is the value of complete insurance on the risky assets

JAM May 2012 1.04 SN 170 Page 5 of 7
Basic functions of capital providers
1. All provide cash capital
2. All are sellers of asset insurance (to varying degrees)
Customers usually offer the least amount because they prefer the contract values
not be tied to the firm
3. Provision of risk capital

Possibility with Contingent Customer Liabilities
Assume a company issues a liability that credits the total return on the S&P 500
Consider three investment strategies for the company
1. Invest all in risk-free securities
In this case the gross assets are risk-free, but the net assets (gross assets less
liabilities) are very risky
Effectively the company is short the S&P 500 index
The company could protect itself by purchasing a call option on the index, so that
represents the risk capital of the company
2. Invest in the S&P 500
Now the gross assets are risky, but the net assets are risk-free
Hence no risk-capital is required
3. Invest in a customized stock portfolio
Now both the gross assets and net assets are risky
The net assets are risky to the extent the customized stock portfolio does not track
the S&P 500 index

Accounting for Risk Capital in the Calculation of Profits
Risk capital is used to implicitly or explicitly purchase insurance on the net assets of the
firm
The gains and losses on this insurance should affect profitability
External insurance commonly shows up as an expense on the income statement; internal
transactions should do the same
If the parent company provides a guarantee, the cost of the guarantee (i.e. insurance
premium) should show up as an expense for the subsidiary
This will not affect consolidated earnings, but it will impact the results by line

JAM May 2012 1.04 SN 170 Page 6 of 7
The Economic Cost of Risk Capital
The expected economic cost of capital must be calculated to adjust the expected profits
If insurance can be purchased at its fair value, then risk capital will not be costly
Usually a spread is built into the price of insurance, which turns out to be the economic
cost
The spread is needed to cover various forms of insurance risk, such as:
1. Adverse selection (the insurance company cannot distinguish good risks from bad
risks)
2. Moral hazard (cannot monitor the actions of the insured)
3. Agency costs (due to inefficiency or mismanagement)
Spreads are relatively high because the principal financial firms are opaque in structure
The cost of the capital is dependent on the form
Shareholders in all equity firms will have high agency costs (flexibility for
management) but low moral hazard (no incentive to increase risk haphazardly)
Debt financing has high moral hazard but less agency costs
The transparency could be increased to reduce the cost of risk capital, but then would
give away potential competitive advantages
The full insurance premium is deducted when measuring the profits after the fact; only
the economic cost is deducted ex ante

Hedging and Risk Management
Firms that speculate on the direction of the market will require more risk capital
Market risk can be hedged with derivatives like futures, forwards, swaps, and options
Hedging broad market risks is usually not that expensive because the spreads are small

JAM May 2012 1.04 SN 170 Page 7 of 7
Capital Allocation and Capital Budgeting
Could assume the capital for a particular business is just the risk capital applicable to that
business; this ignores the benefits of diversification
The amount of risk capital is needed (in addition to just the economic cost) to calculate
the profits after the fact
The diversification benefit will be more pronounced when the businesses are not that
correlated
Notice in Table 3 on page 450 the total risk capital should be $394 rather than $294
Marginal capital should be used for each business rather than the risk capital required on
a stand-alone basis
Correlations among business units affect the total economic cost of capital

Technical Appendix
The risk capital in Table 1 (on page 450) is based on the price of a put option
If the net assets were invested risklessly, they would grow to ( )
0 0
rT
A L e -
The shortfall in net assets relative to the riskless return is ( ) ( )
0 0
rT
T T
A L e A L - - -
Insurance to permit default-free financing is effectively a put option on the net assets with
a strike of ( )
0 0
rT
A L e -
The put option value can be approximated with the following formula
( )
0
Risk Capital 0.4 A T s =
! is the volatility of A
t
/L
t

JAM May 2012 1.05 SN 114 Page 1 of 5
Capital Allocation in Financial Firms by Andre Perold

Introduction
The approach in this article is similar to the risk-adjusted return on capital (RAROC)
Risk capital is determined by the loss exposure of its stakeholders
It is very important to financial firms because customers only want policies from highly-
rated entities
Most of the risk is borne by equity-holders and uninsured debt holders, not customers
who purchase low-default-risk liabilities
Low-default-risk (cash capital) and risk-bearing (risk capital) funding is provided by
the various stakeholders
Firms should try to most efficiently manage risk capital (i.e. minimize blended
deadweight costs)
Sources of deadweight capital costs
1. Information costs
Financial firms are secretive and can change quickly, thus making it impossible
for outsiders to adequately monitor them
2. Higher taxes and agency costs of free cash flow
The tendency of companies to waste excess cash flow on low-return projects
Decreasing firm-wide risk can reduce the cost of guarantees
Diversified firms have more investment opportunities because the risk capital is reduced
Should not operate a transparent business (e.g. S&P 500 index fund) within an opaque
financial firm
Outsiders cannot clearly see the holdings and strategies of opaque financial firms

