Strategic Financial Management

Chapter II

Firm’s Environment, Governance and Strategy
After reading this chapter, you will be conversant with: • • • • Business Environment of a Firm Operational Structure of a Firm Financial Structure of a Firm Performance Plans and Types of Executive Compensation

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Added to this it may also be stated that the unexpected changes in the economic conditions can attribute to a major risk factor. will vary to a large extent on a period of time. The American Economy went through such period during 1974 to 1982. This can be explained from the fact that increased technology has resulted in the increased productivity of both the labor and capital inputs. So one can say that if at all the average returns match with the expected returns. These resources take into account real estate and property plant and equipment. antitrust restrictions on mergers and acquisitions and several other allocated problems. it has to procure a lot of products and services from the product and service providers. For any firm that is carrying out its business. and high volatility rates. because the market’s ex ante required expected return on equity corresponds to the cost of equity capital of the firm. Further there was also the problem of economic recession. so as to secure and maintain a fair level of competitive advantage. inflation and regulation as imposed by government. the betterment of technology results in the evolution of new firms and the death of the older firms which fail to keep themselves at pace with the fast moving technological changes. till the early 1980s. There was a positive signal for interest rates. talented labor and management personnel. Then in brief it can be said that. the firms encountered not only the problem of high rates of taxes but also increased government regulations. and perhaps even with the state of the economy. distribution and legal services. It is important for the firm to continuously seek out for resources at lower cost. State of the Economy The state of the economy both in the current as well as the predicted future plays a significant role on the firm’s businessmen strategies. Though recession has always proved to be disastrous for individuals as well as businessmen firms. then the expected returns on the stocks and the cost of equity capital.Strategic Financial Management FIRM’S BUSINESS ENVIRONMENT Let us look into each of the elements of a firm’s business environment and also see as to how it affects the internal structures and operations of the firm. On a holistic 11 . From the time of end of the Second World War. the manager of the firm should keep himself updated with the state of the macro economy for two reasons (i) to enable himself to predict future economic conditions and (ii) to affect the profitability of capital investment projects. as well as its operational and financial structures and its risks. Coupled with these were the problems of high inflation rates. These issues can be addressed based on the business environment that the US had experienced since the Second World War. These may include labor. and low cost product and service providers. Resources Available to the Firm The dependence of a firm’s ability to operate in its chosen product and service market to that of its ability to secure resource equitably on its business strategy need not be overemphasized. one needs to attain the economies of scale. cost effective technologies. The other reason being that the state of the economy affects a firm’s overall weighted average cost of capital (WACC). To procure these services. by having an influence on both the equity as well as the duelist capital of the firm. Let us now try to answer one intriguing question as to whether the observed average aggregate returns on stocks corresponds to the market’s example expected return. The increased level of technology in the industrial front has given way for enhanced profit for a firm. This has always been an important issue to the managers. There was strengthening of the technological advancements that included both the external as well as internal corporate governance structures. In contrast the economic condition between the years 1983 to 2001 proved to be much more stable. but the issue of consistent below par economic performance has been even more devastating. transportation. electricity. performance and contingencies. In the long run.

Further. hedging of the businessman risk. In any firm. As it is commonly said that. there exists a separation in ownership and control. to the general public. This group can be described as a group of outsiders that is responsible to keep a constant vigil on the activities of the firm by exerting external control and constraints over the firm. they impose taxes. These take into account the interest rate risk. As a result of this. as well as it provides with a better accent to raise finance to external equity and debt finance. Added to this. The main purpose of having these two types of creditor governance mechanism is to find a proper and adequate solution to the problem that arises due to the existing conflict of interest between the firm and its creditors. They carry out the activity of estimating the values of these companies’ shares and comparing them with their market values. And finally it may also include other firms. As a result of these. debt markets and derivatives market. the liquid market enhances the value of the shares. It is the equity investors that estimate the final measure of management performance. Governance and Strategy manner. and currency risk. They even stand ready to take control of the firm in case it performs poorly. in order to protect the interest of the social structure. It is also to be stated that the derivative instruments include the forward contracts. They are equity markets. There also exists a third external governance group. of the firm’s activities. The reason being. Any firm can be characterized as having three types of financial markets. they also include those investors who might be in a position to take a short position in a stock they consider to be overpriced. The importance of the debt markets is also to be cited here. the firm’s management should be able to manage between the vast nexus of contracts with the stakeholders. rather the 12 . The latter function deals with the protection of the property rights. The reliance to the public firms on the debt markets is due to the externally generated funds. As stated earlier. The general public refers to the investors and the ultimate consumers. they provide the adequate service and protection to the firms. several structures. External Governance Groups The federal. These are now playing a dominant role in the financial strategies and policies. This issue gives rise to the fundamental problem that has been constantly addressed as the principal-agent conflict and information asymmetry. which is the stock of the firm. and other major investors in the market who continuously question the efficacy of the firm’s management. regulations and even restrictions on these firms that operate within the industry. This is because the creditors to a firm also impose constraints on the firm’s activities by the use of covenants in debt contracts as well as constant monitoring. Thus it can be safely said that the firm’s financial performance is not guided by the periodic financial statements that are submitted by these firms to the securities exchange commission. The media plays an important role in communicating any information that is available. the government also imposes taxes. contracts and operations of a public firm are designed so as to lessen these problems and their costs. there is also another group of financial analysts that is constantly analyzing the strategies of the different activities as carried out by almost all the publicly traded firms. having a liquid public market is essential to a firm for its equity.Firm’s Environment. whereas on the other hand. On one hand. state and the local governments play a dual role towards the firms. The primary service that is provided by the government to its firms is concerned with the establishment of the property rights through proper legislations and enforcing the legal contracts with the help of its judicial systems. Here the investors are those who not only own a firm’s shares but also to those potential investors who keep a constant watch on the price movement of the stocks and consistently compare those stocks’ market prices with that of their true value. the government constitutes an external governance group. and swaps. keeping in mind the benefits accrued out of public equity. This group comprises of the various professional business analysts and professional commentators. The proportion of debt fund in the total capital structure is determined by several characteristic features. regulations as well as restrictions on the various activities that are carried out by the firms. Another external group can be considered to be the one that is composed of the creditors.

