Transcript OVERVIEW OF FINANCE - University of Pittsburgh

Overview of Corporate Finance
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What is Corporate Finance? (Q1)
• What kind of projects and/or business are you
going to invest your firm’s money in?
– Bayer selling an Alka-Seltzer factory for $1.
• Annual maintenance: $6-7 million
• Removal cost: $20 million
• Capital Budgeting
– process of planning and managing a firm’s investment
in physical or intangible assets
– capital assets
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What is Corporate Finance? (Q2)
• Where will you get the money?
– Commercial Finance Co issued $750 million in 18
month floating rate (150 BP + 3 month LIBOR)
– Stated purpose: Repurchase of AR or Acquisitions
• Capital Structure Choice
– choosing the mix of debt and equity used by a firm
– capital liabilities
3
What is Corporate Finance? (Q3)
• How will you manage your financial activities?
– Overnight money markets
– Previous example: Issue notes to repurchase AR.
• Working Capital Management
– managing short-term operating cash flows
– short term assets and liabilities
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Main Activities of Financial
Managers: Balance Sheet
Cash
Receivables
Inventories
Physical assets
Intangible assets
Payables
Bank loans
Short-term debt
Long-term debt
Retained earnings
Shares outstanding
Working capital management; capital budgeting; capital
financing.
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The Goal of a Corporation
• Possible Goals
– Maximize sales?
– Maximize earnings/profits?
– Minimize risk/maximize risk?
• Maximize the market value of shareholders
equity
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Wave I: Incoming MBA
Wave II: After 1st year
Survey by the Aspen Institute
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Wave III: Graduating MBA
How do we maximize
shareholder wealth???
Basic Principles
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What is the value of any asset?
Today’s value of expected future cash flows
AssetValue(aka NPV ) =
T
CFt

PV
(
GO
)