Risk Capital
Often calculated with value at risk (VaR)
Merton and Perold definition of risk capital
Smallest amount that can be invested to insure the value of the firms net assets
against a loss in value relative to a risk-free investment
Using the above definition, the risk capital for a treasury bond is the price of a put option
struck at the forward price of the bond
VaR ignores the magnitude of the loss in the extreme tail of the distribution
Diversification benefits can be very large
JAM May 2012 1.05 SN 114 Page 2 of 5
Allocation of the Cost of Risk Capital
Diversified financial firms should have lower capital costs and thus greater returns
Opaque financial firms should use low-cost hedging instruments when possible
Capital can be allocated on a stand-alone, fully allocated, or marginal basis
Example
Assume both business units A and B have stand-alone capital requirements of 100
The correlation of their profits is zero
The fully allocated risk capital for both businesses is
2 2
100 100 141.4 + =
The marginal capital for each is 141.4 100 = 41.4
Different investment decisions will be made based on the choice of capital allocation
Many firms only recognize diversification within business units, not between them

A Model of the Financial Firm
In this example, SwapCo is a low-cost swap dealer
SwapCo is in business for one time period; all contracts are due at time 1
SwapCo hedges the liabilities, but there is some residual basis risk that is unhedged
SwapCos profits are , which is the present value of the spread over the fair value of the
customer liabilities
The initial price for the customer is L(0) + , where L(0) is the default-free value
L(0) is invested in the hedge portfolio H; is invested at the risk-free rate
The cumulative hedging error is E(t) = H(t) L(t), which makes the total end-of-year
operating profits equal (1 + r) + E(1)
Assume the profits are normally distributed with mean of (1 + r) + " and standard
deviation of !; the term " represents the risk premium for exposure of the hedging error
to systematic risk
SwapCos Balance Sheet
The initial assets consist of a hedge portfolio, external guarantee, and a cash cushion C
(part of which is from the spread)
The external investment required = C + Cost of Guarantee
The net assets (excluding the external guarantee) at time 1 are:
( ) 1 (1) S C r E = + +
The payoff from the external guarantee is { } , 0 S Max S
-
= -
Only has a positive payoff if the net assets are negative
JAM May 2012 1.05 SN 114 Page 3 of 5
Deadweight Costs
1. Guarantor monitoring SwapCo
Modeled as a fraction, m, of the shareholder deficit, S
-

{ }
m V S
-
, where
{ }
V S
-
is a present value calculation (defined below)
This makes the total cost of insurance equal
( ) { }
1 m V S
-
+
2. Double taxation and free cash flow agency costs
Modeled as a fraction, d, of the shareholder surplus, S
+

The shareholder equity is therefore worth
( ) { }
1 d V S
+
-

Valuation
( ) { } ( ) ( ) { } { } { }
1 1 NPV d V S C m V S dV S mV S m m
+ - + -

= - - - - + = - +

So the net present value is the firms operating profits less the value of the deadweight
capital
{ }
[ ]
{ }
[ ] ( ) ( ) ( ) ( )
1 1
n z zN z n z zN z
V S V S
r r
s s
+ -
+ - -
= =
+ +
, where
( ) 1 C r
z
s
+
= and n( ) and N( ) are the standard normal and cumulative standard
normal distributions
! is the risk-neutral standard deviation of the hedging error

Minimization of Deadweight Costs
Higher initial cash will reduce the guarantee premium and monitoring costs but increase
the double taxation and free cash flow agency costs
Minimize total deadweight costs when the shortfall probability =
d
d m +

The initial cash cushion that minimizes the deadweight costs is
( )
*
1
m
d m
Z
C
r
s
+
=
+
, where Z( ) is the inverse of the cumulative normal distribution
At the optimal cash cushion, the value of the deadweight costs is
{ } { }
( ) ( )
2
1
2
exp
2
1
m
d m
d m Z
dV S mV S
r
s
p
+
+ -
+ -

+ =
+

JAM May 2012 1.05 SN 114 Page 4 of 5
Main Result
( )
( ) ( )
2
1
2
where
exp
2 1
m
d m
NPV kR
R k d m Z
r
m
s
p
+
= -
= = + -

+

R is the value of the put option on the hedging error, which is the Merton and Perold
measure of risk capital
k is the minimized cost of deadweight capital