proposal to increase the number of outsiders in the currently existing board of directors. The insiders. It is always seen that the analysts and the commentators are very prompt in pointing out to the management that involves in the excessive consumption of the perquisites. creates a better image of the company in the minds of its shareholders. This proposal generally calls for some changes in the firm’s internal governance structure. the shareholder initiated proposals gained prominence. At the same time. This may include the structure and composition of the firm’s board of directors. The primary objective for framing these proposals was to increase upon the performance of the companies and to provide them with a positive market 13 . One being the proxy contests and the other being the shareholder initiated proposal. not performing their duties to the best of their capacities or even involving in self engaging empire building. These shareholders vote on the issues of elections for the board of directors. As a result of which. At the same time. But as it is the case with most of the firms. If studied in detail. Thus one can firmly conclude that the above stated external governance groups play an important role in reducing the agency cost that goes with managerial discretion. Proxy contests take into account the campaign among the competing groups for the right to cast the shareholder’s vote on their behalf. the process calls for casting proxy votes for the shareholders. there can be four major classes of shareholders. Internal Governance and Business Strategy Let us now study in detail about various elements of the firm’s internal governance structure and its business strategy. Let us now discuss on a couple of shareholder activism that has gained prominence in recent times. the senior managers of the firm in association with the board of directors. the role that is to be played by the firm’s board of directors is dependent on the firm’s business strategy to a large extent. Further. This can be explained from two points. The other important implication being that the financial analysts and the commentators provide an enhanced picture of the firm’s management which. INTERNAL GOVERNANCE The internal governance structure of a firm is made of shareholders.Strategic Financial Management estimation of the true value of the firm is the result of the constant effort of the analyst and the media. Keeping these considerations in mind one has to keep the firm’s governance structure and the business strategy on an equal basis. the promoters of the firms decide upon the predetermined product and service markets. the board of directors and the firm’s managerial hierarchy as well as its internal capital markets. The first being that the information that is generated by these analysts and the media helps in lessening the information disparity between the firm and its investors. acquisitions and the sale of the various assets. This is of greater significance because in order to maintain good competitive advantage. the former should always be placed on a higher cadre over the latter. one being that the reduction in the information asymmetry helps in increasing the liquidity and efficiency of the market for the firm’s stock. They also vote on the issues of mergers. a firm needs to keep some of its valuable information within its four walls. Let us now take a look into the shareholder initiated proposals. the pension funds and the outsiders that comprise the individuals as well as the other outside firms. it can be seen that the monitoring done by the media and the analysts results in two important implications. the mutual funds. In other words. It has been always an issue of argument that the firm’s governance structure is of greater importance than its business strategy. It is to be noted that the common stockholders have the voting right of one vote per share if at all they are allowed to vote. say for example. with more information being made available by the media and the analysts it will be very difficult for the firm to maintain those valuable information that it wants to keep private. in turn. After the decline of the takeover activity in the 1980s. For a publicly traded non-financial American firm. works out on the firm’s business strategy and at the same time its operational and financial structures on a constant basis.

