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CLASS NOTES

WEEK VIII

READING ASSIGNMENT
GT Ch.18

Alex Kane 1 IRPGEN422  Investments

The hardest Conflict: Management Vs. Shareholders
• First theoretical thesis: Jensen and Meckling,
Theory of the firm: managerial behavior, agency
costs and ownership structure, 1976
• Took more than 10 years to penetrate management
programs, even today, not many treat in depth
Issues: how decision should be/are made in view of:
– Whose interests is management actually looking after?
– Diffused ownership -- difficulty in oversight
– Management with controlling shares -- potential abuse?
(international studies of corporate governance and
control)
– Managerial control and capital structure
– Executive compensation
Alex Kane 2 IRPGEN424  Corporate Finance

How effective is the market discipline?
• GT: Text with copyright of 2002 (written in 2000-1
and published by 8/01) suggests:
• “Although these incentive issues probably cannot
be eliminated, financial markets have evolved in
recent years in ways that lessen the more significant
problems.” (Points to outside directors)
• We have seen that the interaction of better market
discipline combined with regulatory failure can
exacerbate the problem
• The principle of second best welfare plans
Alex Kane 3 IRPGEN424  Corporate Finance

Management Constituents • Who do they represent beside shareholders? – Themselves – Other constituents: debtholders. employees • Public believes(?) employees must take top priority • Behaviorists hypothesize: people with whom they have most contact: employees (?) institutional shareholders (?) suppliers/customers (?) Long- serving mangers more inclined to balanced views • Difference concept of management from the Japanese quickly disappearing structure Alex Kane 4 IRPGEN424  Corporate Finance .

Management ownership and control • Median ownership of CEOs (1990) 0. Reason? diversification. Value of control may be less than cost of non-diversification • Proxy fights are not efficient (stacked against shs) • Who protects shs? – Institutional investors like CALPERS (few) – Takeover threats (subject to social debate and policy) Alex Kane 5 IRPGEN424  Corporate Finance . 80% of of CEOs own less than 1.4% • Outside shareholders even more diffuse creating a free-rider problem as to monitoring.25%.

rM –rf = 8% • Reward-variability (Sharpe) measure: • M: 8/20.1) • John can increase Axel Inc. Axel: (beta*8+4)/40 • Investment not acceptable. Mkt Pf SD: 20%.’s value by $60M (from $300M) over the next 5 years. • Required investment: His entire wealth of $60M to purchase 20% of the stock. Diversification and Monitoring (Ex.18. monitoring cost high Alex Kane 6 IRPGEN424  Corporate Finance . IRR = rE + 4% • Axel SD: 40%.

Improvement in corp governance • Changes in early 1990s – fuller disclosure of compensation – shs access to copr shareholder files -. terminated directors more likely from outside the corp Alex Kane 7 IRPGEN424  Corporate Finance .makes proxy fights easier • Greater emphasis on outside directors – majority of outsiders up from 71% in 1979 to 86% in 1989 – directors prob to be terminated 1983-1994 doubled from 1971-1982.

g. SPEs. even in the most advanced systems there is a long way to go – conflict of interests in the auditing business – conflict of interests in investor services (exacerbated by pricing difficulties) – unsatisfactory transparency. exacerbated by taxation Alex Kane 8 IRPGEN424  Corporate Finance .International perspective and current issues • Governance is shown to affect value world wide • Studies show that legal protection of shareholder rights significantly affect share value • However. e..

Where do we find mgt with large holdings? • Founders of corporations may hold large blocks of shares despite diversification motive – Tax issues (Gates) – in countries where lack of legal protection makes it difficult to find buyers (Mexico) – in industries with greatest potential for management incentive problems (media) – industries with uncertainty about future create signaling problems. computers) Alex Kane 9 IRPGEN424  Corporate Finance . Sale of stock signals disappointing future (technology.

Inside Ownership and Firm Value (Ex.18.2) • Bates owns Bates Inc. Value tied to Bates efforts – Bates wants to sell large fraction of shares – Current value $100M – Bates sells >50% => value falls to $80M – Bates sells <33% => value falls to $90M • How much will Bates sell? – Sell 50% => get: cash=$40M stock=$40M – Sell (1/3) => 30M 60M – Depends on – Interest in putting efforts into the firm – Risk aversion • Empirical evidence: entrepreneurs selling smaller fraction receive higher price/share Alex Kane 10 IRPGEN424  Corporate Finance .

will we find managers with larger holdings and slack in companies with easier access to slack? Alex Kane 11 IRPGEN424  Corporate Finance . Managers with Large Holdings • The incentives argument – These managers will try harder • The abuse argument – These managers have a better chance of creating slack • Question: Can we identify companies with easier/harder access to slack? If so.