Numerical Example
Risk-free rate = r = 10% = 150 ! = 250 d = 10% m = 100%
( )
90.7
2 1
R
r
s
p
= =
+
, which means the return on capital is
150
165%
90.7
=
( ) ( ) ( )
*
0.909 250
1 1.1
m
d m
Z Z
C
r
s
+
= = =
+
303
N(1.335) = 0.909
( ) ( ) ( ) ( )
2
2
1 1
2 2
exp 1.1 exp 1.335 45.1%
m
d m
k d m Z
+

= + - = - =

The return on capital (165%) is clearly more than the deadweight cost of capital (45.1%)
Cost of the Guarantee
( ) ( ) ( )
{ }
[ ] ( )[ ]
( ) { }
2
1
2
1 303 1.1
1.3332
250
1
( ) exp 0.1641 ( ) 0.0912
2
( ) ( ) 250 0.0425
9.66
1 1.1
Guarantee Cost 1 19
C r
z
n z z N z
n z zN z
V S
r
m V S
s
p
s
-
-
+
= = =

= - = - =

- -
= = =
+
= + =

Total Investor Capital = C + Cost of Guarantee = 172
( ) ( ) 150 45.1% 90.7 109 NPV kR m = - = - =

JAM May 2012 1.05 SN 114 Page 5 of 5
Application of the Model to Capital Allocation Within the Firm
Should seek to maximize NPV of the firm

Capital Budgeting
If k is constant, then for any project just need the marginal effect on the profits and firm-
wide risk capital
Should accept the project if 0 k R m D - D >
The incremental risk capital can be approximated with R bR D = , where b is the
correlation coefficient of the projects profits with firm-wide profits
If b is negative, then the project will act like a hedge

Risk Management
Any risk that can be costlessly hedged should be hedged
Costly hedges should be evaluated like any other project

Comparison with RAROC
In this model the numerator (#) is the economic value of profits and the denominator
(#R) is the marginal risk capital
The hurdle rate (k) measures the firms deadweight cost of capital

JAM May 2012 1.06 SN 166 Page 1 of 10
Corporate Finance Theory by Megginson
Chapter 2: Ownership, Control, and Compensation

Introduction
Corporate finance theory usually assumes perfect capital markets
A countrys legal, cultural, and historical environment affect finances
Successful countries (e.g. US, Japan, and Germany) have different structures
An economic system must simultaneously promote competition and cooperation
Companies must be monitored and disciplined

Legal Forms of Business Organization in the United States
Basic forms of business ownership in the United States
1. Sole proprietorship
2. Partnership
3. Corporation
The forms differ in the number of people that own the business, legal responsibility of
members, and tax treatment
There are also hybrid organizations such as limited partnerships
Regular corporations constitutes most of the business

The Sole Proprietorship Form
A sole proprietorship is a business with a single owner
All business assets belong to the owner personally
They are easy to start and terminate
The tax reporting is also simple
Sole proprietorships dominate industries in which the optimal size is small
Key disadvantages
1. Limited life
2. Limited access to capital
Can only access capital from reinvested profits and personal borrowings
3. Unlimited personal liability

JAM May 2012 1.06 SN 166 Page 2 of 10
The Partnership Form
Like a proprietorship, but more than one owner
All partners can execute contracts binding on others, and all partners are personally liable
Usually the partnership agreements are in writing
Partnership income is only taxed at the personal level
Advantageous because people can pool resources and expertise
Partnerships strive in industries that should not separate ownership and control
Also competitive in knowledge-intensive businesses that need little financial capital
Advantages
1. Income only taxed once
2. Can raise funds from multiple partners
Disadvantages
1. Limited life
2. Limited access to capital
3. Unlimited personal liability

The Corporate Form
A corporation is a separate legal entity
It can own property, sue and be sued, and execute contracts
Benefits
1. Limited liability for shareholders
2. Perpetual life
3. Can contract with many managers, suppliers, customers, and employees
4. Many ways to raise capital
5. Ownership shares can be traded freely if it is a public corporation
Disadvantages
1. Corporate income is taxed at both the company and personal levels
This is a huge incentive to remain a sole proprietorship or partnership
2. Transaction costs of setting up and running corporations
SEC filings, shareholder communications

JAM May 2012 1.06 SN 166 Page 3 of 10
3. Monitoring and disciplining corporate executives (separation of ownership and
control)
Shareholders are residual claimants that can diversify
No individual shareholders steps up to effectively monitor management even
though it is in their collective best interest
Individual shareholders are looking for a free ride
Executives effectively seize control of the corporation

The Limited Partnership Form
Combines the best features of the general partnership and corporate organization
Limited liability without the double taxation
Only the general partners are legally liable
Usually there are many passive investors (limited partners)
Common for commercial real estate ventures and research and development
Investors can utilize tax losses in the early years
Disadvantages include long lives and illiquidity
Also difficult to set up and monitor