that the optimal structure of the board will comprise of both the insiders as well as the outsiders to the firm. Such studies have found out a negative correlation between the percentage of votes cast in favor of the proposals and the percentage of stocks held by the corporate insiders and the non-management members of the board of directors. the shareholders’ proposals can also add value if they help in gaining control of a corporation or tend to exert pressure for specific policy changes. these studies have also shown positive correlation between the votes that have been cast for proposals and the management members of the board. An insider to a board is the one who has been in the employment of the firm for a long time. and who has shown the ability to rise on the corporate hierarchy. and to compel the firm to pursue the politically motivated and value decreasing investments. There is yet another school of thought that is of the opinion that the shareholder activism seems to impair firm management. Any employee to the firm who has got employment because of having any family relationship with the senior management may also be referred to as the insider to the board. The first is that even if the proposal turns out to be unsuccessful. the payment of dividends. The insiders to the board carry along with them a lot of experience. as well as decrease the value of the firm. Those proposals that are sponsored by the individual investors bring fewer votes and at the same time they tend to impact the stock price to a very lesser extent as compared to those proposals that are sponsored by the institutional investors. the outsiders are those who have not been in the employment of the firm and did not have any long-term relationship with the top boss of the company. The primary functions that are carried on by the board involve the hiring. perspective and insights which they have gained during their long tenure of employment. There has been enough evidence to justify the fact that the voting of the shareholder and the reaction of the stock market is dependent on several issues that are considered in a proposal as well as the identity of the proposed sponsor himself. Governance and Strategy value. Added to this. On the other hand. Whereas the outsiders to the board bring along their experiences that they have gained while working in other 14 . One of the important factors of the board is the ratio of the number of outsiders to that of the number of insiders that constitute the members of the board. Let us now shift our focus towards the corporate boards. the message may reach the management that the shareholders are unhappy with their performance. But the bottom-line is pretty clear. Thus they find their applications more in those firms that are found to perform poorly. Further. At the same time. The corporate boards generally have a membership of around 6 to 12 people.Firm’s Environment. voting on the major management proposals. They receive a larger share of votes and at the same time they tend to have a negative impact on the stock prices. There is also the possibility that the public institutions may use the corporate governance proposals so as to gain influence over the target firm’s decisions. Keeping this in mind. compensating as well as firing the senior management. degrade the level of performance. it can be concluded that the corporate governance proposals that are sponsored by the public institutions will have a tendency to decrease the value of the firm as well as its operating performances. voting on the issues relating to stocks and bonds. Several studies done on these relevant subjects have thrown some light on the conflicts of interest between the shareholders and the management. Another study done by Karpoff et al on the shareholder initiated corporate governance proposal has concluded that such proposals have the ability to increase the firm’s market share primarily because of two reasons. decisions regarding the repurchase of company’s stocks and finally providing the senior management with the much needed strategic information and advice. this percentage never showed any sign of increase over a sample period. the outcome of the voting has shown that though the percentage of votes cast in favor of the proposal averaged less than the majority of the casted votes.

dividend policies and compensation policies. is that what we term as the long purse hypothesis. It is worthwhile to mention here that the operational as well as the financial structures of a firm are determined by the firm’s business strategy as well as its size to a large extent. OPERATIONAL STRUCTURE Let us now discuss some of the most important aspects of a firm’s operational structure. they may be having regional and divisional managers who shoulder the responsibilities of firm’s operations within their sphere.Strategic Financial Management firms. It is worthwhile to mention here that the outsiders can express a more free opinion about the performance of the CEOs as and when they feel like doing so. Developing an effective competitive strategy against its competitors within the industry. It may also happen that all these three positions are being held by one single individual. This may involve major capital budgeting decisions that may include the strategic and logistical planning of capital investments and divestitures as well as decisions relating to the financial structures. Let us go back to the argument that was put up by Williams which stated that a typical industry will consist of a few. The basic rules of capital budgeting takes into account the concept of net present value (NPV). BUSINESS STRATEGY The business strategy of a firm can be said to have three essential elements. Management Hierarchy and Internal Capital Markets For any typical firm. Establishing the goals in terms of the market shares and profits. The indifference nature of the firm can be attributed to the fact that in an 15 . the board chairman and the chief executive officer. This required fund can be procured by the issuance of equity or debt or by using the retained earnings. In an ideal capital market a firm shows an indifferent approach while raising funds it needs to pursue for a positive NPV. including financial planning. Due to the increasing work pressure. Say. At the same time it also stated that there will be many smaller lesser profit making companies that are labor intensive that have very little or no debt. capital intensive industries which are highly profit making and which carries along with them some element of debt in their capital structures. issue of equity as well as the concerns involving their repurchase of shares. it further teaches us that a project should be accepted only if it yields a positive value of NPV. where the estimation of the NPV is done by discounting the project’s expected cash flows at the rate of the firm’s WACC. issuance of debt and their retirements. Capital Budgeting Process The capital investment decisions are unarguably the most important decisions that a firm has to make. Larger firms may also have a broader span of management hierarchies. for example. They are: 1. 3. This is mainly due to the reason that these decisions ultimately result in the shareholders’ value creation. 2. This. The ultimate responsibilities of the company are vested with that of the chief executive officer. Let us now study some more details about the financial strategies and policies of a firm. certain firms may also hire a chief financial officer (CFO) for the smooth running of their business. the management hierarchy starts at the top level with the firm’s president. Targeting the specific products or the service markets. in other words. large. In addition to this there may be certain firms that may go for high leverage showing their strong intention to go for aggressive competition or there may be firms with lower leverage strategies that help it to squeeze out the highly leveraged firms.