Managers with Large Holdings: Random? Type of business affects  holdings and incentives (1990)  Best incentives Worst incentives Alex Kane 12 IRPGEN424  Corporate Finance .

value falls with concentration – Suggesting that greater control leads to abuse – Criterion used is market-to-book value. fund discount only 4.2% – Absent large shareholders. large shareholders control decisions Alex Kane 13 IRPGEN424  Corporate Finance .1% • International studies: where abuse is easier. sensitive to tangibility of assets • Closed-end funds – Average fund discount is 14. Empirical Evidence on Managerial Control and Value of Shares • Studies point out that – Up to concentration of about 5% value increases – Beyond about 5%.

Hence. executives will choose investments that enhance and preserve control – Invest in business requiring their expertise (??) – Implicit contracts (with key employees or Spielberg:-) – Investing in fun business (Bronfman of Seagram) – Short-term projects create quick recognition and slack – Minimize risk (including sigma): bad outcome may cost job (only 43% of CEOs and 46% of directors keep job in BR) – Large empires: invest in projects that increase size and decrease sigma risk. Managerial Control and Investments • Control of corporation beneficial to managers. Pay less dividends and reinvest Alex Kane 14 IRPGEN424  Corporate Finance .

the company invested $2. RJR Nabisco • This large company emerged from the merger of the tobacco (RJR) and food (Nabisco) giants • A few years later it was taken private by its management in a famous LBO • Prior to the LBO.8B in a cost saving project at IRR≈5% • After the LBO (management owns the firm). the project was scaled back Alex Kane 15 IRPGEN424  Corporate Finance .

Outside Shareholders • Incentives to affect investments that neutralize management biases • Allied Industry example: Choose the capital intensive process that limits flexibility • Flexibility is a valuable asset the greater the corporate risk. significant loss of NPV • Alternative: improve monitoring of management • Result: – benefit of discretion greater with uncertainty – Monitoring preferred to discretion with less uncertainty Alex Kane 16 IRPGEN424  Corporate Finance . Impact of Large. Hence.

positive relationship between leverage and % of – Compensation tied to performance – Equity owned by management – Investment bankers on the board of directors – Ownership by large outside shareholders Alex Kane 17 IRPGEN424  Corporate Finance . Debt and the Conflict between Management and Large Shareholders • Risk averse mangers will limit debt • Large shareholders prefer more debt – To avoid management over-expansion of firm (create debt overhang) – Increase motivation to take risk – Increase incentives to perform (avoid BR) • In a study of 124 manufacturing firms.

choose higher leverage Alex Kane 18 IRPGEN424  Corporate Finance . Higher leverage to control CEO • Tom and Charley want to invest in real estate • Tom will manage the project. Charley in charge of finance • Both have resources hence can choose how large a mortgage to take • This decision is to be made by Charley • Should Charlie go for higher or lower leverage? • To limit Tom’s slack.

) Good Medium Bad Value with project 250 175 125 Value w/o project 50 50 50 Project NPV 100 25 –25 • New manager is expected to fund project regardless of state of the economy • How can financing of initial investment prevent such outcome? Alex Kane 19 IRPGEN424  Corporate Finance . an additional $100M may be needed for expansion Value in State (mil. Leverage Choice Problem (Ex. One year later. 18.3) • Initial investment $100M.

senior debt (why?) • Project can be financed in all but bad economy • Note: Problem solved only if there are no sufficient internal funds to finance the project Alex Kane 20 IRPGEN424  Corporate Finance . Choosing Appropriate Financing • Project has negative NPV if economy is bad • If initial investment is financed with equity. manager can fund project with debt even in bad economy (why?) • The idea is to finance initial investment with senior debt. so lenders will not buy junior debt • Issue $25–75M of 2-year.

) Good Medium Bad Value with project 250 175 125 Value w/o project 50 50 50 Internal CF 100 25 100 • The assumption is not much of a stretch.4) • Suppose there are internal funds generated Value in State (mil. 18. Persistence of Problem (Ex. bad economy may lead to liquidation of assets etc. • Can senior debt financing of initial investment solve this problem? Alex Kane 21 IRPGEN424  Corporate Finance .

but cannot by itself replace monitoring Alex Kane 22 IRPGEN424  Corporate Finance . need to issue 1-yr debt • Suppose the firm takes on: – Short-term (one-year) debt of $100M – Long-term (two-year) senior debt of $25–75M • Management will not fund the project in the bad state. Why isn’t this a solution? • Because management will also fail to fund in the medium state when NPV is positive • Result: Debt ratio is important. Limitation of Debt Financing • To counter internal funds.