The S Corporation Form
Allows shareholders to be taxed as partners while retaining limited liability status
To be eligible, must have less than 35 non-corporate shareholders and cannot be a
holding company
Only a single class of equity can be outstanding
Can easily switch to a C corporation if outgrows the 35 shareholder limit

Organizational Choices Confronting US Business Owners
The forms differ from each other in ease of formation, length of existence, access to
capital, liability of equity investors, and tax treatment
Public companies have stock listed on the exchange
Private companies rarely report much information
Capital requirements usually force companies to choose C corporations, despite the tax
disadvantage

JAM May 2012 1.06 SN 166 Page 4 of 10
Forms of Business Organization Used by Non-US Companies
Worldwide Patterns
In most capitalistic economies, some form of joint-stock, limited liability structure
dominates
They are similar to publicly traded US companies

State-Owned Enterprises and Privatization
Outside the US, state-owned enterprises (SOEs) were common in industries such as
telephone, television and airline
Privatization programs are transforming this
The British government privatized much of their industry in the 1980s
The success of Britain led to similar programs in other countries

Ownership Structure and Corporate Policy
Three basic models
1. Open corporate model (common in large American corporations)
2. Closed or entrepreneurial model (common in large private companies in western
Europe and east Asia)
3. Industrial group model (e.g. Keiretsu in Japan)
The Open Corporate Model
Limited liability company with transferable claims
Professional managers with many financing sources
These companies dominate business in the US, Canada, and Great Britain
Many of these corporations are very large
Key financial characteristics
1. Rely on public capital markets for external financing (but finance most internally)
2. Shares are held by many shareholders that each hold a small percentage
3. Countries rely on formal legal contracting, government regulation, and private
litigation to control
4. Large, liquid, and informationally efficient stock and bond markets
5. Regulations designed to protect small stockholders
6. Controlled by professional managers
7. Equity-based compensation for managers and employees
8. Active market for corporate control
JAM May 2012 1.06 SN 166 Page 5 of 10
Weaknesses
1. Separation of ownership and control
Many agency problems
Managers may select directors who are loyal to management
Difficult to control managers that have enough free cash flow
Institutional investors could take a more active monitoring role, but American
security laws prevent this
Takeovers are expensive and difficult to execute successfully
2. Entrenchment incentives
3. Lack of powerful, informed monitors
4. Excessive, mandated information disclosure
Reduces value of proprietary information
Strengths
1. Can raise enormous sums to finance corporate investments
2. Financing transparency promotes investor and political support (reduces mistrust)
3. Allocational efficiency corporate resources given to most successful managers
Disciplined by internal governance and market competition
Focus on value-maximizing activities since shareholders want to maximize
earnings
4. Specialization of labor through ownership separation
5. Promotes private pension plans
6. Risk-tolerant equity markets promote entrepreneurial growth
7. Technology lowers information acquisition and monitoring

The Closed, (Entrepreneurial) Corporate Form
Sometimes appears to be a younger, not-yet-mature open corporation
However, many choose to remain small
Consists of non tradeable shares and a very tight ownership structure
Many are controlled by their entrepreneur/founders
Typical of the financial-intermediary-based corporate finance systems
Geographic Distribution
More important outside the US (Europe and east Asia)
These economies are much smaller than the US, so smaller companies are optimal
JAM May 2012 1.06 SN 166 Page 6 of 10
Characteristics of Financial-Intermediary-Based System of Corporate Finance
1. Many mid-sized, closely-held companies; few large, publicly-traded companies
2. A few strong commercial banks dominate corporate financing and governance
3. Commercial banks also serve as investment banks
4. Capital markets play small, but growing role
5. Little mandated information disclosure, so less transparency
6. Less reliance on professional managers and stock-based compensation
7. Rare struggles for corporate control; protection from hostile foreign acquisition
Strengths of Financial-Intermediary-Based System of Corporate Finance
1. Intermediaries are natural corporate monitors; European bankruptcy laws favor
creditors over shareholders and managers
2. Commercial banks have comparative advantage in raising investment capital
compared to public capital markets
3. Intermediaries can build long-term relationships with client firm management
teams
4. Can better handle borrower financial distress
5. Better at funding multi-year investment programs
Weaknesses of Financial-Intermediary-Based System of Corporate Finance
1. Conflict of interest for bankers acting as creditors and shareholders
2. Very little public transparency
3. Higher costs for large scale financing
4. Information processing technology is reducing value of bank franchises
Strengths of Closed Corporate Form
1. Important decisions can be made quickly and executed by people with a stake in
the business
2. Very few agency problems since managers and shareholders tend to be the same
people
3. Develop niche marketing strategy that is focused
Weaknesses of Closed Corporate Form
1. Current stockholders cannot diversify or attract professional managers with equity
2. Often become trapped in hostile control coalition (nobody can leave)
3. Financially constrained (usually limited to debt issues)