Thus here it can be said that the profitable firms have an added advantage in financing growth.Firm’s Environment. But perhaps no absolute answer can be given to as why certain firms grow large and earn more profits whereas others do not. there is a close relation between the economies of scale or in other words their profitability. and their capital intensive nature. Successful firms possessed innovative. Advantages of Being Large The very fact that the larger firms are generally more profit making than the smaller and the lesser ones need not be mentioned. Thus it is the duty of the senior managers to plan out incentive compatible contracts so that such problems can be avoided. This provided them with greater access to the debt and equity markets so that they could raise additional funds when required. Other large and manufacturing firms such as the general motors are also highly capital intensive. in the case of a self serving manager. the cost that is associated with the principal-agent conflicts and information disparity can negatively effect the capital investment and the financial decisions of the firm. The problem of delegation has always been a cause of concern for many firms. but still it may go for increasing the riskiness of the firms’ operations as a means of expropriating wealth from the creditors. the focus of the capital governance is towards the monitoring of the management’s ability to identify the positive NPV projects. there may be cases where the project is accepted though it has a negative NPV. because the financing decisions are obligatory in nature. Further it has been seen that almost all these firms had a well developed market structure where it could supply its products. strategy wise founders who were succeeded by the equally competent CEOs. As per the pecking order hypothesis. As it has been stated earlier. But it can be said that towards the way to success. most of the firms have treaded on a similar path. the balance between the capital and the labor intensities depend on the industry within which the firm operates. These firms enjoyed the benefits of being the first mover in the market and as a result of this they could capture at least temporary profits and were able to exploit the opportunities effectively following an initial public offering. because he is more concerned with building his own empire. Thus one can say that the capital budgeting and the financing decisions are exclusive in nature. Governance and Strategy ideal capital market all the securities are sold at a fair price and all the capital structure yields the same level of WACC. especially the external equity capital. Based on this platform. Firm’s Production Function For any firm. On the 16 . There may also be cases of firms having risky debts outstanding in their balance. With the increase in the number of these firms. they could reap the benefits of the economies of scale which in turn helped them in generating extra profits and to force the competitors out of the existing markets. The problem may be of the form that the divisional manager may have better information about the profitability of the project than the senior management of the firm. to be costly. Coupled with this if the divisional manager has a self serving incentive to build his or her own division. Certain firms that are engaged in the transportation and the utilities industries have larger scale of operations and as such they are the most capital intensive industry in the American market. especially in a multidivisional firm. they go for funding the expansions using the internal equity. this is always a preferred method of financing growth under the conditions of asymmetric information which considers the element of external capital. Finally it can be mentioned here that as far as the firms’ financial policies and the strategies are concerned. Say for example. Finally there may even be cases where a firm may sacrifice a positive net present value if only its creditors derive benefit out of it. Thus for such firms. he/she may indulge in the practice of showing a better picture about the quality of the proposed project so as to garner greater capital funds from the company’s headquarters.