Public debt requires prospectus Alex Kane 23 IRPGEN424  Corporate Finance .4 could be solved if it were understood that debt would be negotiated in the medium state • Banks are also an alternative to a large outside shareholder monitoring management. re-negotiation is impossible because of the free-rider problem • Result: A firm may not be able to sell desired- size bond issue to the public • Banks may be able to solve this problem • Problem in example 17. Banks Vs. They also neutralize the asset substitution problem • Banks can be trusted with confidential info. Diffused Bondholders • Re-negotiation of debt is an important way to resolve conflicts in bad states • When debt is diffused.

The Principal Agent Problem • The elements – Uncertainty – Unobservable efforts – Agency cost: value of perfectly managed firm less actual • Oldest solution: share cropping. Optimal? • Only if farmer risk-neutral and has subsistence • Contemporary solution: Design incentive contracts • Example: Should you equalize risk of agent to principal? • Answer: No! Principal’s wealth and risk sharing • Question: is stock compensation adequate? No. It’s amazing how pervasive this solution is! Alex Kane 24 IRPGEN424  Corporate Finance .

not too much Alex Kane 25 IRPGEN424  Corporate Finance . profits and stock returns • The study of 2505 CEOs over 1974-1988 shown in Exhibit 18. Executive Compensation and Share Value • The elements: Fixed.0701x10M = $701. it cost to: – Wasserman of MCA = .1 • Fact: Corp jet costs $10M.000 – To Chandler of Kodak = .00008x10M = $800 • Question: will Wasserman avoid the purchase? • Study conclusion: too little performance compensation.

Executive Compensation and Performance • Exec promised 30% of k=(E-E*) over next 5 years • Suppose mangers doubles earnings. as revealed by first-year results • Manger’s compensation up in each year by .3k • Stock will go up by about 100%. low correlation between annual compensation and stock return • Longer-term study shows sensitivity 10x larger than the calculation in the Table (Jensen and Murphy) Alex Kane 26 IRPGEN424  Corporate Finance . then behave normally • Result.

But the risk is too large for managers • Study (1999) shows that less volatile firms are more likely to tie pay to performance • Recent evidence: dramatic increase in performance compensation. Adequacy of pay/performance schemes • Difficult in large firms. mostly through options Alex Kane 27 IRPGEN424  Corporate Finance . Sensitivity of pay to performance much larger in smaller firms • High-growth firm are expected to show higher sensitivity of pay to performance.

18. Compensation and Stock Returns • Event studies examine response of stock prices to the adoption of performance pay schemes • 42 plans adopted during 1970s: – Between 7 months prior to adoption to adoption date – Stock prices increased by 20% on average • Cross section relating Market-to-book value to performance pay plan finds positive correlation • These studies do not prove causality! It is possible that such schemes are adopted on the heels of.5) Alex Kane 28 IRPGEN424  Corporate Finance . or prior to. stock-price increases (Ex.

50 X = Annual 10-year return on: JC stock/peer group stock – Peer group: Fortune 500 firms in same business – $A invested each year in JC stock – Value of accumulated stock paid out after 7 years • Problem with such plan: managers gain from losses of other firms.000 times X 0 < X < 1. Incentive for super-aggressive competition. Reason for scarcity of such plans Alex Kane 29 IRPGEN424  Corporate Finance . One Example of Relative Performance Compensation • Johnson Controls (JC) plan for two top executives Annual base amount: A = 300.000 and 100.

Relative performance • Study of 177 large U. firms shows the frequency of relative-performance pay – 25% of the 125 industrial firms – 57% of the 52 financial service firms – 42% of utilities • One reason this scheme is not as prevalent in industrial firms may be its incentive to hurt competitors Alex Kane 30 IRPGEN424  Corporate Finance .S.

6. EVA. prices will not reflect year-by-year success. GT argue that a flaw in stock based plans is that stock price reflect expectations from managers prior to hire. • This argument is tenuous. • In example 18. What is wrong with a plan tied to better-than-expected performance? • Real problem with stock-based plans is systematic risk • Problem with E-based plans: what benchmark? Was IRR high or was it just scale? Alex Kane 31 IRPGEN424  Corporate Finance . CF. Stock Based Vs. Hence. Earning Based Plans • Earning-based variables: E.

Value Based Management Methods • Contribution of the 1990s • The principle is to evaluate performance of a unit against a charge for capital used • These methods (although far from perfect) have the decisive advantage over stock-based plans of avoiding the unnecessary systematic risk and pitfalls of stock vs. flow problems associated with stock-price changes (since compensation is a flow) • Compensation is one reason for spin-offs and undesirability of conglomerates Alex Kane 32 IRPGEN424  Corporate Finance .