JAM May 2012 1.06 SN 166 Page 7 of 10
Large Industrial Groupings
Virtually no role in the US since the early 1900s; now mostly prominent in Asia
Key features
1. Close alliance of manufacturing, marketing, and banking companies
2. Group held together with cross-shareholdings and joint ventures
3. A commercial bank typically provides financing
Successful examples are in Japan and South Korea
Historical Evolution
Japan began to industrialize at a rapid rate around 1870
Large, family-controlled corporate groups led the way (called Zaibatsu)
The Zaibatsu were broken up following World War II, but reemerged as Keiretsu in
1955
Characteristics of Industrial Group System
1. National economies dominated by small number of large and powerful industrial
groups
2. Commercial bank leads a group of manufacturing, distribution, and assembly
companies
3. The lead company exercises control through direct majority shareholdings or
managerial authority
4. Leading exporters for country, so close relationship with national government
5. Some are run by founding families while others are run by professional managers
6. Capital markets play a very small role
7. Stock-based compensation is almost never used
Strengths of the Industrial Group Corporate Finance System
1. Good for rapid economic development without need for foreign investment or
heavy government involvement
2. Groups become very strong and discourage foreign competitors
3. Banks can provide financing and monitoring
4. Can quickly share information within the group

JAM May 2012 1.06 SN 166 Page 8 of 10
Weaknesses of the Industrial Group Corporate Finance System
1. Group will become unstable unless all members grow at the same rate
2. Difficult to consider competitor inputs even if cheaper or better quality
3. Reliance on national products prevents consumers from getting cheaper foreign
products
4. Only Japan and Korea have had success
Korea seemed to copy Japanese model, but the lead companies have tighter control over
group companies

How Corporate Control is Exercised
Corporations should benefit society in general and shareholders specifically

Internal Corporate Governance Mechanisms in the United States
Publicly-traded US companies must disclose a lot of information (e.g. revenues,
expenses, compensation)
Must also hold annual shareholder meetings, which are described in advance by a proxy
statement
The most important shareholder vote is electing the board of directors
The director vote can be interesting if a proxy fight occurs
In a proxy fight both the managers and rival team will solicit shareholders for votes
Shareholder votes are also needed to approve items such as corporate mergers
The board must hire, fire, monitor, and compensate the firms managers
The board is a fiduciary for the shareholders
It is difficult for shareholders to make managers and the board act in their best interest
Corporations can become hijacked by entrenched managers

The US Market for Corporate Control
Corporate combinations can occur through acquisitions or mergers
The combination type affects
1. Accounting treatment
Acquisitions use purchase method of accounting while mergers use pooling of
interest treatment
2. Method of payment
Acquisitions involve cash payments; mergers involve stock exchanges
JAM May 2012 1.06 SN 166 Page 9 of 10
3. Role of target firms board of directors and both firms shareholders
Mergers require negotiations between the boards
An acquirer can make a tender offer and bypass the target firms board
A friendly offer is supported by the target board
Entrenched insiders use defensive strategies such as share repurchases and poison
pills
Patterns in American Market
1. There are takeover waves in the corporate market; usually occur during times of
economic expansion
2. Net synergistic gains usually come with significant ownership changes; this
contradicts public opinion
3. Target firm shareholders usually yield large returns from a takeover; shareholders
from bidding firms sometimes lose and sometimes win
4. Insider shareholdings tend to increase equity values for all firms, thus increasing
the returns for the target firm shareholders
Less profitable and smaller firms are often targets for takeover
5. The federal government is now more open to horizontal mergers
Alternative Means of Exercising Corporate Control
Hostile takeovers and proxy fights are expensive
Institutional investors, particularly pension funds, could exert their influence

Non-US Corporate Governance Systems
Other countries have monitoring difficulties also, but they have fewer large companies to
monitor
Japanese firms are monitored by the lead company, but this does not help individual
shareholders
European companies are generally monitored by banks

Governance Systems Employed by US Venture Capitalists
Great at shifting business risk onto the entrepreneur while giving him incentive to
accomplish appropriate goals
It is a pretty restrictive arrangement

JAM May 2012 1.06 SN 166 Page 10 of 10
Compensation and Incentives: Theory and Evidence
Appropriate compensation arrangements can reduce agency costs that arise between
managers and stockholders