certain firms such as Microsoft that falls in the service industry characterizes labor intensiveness. Ownership structure Financial planning and leverage Executive compensation policies. FINANCIAL PLANNING Financial planning mainly takes into account two major aspects. Financial Planning and Leverage Let us here discuss some of the factors that affect the firm’s leverage.Strategic Financial Management other hand. This aspect can at least to some extent explain the absence of positive relationship between the insider share ownership and the performance of the firm. c. FINANCIAL STRUCTURE Let us now discuss about the basic pillars of a firm’s financial structure. they may find it rather difficult to do so in case a majority of the firm’s shareholding is with outside investors. But once the ownership of the stocks increases beyond this level. It is the policy of many firms to engage an internal auditing team that will oversee the entire product development process. on the other hand. Ownership Structure The optimal structure may widely vary across firms due to the factors that affect the trade offs that exist between the advantages of diffused ownership and cost of managerial discretion. the value of the firm as measured by the Tobin’s Q simultaneously increases as expected. the firm’s value no longer increases. when such an ownership becomes substantial. The procedure of developing the intricacies of a marketing strategy is a long drawn process. Whether the company is complying with the quality and cost controls and finally whether the reports on all the activities are accurate. These studies focused on the relationship of the fraction of the firm’s shares that is held by the executives and the market value of the firm. One of such devices has been the executive stock ownership. There have been several studies done so as to focus on the importance of such devices. Another way by which the trade off can be seen is to relate the top executive turnover with that of the firm’s ownership structure. b. Let us now discuss each of these elements in detail. if the outside shareholders need to reduce the adverse value effects of the management entrenchment. one being the predictions regarding the timings and the future capital expenditures on the 17 . Here it should be noted that the internal auditing and the cost control procedures are major aspects of any firm’s operations especially for a firm that is operating in a highly competitive product or service market. it will be always at the cost of the less diffused ownership and its associated benefits. A secondary trade off can also be brought into the picture. a. Internal Auditing: Quality and Cost Control The birth of a capital investment project begins when the board gives its approval for the expenditures that are to be made. One particular way by which one can study the trade off as stated above is by examining the effect of incentive alignment devices on a firm’s market value. It has been further found out that if the top executives own a substantial amount of the firm’s share then they can establish themselves despite the firm’s poor performance. Studies relating to this have shown that with the increase of the stock ownership from about zero to about three to five percent. whether all workings are done according to the plans and if any further changes are required in those plans. The internal auditing team provides the firm with valuable information that may include information pertaining to whether all the parties involved in the project are working on a consensus basis. But.

The main purpose of the financial planning analyses is to reveal the expected future needs of the firm as far as the external debt or equity funds is concerned. To site an example. Any how. LEVERAGE. that the observed cross sectional variations in incentive devices and their complexity 18 . it seems strange that a firm that is expected to be highly profitable would face problems in securing debt financing when the firm’s current capital expenditures exceed its available internal funds. as explained by Shleifer and Vishny. Further. In one instance it mentions about the negative relationship between the growth of the firm and its financial leverage. Say as an example. the grants of the restricted stock or the stock options that provide compensation that is a function of the future performance of the stock price. The serious problem that one can associate with the high powered incentive contracts is that they result in creating avenues for self dealing managers. or they may even indulge in manipulating the accounting numbers and investment policies so as to increase upon their pay. In such situations. Thus in a nutshell it can be said that the primary purpose of the financial planning process is to strike a balance between the amount as well as the timing of the future outflows of the firm with that of the net cash flows that may accrue from the operations and the proceeds of the debt or equity issues. As a result of which. he tries to reduce the firm’s operating leverage or taking on only the low risky projects. option may not always be so much an incentive device as some what canceling mechanism of self dealing. Let us now delve into the problems that are generally confronted with the standard incentive devices in executive compensation contracts. And the other issue being how the firm will finance its capital expenditures. Further. the leverage of a firm may depend on whether the firm has recently gone for raising debt funds for its capital investments because it faced lack of sufficient internal cash. an executive who is risk adverse in nature personally motivates himself so as to reduce the firm’s business risk and financial risk. and long-term performance plans.Firm’s Environment. INVESTMENTS AND THE GROWTH OF A FUND There have been several studies that have shown a negative relationship between the leverage of a firm and its growth. As far as reducing the business risk is concerned. those annual bonuses that are tied up to the firm’s earnings. because they know that the earnings or stock prices are likely to go up. The results he found out are suggestive of the fact that. a typically diversified shareholder is only exposed to the firm’s systematic or diversified risk. Executive Compensation As it has been stated earlier the incentive devices in executive compensation contracts play a crucial role in determining and linking the shareholders and the manager’s interest. Yermack (1997) found out that managers tend to receive stock option grants shortly before any announcement of good news and they tend to delay such grants until after any announcement of bad news. The problem can be even more serious. the strengths of incentive devices in executive compensation contracts is associated with their importance and to their positive net worth. It can be said that. Governance and Strategy projects and the future earnings that the company will produce. With regard to the financial leverage. But it is also to be noted here. there can also be the potential for the performance indentures to boomerang. One of the studies that have been conducted puts forth two competing relationships. dividends and stock repurchases over the period of time. we will also discuss some evidences relating to the compensation devices in brief. if those contracts are negotiated with poorly motivated board of directors rather than with larger blocks of investors. These incentives generally include the portion of the firm’s share that is held by the management. debt payments. The primary problem is from the firm’s point of view. he tries to reduce the firm’s leverage below its optimal level if at all such a level does exist. On the other hand. PROBLEMS WITH INCENTIVE DEVICES It is to be borne in mind that there cannot be any perfect incentive device. the managers may negotiate for their vested interest. an executive’s personal portfolio is not well diversified and is exposed to the firm’s risk to a great extent. the recent developments that have taken place in alternative incentive devices. In contrast. Let us now explain this in more detail.

the market’s valuation of the firm’s stock price is dependent on the information that comes directly from the firm’s management. They can do it by switching depreciation methods. the management can also manipulate accounts of earnings. There may also be the chances. the problem that arises is that the manager become more concerned on the firm’s short-term accounting earnings. enhancing the profit potential of the existing or pending projects or price of the firm’s shares. Further. One last finding in the study was in relation to the excess returns generated around the announcement of the performance plan adoptions which showed that such excess 19 . the annual earnings based bonuses. and replaced them with the long-term performance plans that reward the executives according to the firm’s earnings or stock price performance over a period of three or five years rather than rewarding annually as it is the case with earnings based bonuses. but also certain other factors that are beyond the contract of the manager. like long-term performance plans. a manager may be of the opinion to hire off a poorly performing asset even if by doing. Further it has also been observed that.Strategic Financial Management shows that it is rather difficult to bring together the interests of the senior management and the shareholders through terms in a compensation contract. But it has been seen that both these kinds of incentive devices are not free from problems. This is consistent with the fact that such plans would result in the reduction in the agency problems. Say for example. it adversely affects the short-term earnings of the firm because of the writing down. so as to increase the market value of the firm’s equity. EARNINGS BASED BONUSES VS STOCK RELATED GRANTS The everlasting debate served by placing the management’s attention on earningsstock price performance. Their studies have reported a considerable positive excess returns around the time when such plans were adopted. A positive aspect of a long-term performance plan is that. which may be of potential harm to the firm’s long-term profitability. the stock price of the firm depends not only on the firm’s performance. Let us now discuss the recent developments that have taken place in alternative forms of incentive plans. A bonus plan based on earnings may be better off because it is a reward to the CEO for the realized performance. at least in the short run. Long-Term Performance Plans The development of the long-term performance plans can be partially attributed to the fact that there existed certain problems with both the annual earnings based bonus plans and the stock related grants. Taking into account. The studies have concluded saying that the long-term performance plans serve as an effective mechanism to motivate managers to make better decisions. Another study as conducted by Kumar and Sapariwala (1992) probed into the markets’ reaction to the announcement of adopting the long-term performance plans and the subsequent changes in the performance of the adopting firm. the stocks and the stock options grant focus directly on the shareholders interest. where management might manipulate the stock’s price. Studies conducted have revealed that the reaction of the market to the announcement of an asset sale is more favorable if the firm’s management has a long-term performance plan than if it does not have. and writing down assets though the extent to which they can manipulate accounts is limited as companies have to rise by the generally accepted accounting principles [GAAP]. In contracts. As a result of which many firms have actually removed both these forms of incentive plans. They may also include market wide factors that generally affect the stock’s price. there exists a close allocation between the adoption of long-term performance plans and the resulting growth in the firm’s profitability. The problem that can be associated with the stock related grants is that. This may be due to the existence of information asymmetry. recognizing on delaying the revenues. It is of the common practice that managements use accounting methods according to their convenience. which is actually the ultimate determining factor of the share value of the firm.