Components of Standard Compensation Packages in US Firms
Compensation packages become more complex as one moves up the corporate ladder
Typical components of compensation package
1. Base salary
Protects the manager from financial ruin if the company has few bad quarters
2. Cash bonus based on business-unit performance
Rewards good short-term performance
3. Stock options
Focus all managers on common corporate goal
4. Deferred cash or stock payments contingent on remaining with the company
These are called golden handcuffs

Specialized Compensation Techniques and Instruments
Golden parachutes are cash payments made if an executive loses his or her job after a
takeover
Phantom stock gives managers cash payments that mirror those received by shareholders;
this minimizes shareholder dilution
Some companies allow a new executive the right to purchase a large block of stock at a
reduced price

JAM May 2012 1.07 RM String Page 1 of 3
Risk measures: how long is a risky piece of string?
CSFB Handbook, Chapter 9

Why think about risk measures?
One does not know the ending value of a risky portfolio
The distribution contains a lot of information, including mean, standard deviation, and
probability of losing more than $A
So the distribution cannot be represented by a single number
A single dollar measure is needed to communicate at a high level with audiences such as
regulators, senior management, and investors

Examples of risk measures
The profit distribution is normally skewed to the left (i.e. small chance of very big losses)
Risk measures include
1. Mean (expected) loss
2. Standard deviation of loss
3. Value at Risk (VaR)
Find a value Q such that P(X<Q) = p, a given tail probability
4. Conditional VaR
The expected loss given the loss exceeds Q
[ ] | CVaR E X X Q = <

Artzner's theory
Coherent risk measure axioms
1. Homogeneity
If the distribution is scaled by a multiple $, then the risk is scaled in proportion
( ) ( ) Risk X Risk X q q =
2. Translation
If A is a constant,
( ) ( ) Risk X A Risk X A + = -
The risk measure should be reduced as noted above because we are concerned
with downside risk, not just uncertainty
3. Monotonicity
( ) ( ) in all states of the world, then If X Y Risk X Risk Y
Again, the focus is on downside risk; this means the risk of Y is greater than the
risk of X because it is always worse
4. Subadditivity
The risk of a portfolio is never more than the sum of the risks of its constituents
( ) ( ) ( ) Risk X Y Risk X Risk Y + +
The risk of a portfolio should be a convex function of asset allocation
It is beneficial (or at least not detrimental) to diversify
5. Risk Sensitivity
The risk measure should decrease as the mean increases (because less chance of a
loss) and increase as the standard deviation increases
( ) ( ) ( ) ( ) ( )
( ) ( ) 0 0
d Risk S V d V U V d V
S V U V
m s = +
< >

Summary Table
Homogeneity Translation Monotonicity Subadditivity Risk
Sensitivity
Mean Loss X X X X
Standard
Deviation
X X X
VaR X X X
CVaR X X X X X

Subadditivity, convexity and risk sensitivity in more depth
This section explains (or defends) some of the boxes in the table above
The mean loss, standard deviation, and VaR risk measures are all not risk sensitive
The mean loss is not a function of the standard deviation
Reducing the mean of the distribution does not necessarily increase the standard
deviation
Increasing the standard deviation may reduce the VaR, depending on the threshold

Conclusion
CVaR is the superior risk measure

JAM May 2012 1.08 SN 178 Page 1 of 9
Economic Capital Modeling: Practical Considerations
Study Note FET-178-12

1. Introduction
Required Economic Capital is the amount of economic capital a business thinks it needs
Available Economic Capital is the amount of economic capital the business actually has
Economic capital can be used to value the business or manage the risk
Regulatory pressure from banks (Basel II) and insurers (Solvency II) encourage the use
of economic capital analyses
Difficult to calculate embedded value at insurance companies

2. What is economic capital?
Required Economic Capital is based on a certain probability of default; it is not the same
as regulatory capital
Available Economic Capital is the excess of the assets over liabilities, both valued on a
realistic market basis
Specifics needed in defining economic capital
What risks are considered?
What probability of ruin is acceptable?
What time period is used in the ruin measurement?
Is future new business considered?
When considering the amount of capital at an insurance company, it is important to know
the basis for valuing assets and liabilities
There is a movement towards fair value, but that is difficult for liabilities that are not
traded regularly

3. What are the benefits of economic capital analysis?
Insurance companies hold capital to take on risk and absorb fluctuations
Most hold enough so there is a high probability of meeting financial obligations
There is a cost to this capital since shareholders demand a fair return
Must balance this cost with the probability of ruin
Shareholders want to avoid overcapitalization while regulators are concerned about
undercapitalization