Their ultimate study dealt with the estimation of the common stock and options holding of managers in each group. monitoring by the board and the firm’s major shareholders. percentage of equity held. and performance. both because the boards of these firms have not resolved the agency problem of managerial discretion.Firm’s Environment. One category belonged to that group that subsequently experienced an increase in the variance and the other group that subsequently underwent a decrease in variance. Board and Ownership Structures. Relationship between the Executive Compensation and Firm’s Financial Policies and Performance The relationship between the firm’s executive compensation and its financial policies is not that simple. managerial equity investments. Apart from this. i. it has been found out that the security holdings of managers of firms with a debt-equity ratio that increases are larger than those for which the ratio decreases. It may happen that the contingencies that are involved in the executive compensation contract may both effect as well as get effected by other associated financial variables. the executive compensation will be higher and the firm performance lower. their managers’ common stock and the options are larger than those firms for which the variance in returns decreases upon such announcements. a capital investment or a change in the leverage. Thus it can be said. the 20 . Their findings can be summarized in the following points. the most commonly used accounting performance measure. the profounders of the theory had identified the firm that had actually taken one of two types of actions that could change the volatility of the firm i. One of their findings says that. they were also of the opinion that those managers who either hold shares in their firm or have stock options on the equity of the firm. Executive Compensation. Forms of Executive Compensation and Managerial Risk Taking Studies conducted by Agarwal and Mandellear (1987) have focused on the effects or provisions in executive compensation contracts on a firm’s financial policies. The authors also divided the leverage changing firms into two groups. and Performance Studies conducted by Tarcker et al (1999) analyzes the interactions among the executive compensation. For those firms whose variance in return increases upon an investment announcement. Ownership and Governance Structures of Leverage Study conducted by Mehran (1992) on 170 US manufacturing firms tested the hypothesis from agency theory about the relationship that existed between the firm’s leverage and the executive incentive plans. The studies were conducted on the platform that the managers generally have a self serving incentive so as to decrease the volatility of the firm. Let us now try to understand the relationship of the compensation plans with some of these variables. Executive Compensation. internal governance.e. Based on this they divided the firms into two categories. ii. Governance and Strategy return is positively skewed with the subsequent change in growth of earnings per share. that managers who hold the share or stock options will be more willing to take actions that increase the risk. The study found a positive relationship between the firm’s leverage ratio and the percentage of executives’ total compensation in incentive plans. will then be indulging in risk reducing activities because their compensation contract better aligns their interest with that of the firm’s shareholders. Further. for firms with boards. Those firms that increased the leverage and those that decreased the leverage. whereas those managers who do not hold shares or stock options are more biased towards the risk reducing actions. In order to test the validity of the hypothesis. They studied the change in the variance of returns on the firm’s stock with the announcement of any capital investment.

etc. because any typical capital-intensive firm is larger and so enjoys the business risk-reducing 21 . the more it is likely that the firm attaches compensation to the effect of the firm value. One of the important ingredients of a firm’s business strategy that determines its business risk is the industry in which the firm chooses to operate. or in other words. a traditional debate exists stating that a firm’s business risk is positively related to its capital intensity. by examining the shareholders’ authorized compensation arrangements that provide a more critical ex ante perspective. c. Evidence on the Pay Performance Relationship Jensen and Murphy (1990) studied the sensitivity of the chief executive officer compensation that comprised pay. plants. As a general finding. There are two aspects of a firm’s operational structure that can influence its business risk. that a larger firm is generally more geographically diversified. alternative suppliers. the larger the proportion of the value of the firm in terms of growth options. But this fact is pretty surprising. He focuses on the flexibility the firm’s board has while negotiating a contract with the senior management. Regulations tend to prohibit the managers investment discretion and reduces the marginal product of the decision maker. b. the wealth of the chief executive officer changes by 0. At the same time. d. financial policies and executive compensation. options and stockholdings on the firm’s performance. on an average. But the authors suggest that this argument may fail as the management executives are averse to risk and thus they may refuse to accept the risk that is associated with such incentives. The second advantage being. Risks. The argument states that.325% for a change in the shareholder’s wealth. Investment Opportunities. the relationship between the capital intensity and business risk may be difficult to prove empirically. its operating leverage.Strategic Financial Management percentage of investment bankers on the board of equity held. the percentage of investment bankers on the board of directors and the percentage of equity that is held by individual investors. Firms attached with more growth options use stock options more frequently. Financial Policies and Executive Compensation Studies conducted by Smith and Watts (1992) speak about the relationships among the firm’s investment opportunities. as it rises the basic rationale behind the compensation plans. These results appear to be very surprising and suggest that the chief executive officer has very little personal incentive to increase the shareholder’s wealth. rather than the ex ante terms in the executive contracts. This issue was given recognition by Kole (1997). One. say in terms of its customer’s base. Larger proportion of value attributed to growth options is representative of greater management compensation. any capital intensive firm is filled with a considerable fixed cost and as a result its operating earnings are more prone to changes in its revenues. that is. that the firm enjoys a semi monopoly status within its industry by the virtue of economies of scale though this status will not protect the firm from a decline in aggregate demand for the industry products. employees. as they should contain performance incentives that actually bring together the managers’ and the shareholders’ interest. They found out that. As far as the capital intensity is concerned. Some of their findings are: a. Performance. because the management in such firms is more difficult to monitor. its business risks become well defined. and Contingencies Business Risk and Financial Risk as Determinants of Equity Risk The riskiness of the firm’s operating earnings. But it is to be mentioned that the studies conducted by Jensen and Murphy may not have yielded accurate results. as it used data on ex post compensation. once the management decides on its business strategy and operational structure.

It is to be remembered that the decisions related to these contingencies. and the importance of their interest lies in the riskiness of the firm’s business risk. Governance and Strategy effects of the large sized firms. iii. the firm’s WACC will depend on the state of the economy. and if so by what extent? Studies conducted by French and Tama have concluded that firms generally invest in projects whose IRR exceeds their WACC. It is mainly for this reason. irrespective of the fact whether such performance has been good or disappointing. The business risk and financial leverage work in accordance to determine the risk of a firm’s equity. Thus. at some point of time. Though the initial outlay on the project may be relatively easier to determine. and not the profitability of firm’s original projects. this criterion holds good for all projects. the project may be abandoned and the assets may be liquidated or even redeployed further estimating the firm’s WACC may not be always an easy task. Contingencies Managers generally confront with contingencies as a result of past performances. whereas.Firm’s Environment. that best explains its business risk and then it considers its leverage. Say for example. for any given set of risky assets and operations. If the firm’s management wishes to limit the firm’s equity risk to some level of tolerance. Let us here discuss four classes of contingencies: i. so. The term “financial risk” is used in reference to either a firm’s risk of bankruptcy or to the effects of leverage on earnings and stock price volatility. where the firm’s management initially decides on its optimal business strategy and its operational structure. though by a marginal percentage. Cost of Capital. iv. This is due to the fact that the financial leverage works to focus more on the firm’s business risk on a smaller equity base. This problem is coupled with the fact that there exists even the present issue of future “contingencies”. Let us now use empirical evidence on this issue. With few exceptions. that the interest of the shareholders and the management are aligned. The firm’s WACC is dependent on both its business risk as well as its capital structure. both in terms of amount and timing. If that is not so. Let us now take the case. It is worthwhile to mention here. one can suppose that the firms that have higher business risk will tend to have lowest leverages. Say for example. the question still remains unanswered as to which effects influence in determining a firm’s business risk. the management is concerned with the interest of the firm’s equity holders. Let us now try to answer one peculiar question. that only such projects are beneficial because they tend to increase the share value. but also on the firm’s financial leverage. Financial Risk. it is much more difficult to estimate the expected future cash flows. if the cash flows are adverse. ii. Also. additional capital expenditures may be called for. the firm’s financial risk increases with its financial leverage. Growth opportunities Restructuring Merger. on the other hand. Say. acquisition or buyouts Bankruptcy or liquidation. determine the majority of the firm’s future profitability and the shareholder’s value. Profitability and Share Value The traditional capital budgeting identifies projects which have higher expected rate of return (IRR) than the firm’s weighted average cost of capital. Leverage and Equity Risk It is to be mentioned here that the risk associated with the firm’s equity is dependent not only on the firm’s business risk. if the initial results on the project’s profitability are favorable. Further. it 22 . Let us now discuss this in detail. Estimating the IRR of a project may not be that simple as it seems. then the decisions related to such contingencies may be suboptimal. Do firms ever adopt projects whose IRRs exceed their respective WACCs. then it has to employ less financial leverage when its business risk is higher. Business Risk.

This has led firms to pursue their core competencies coupled with their growth opportunities. • The capital budgeting decisions. A final contingency deals with the bankruptcy or liquidation element. for any company that is in financial distress. financial leverage. the managers are engaged in self serving empire building. The designing of the executive compensation policies is a difficult task as the interests of the managers and that of the stakeholders’ tends to clash. resource availability. Decision regarding the production function (capital\labor intensive operations). e. For a firm that is going to acquit. Decision regarding the size of the company. There have been two milestones in the development of US firms in 1980s and 1900s. Decision regarding the financial structure of the company. ii. As far as the target firm is concerned. In the case of liquidation. Alignment of the interest of the shareholders and the management through the incentives in the executive compensation contracts. The operational structure of the firm consists of the a.Strategic Financial Management may be seen that many firms are growing. it may try to gain critical economies of scale in its existing products market or to pursue a profitable opportunity in a complementary product market. SUMMARY • The business environment of the firm consists of the state of the economy. managerial hierarchy and the internal capital markets). and the proceeds are distributed to its claimholders may be of the last resort. Internal Corporate Governance. • The financial structure decisions typically comprises of the ownership structure. the assets of the firm are sold. only some of these firms are pursuing profitable growth opportunities. whereas in other managements. d. These are: i. Once a firm declares bankruptcy. Internal audit consisting of the cost and the quality audit. government and the creditors). • 23 . It thus views executive compensation not only as an instrument for addressing the agency problem between managers and shareholders. b. board of directors. but also as part of the problem itself. These types of contingencies after reshuffling its assets and financial structure. Another important form of contingency for acquiring firms and targets refer to the mergers and acquisitions. internal governance groups (The shareholders. but as a matter of fact. it gets protection from its creditors and also an opportunity to remerge. it generally is profitable to the shareholders of the acquired firm. c. based on priority. dividend and stock repurchase policies and the executive compensation policies. and the firm ceases to exist. external governance groups (media.

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