JAM May 2012 1.08 SN 178 Page 2 of 9
4. How can economic capital analysis be applied?
International Regulatory Trends
Weaknesses in formulaic approaches in determining required capital
No link with effectiveness of company's risk management
Formulas can't deal with all types of risk
Prudent management is not the same is meeting capital requirements
Formulas do not handle new products or risks
Diversification is not measured correctly
Solvency II by the European Union is designed to measure required capital on a much
more realistic basis
Solvency Capital Requirement (SCR) is based on a 0.5% probability of ruin over a
one-year period
Minimum Capital Requirement (MCR) is calculated with a simple formula and is the
minimum allowed by regulators
Eventually the SCR will be calculated with internal models; this allows insurers to
more correctly manage their risks
SCR is similar to economic capital
The United States uses NAIC Risk-Based Capital (RBC)
For the most part it is formulaic
There is slow movement to more realistic calculations (e.g. stochastic projections for
variable annuity guarantees)
In Canada, principles-based reporting has been around for several years
Switzerland uses stochastic modeling and extreme scenarios
The International Association of Insurance Supervisors (IAIS) is working on a common
assessment of insurer insolvency; recommends a total balance sheet approach

European Embedded Value
Most leading European life insurers have disclosed information about embedded value
The disclosures were designed to give more information than was present in statutory
statements
Extreme market conditions revealed problems with embedded guarantees
European Embedded Value (EEV) principles takes an explicit approach to valuing
options and guarantees
The EEV principles give much latitude to companies in the calculations

JAM May 2012 1.08 SN 178 Page 3 of 9
Risk-Adjusted Return on Equity or Capital (RAROE or RAROC)
Insurance products have different levels of risk
Should not price all the business and the same discount rate

5. What type of risks should be considered?
For economic capital, only focus on the downside risk

IAA Risk Categories
1. Underwriting Risk
Mortality, morbidity, persistency and lapse risk
Shows up in pricing, design, and claims management
2. Credit Risk
Default and change in credit quality
Includes concentration and counterparty risk
3. Market Risk
Driven by interest rates, stock prices, exchange rates, real estate prices, and
commodity prices
4. Operational Risk
Risk of loss from failed internal processes, people, or external events
Operational failure and operation strategic risk
5. Liquidity Risk
Assets not sufficient to meet liability needs
Function of both assets and liabilities
Could be triggered by downgrade in credit rating

JAM May 2012 1.08 SN 178 Page 4 of 9
Three Key Components for Modeling
1. Volatility Risk
Random fluctuations in frequency or severity
Can reduce with diversification, but cannot eliminate
Smaller companies are more exposed to this risk
2. Uncertainty Risk
Either mistake in the model or the parameters used in the model
This risk is not diversifiable
Medical insurance has more uncertainty risk because it depends on many factors
government policy, medical technology changes, economic environment
3. Extreme Events (Calamity)
High impact but low frequency
Difficult to account for because may not be in historical data

6. How should each of those risks be measured?
Measure effect of specific risk to a company's surplus
May consider effect of diversification when calculating aggregate risk
Approaches to Measure Losses
1. Scenario-based Model
Deterministic or stochastic
Scenarios cover multiple risks at the same time
2. Static-factor Model
Linear combination of static risk factors multiplied by company-specific amount
Basis for NAIC RBC used in the United States
3. Stochastic-factor Model
Identify risk drivers
Measure delta and gamma for each risk driver
Model joint distribution of risk drivers
Aggregate losses across all risk types
4. Covariance Model
Special case of stochastic-factor model
Use first order sensitivities and VaR as risk measure

JAM May 2012 1.08 SN 178 Page 5 of 9
Approaches for Risk Types
1. Underwriting Risk
Major drivers are mortality, morbidity, longevity and lapse
The first three can be separated into diversifiable and systematic components
The volatility risk can be measured as the difference between the best estimate and
tail liability measurement
Systematic risk relates to misestimates of the mean and deterioration of the mean
Could test by assuming the sample mean is the 95
th
percentile of the true distribution
Mortality trend improvement can come from medical advances
Catastrophic mortality risk should also be considered
Policyholder options (e.g. surrender, annuitize) are often dependent on economic
conditions
Must test by simulating various economic environments
2. Credit Risk
Modeled similar to banking standards
Consider default, credit migration, spread, and spread volatility
Can use models such as CreditRisk+ and KMV
Model rates of default and recovery
KMV models defaults as an option against the firm's assets
3. Market Risk
Often called asset liability management (ALM) for insurance companies
Changing asset yields can affect liability values
Difficult to value liabilities since there is not an active market
4. Operational Risk
Quantitatively modeled or qualitatively assessed
Can do with simple add-on models or stochastic frequency-severity models

JAM May 2012 1.08 SN 178 Page 6 of 9
7. What modeling decisions should inform the analysis?
VaR (Value at Risk) vs. Tail-VaR (Tail Value at Risk)
VaR measure the probability of ruin at a given quantile of the probability distribution
TAIL-VaR considers the probability and severity; it is the average of losses that exceed a
given quantile
Shareholders are only concerned with VaR because at that point the position is worthless
Regulators are concerned with the magnitude of the losses
TAIL-VaR is better for low-frequency high-severity events
Conditional tail expectation (CTE) is very similar to TAIL-VaR and is used in US
regulations

Stochastic Analysis versus Stress Test
Both can be used to see impact of extreme events
Stochastic Analysis
Project future cash flows based on multiple scenarios
Must use many scenarios (~10,000)
Specify the probability of each scenario; could just assume all equally likely
Stress Test
Base analysis on a few extreme scenarios
The probability of the scenarios are not specified
Dynamic Capital Adequacy Test in Canada uses this approach
Common to express economic capital as the amount needed to cover losses that can occur
over X years with Y% confidence
Sometimes difficult to specify a probability (e.g. for a specific government action)

JAM May 2012 1.08 SN 178 Page 7 of 9
Real World versus Risk Neutral
Risk Neutral
Discount all cash flows at risk-free rate
Assumes no arbitrage
The probabilities are derived so the average present value of the cash flows equals the
actual observed price
Real World
Cash flows are discounted at rates greater than the risk-free rate
Difficult to determine the spread to the risk-free rate
It is more common to use the real-world approach when determining economic capital
Difficult to convert the probability distribution in a risk-neutral world to one in the
real world

Diversification Effect
The total capital required is likely less than the sum of the individual risks
Correlation assumptions can be used to determine risk dependencies
However, should consider how correlations change in extreme scenarios
Copulas is a technique to measure dependency between risks
Often used in default risk modeling
Copulas are not easy to use; also difficult to determine goodness of fit
Regulators are aware of tail dependencies and are thus reluctant to give too much
diversification credit
Insurance companies that engage in various activities benefit from diversified risk
Regulators are concerned about the solvency of each legal entity, so diversification may
not be beneficial for a conglomerate

JAM May 2012 1.08 SN 178 Page 8 of 9
Time Horizon to Consider
Usually either focus on a one-year time period or long-term period (e.g. 30 years)
One-year Time Horizon
Calculate impact of short-term shock on solvency
The risk factor change could have impact on cash flows after one year
This method could not be used to calculate VaR or CTE, but the ease is appealing
Could determine the capital necessary to have an X% chance of remaining solvent
over many stochastic scenarios
Multi-year Time Horizon
Use stochastic scenarios to check solvency level during or just at end
This method may not accurately measure impact of management actions (e.g.
investment or dividend policy)
The IAA seems to imply a one-year time horizon is adequate

Whether to Allow Negative Cumulative Surplus in the Middle of the Time Horizon
Must decide if only to check surplus at the end of the horizon
More capital is required if do not allow negative surplus in the middle of the time horizon
Could allow negative surplus in the middle but use a realistic borrowing rate

Whether to Account for Future New Business
Should confirm writing new business will not hurt company's economic capital
Profitable new business will likely be beneficial in the projection, but still may require
more up front capital

8. Illustrative Examples?
Example 1: Deterministic Stress Test
Apply instantaneous shock to various risk factors
Simulates impact to economic balance sheet before management has time to react
Common way to determine capital requirements in the UK and Switzerland
Shocks could be to such factors as equities, volatilities, or interest rates
Could standardize the shocks by making them the same number of standard deviations
The economic capital required is the change in capital position after the stress test
The stress test can be used to determine the effect of various hedging programs; if
effective, they can greatly reduce the capital required
JAM May 2012 1.08 SN 178 Page 9 of 9
Example 2: P&L Projection
Again based on a unit-linked investment product
Main sources of risk
1. Delta measure of the risk that the underlying assets fall; this will increase the
value of the guarantee
2. Rho measure of interest rate risk; if rates fall, the present value of the liabilities
increase
3. Vega measure of volatility risk; the hedging cost and guarantee value increases
when volatility rises
Must project P&L across a wide range of realistic scenarios
Can calculate the economic capital with VaR or CTE
Can test the impact of hedging by graphing the P&L projections
Hedging will not eliminate the risks, but can drastically reduce the impact

Holistic VaR Aggregation Towards Enterprise Risk Management (ERM)
Could use the previous approach for each source of risk independently
1. Market Risk
2. Credit Risk
3. Liquidity Risk
4. Underwriting/Demographic Risk
5. Mortality/Longevity/Morbidity Risk
6. Lapse Risk
7. Policyholder Behavior Risk
8. Expense Risk
9. Operational Risk
10. Group Risk
Can aggregate the risks using a correlation matrix
Value at Risk could be measured as the difference between the expected value and the
lower 5
th
percentile

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