t
t = 0 (1+ r)
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What is the appropriate r?
• ...that r which reflects the riskiness of the
cash flows
• Conversion rate across time
• Different ways to refers to r
–
–
–
–
–
–
–
Opportunity cost of capital
Required rate of return
Cost of capital
Appropriate discount rate
Hurdle rate
Capitalization rate
Etc.
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Guiding Principle
• Capital should be allocated to any project with a
positive value
• NPV>0: Is it really this simple?
– Each investor wants to maximize wealth but is subject to
different risk preferences and consumption patterns.
– Efficient capital markets allow the investor to choose risk
levels and time consumption.
• Therefore, the corporate manager should just focus on
maximizing wealth.
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Is maximizing shareholder wealth optimal?
• From a behavioral viewpoint is it a flawed
design?
• Is this goal sustainable and consistent?
– “Maximizing”?
– “Shareholder”?
• Shareholders are the residual claimant
– Risk and reward
– “Wealth”?
12
Is maximizing shareholder wealth optimal?
• From a societal point of view, is this a flawed
design?
– In the eyes of the benevolent social planner?
• Is this goal sustainable and consistent?
– “Maximizing”?
– “Shareholder”?
• Do shareholders deserve this right?
– “Wealth”?
T
CFt
Wealth = 
t
t = 0 (1+ r)
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Value of the Corporation: Perfect World
P
VFirm   NPVp
p 1
• where NPV is the stand alone, equity
financed value of each project (p) and there
are P total project(s)
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What are other possible sources of value
creation/destruction?
• Capital structure
– Created through market imperfections
• Inter-project relationships (NPV’s are
correlated)
– Synergies
– Diversification
• Risk Management
• Organizational Form/Incentive Structure
– Agency issues
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Why are there inconsistencies
between management and finance?
• Different cultures
–
–
–
–
Accounting numbers are what matters
All diversification is good
Do poor NPV projects for “strategic reasons”
“Greed is good” image
• Discounted cash flow (DCF) is not trusted
• DCF is not a perfect solution
• ???
16
How can we manage these
inconsistencies?
• Communication
• Intricate knowledge of DCF
• Execute and manage DCF effectively
– Scenario/Sensitivity analysis
• Economics and Statistics
– Common sense!
• Identify what is causing NPV not to be near zero
• Long run NPV should be zero
– Manage bias: Cognitive and Motivational
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Weakness in Finance Theory
• r?
– Difficult to estimate but probably the least critical
to do with high precision
• E(CF)?
– Difficult to estimate incremental flows
– Understand implications of increasing CF volatility
• Time series decision making
– DCF assumes nothing changes after the beginning
of the project
– Improve with real options framework
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Organization of Economic
Functions
The firm is a way of organizing the
economic activity of many
individuals
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Building Blocks: Individuals
• REMM (Resourceful, Evaluative, Maximizing Model)
– Every individual is an evaluator
• Cares about everything
• Willing to make tradeoff and substitutions
– Are maximizing
– Wants are unlimited
– Are resourceful
• Economic Model: reduced form of REMM, only
maximize wealth
• Other models: Sociological, Psychological and Political
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Building Blocks: Firm
• Forms
– Sole proprietor
– Partnership
– Corporation
• Nexus of contracts
– Debt contracts: Claim on the firm’s assets and/or cash flows
– Equity contracts: Claim on the firm’s residual assets and/or cash
flows
– Other stakeholder contracts: Customers, government,
community, employees, etc.
– Shareholders (principals) and management team (agents)
contract
21
Corporation: A legal entity composed of
one or more individuals or entities
• Three distinct interests: separation of ownership and
control
– Shareholders (ownership, principal)
– Board of Directors (control)
– Top Management (implementation, agent)
• Limited liability
• Unlimited life
• Transferable ownership
• Corporation is a taxable entity
– Distributions to shareholders are taxed again at the personal
level
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Potential Problems: Between Claimants
• Information Asymmetry
– Methods to manage:
• Monitoring
• Signaling
• Agency Problems: Goals of the parties are not aligned
– Agent someone who is hired to represent the principal’s interest
– Equity: Potential conflict between shareholders and managers
(principal-agent problem)
• Traditional: Outside (non-management) shareholders
• Overvalued equity
– Debt: Potential conflict between shareholders and debt holders
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Agency Problem of Outside Equity
• Managers expropriate wealth from shareholders
• Moral hazard problems
–
–
–
–
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Effort aversion
Excessive perquisite consumption
Underinvestment due to risk aversion/short horizon
Entrenchment
Accept poor investment projects (NPV<0)
• Empire building
• Hubris
• Free Cash Flow (FCF) Hypothesis (Jensen (1986))
24
Examples of Agency Problems/Costs
• Direct expropriation
– Take cash out
– Looting assets, low transfer pricing
• Wide scale looting during Russian privatization
• Indirect expropriation by non-optimal investing
–
–
–
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Empire building: excess firm expansion
Hubris: incorrectly assessing an investments worth
Underinvestment/Overinvestment
Not maximizing shareholder wealth
• Making poor capital budgeting decisions (incorrect method, execution, etc.)
• Decision making based on managers wealth maximization not shareholders
• Inefficient actions
– Shirking (too little effort)
– Excess consumption of perks
• Illegal actions
– Misleading statements
– Insider Trading
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Ways to Manage Agency Problems
• Board of Directors
– Outsiders versus insiders, CEO/Chairman role
– Size
– Composition of audit, nominating and compensation committees
• Firm’s voting structure
– Dual class stocks
– Concentrated versus Disperse Ownership
– Outsiders versus Insiders
• Incentives
– Options, performance shares
– Ownership of executive and directors
• Takeover market
– Antitakeover provisions, regulations
– Ownership structure
– Going private?
•
•
•
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Managerial labor market
Judicial Review
Government: New role of regulators?
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Monitoring function: Debt, Institutional Investors, Blockholders
Agency Problem of Overvalued Equity
• “Overvalued”: When management knows they
can not sustain value
• Managers more likely to behave sub-optimally
– Target based corporate budgeting systems
• Manipulation of both target and realized result
– Skew preference for short term cash flows
(earnings)
– Excessive risk taking: Place high risk bets
– Earnings management: More likely and higher
error
• Jensen (2005)
27
Earnings Game
• CFO’s were asked if they were not on target for
earnings which actions would they consider doing
(Graham, Harvey & Rajgopal, 2004).
– 80% would delay discretionary spending
– 55% would sacrifice small value projects
• Why do executive play this game?
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–
–
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Favorable market conditions
Stock based compensation
Hubris/Egos
Overvalued equity lets them buy at a “discount”
• Analysts have become more of the process
– High profile
– High compensation/Hubris/Egos
• Jensen and Fuller (2002)
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Empirical evidence
• Enron, Nortel and other companies
• M&A’s: Large loss deals (>$1 billion lost)
– For every $1 spent, they lost $2.31 in
shareholder wealth at the announcement (Moeller,
Schlingemann and Stulz (2005))
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-40
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80
Billion dollars
Aggregate dollar return to acquiring-firm shareholders
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-160
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Manage Agency Problem of Overvalued Equity
• Not an obvious, incentive based answer
– Can’t buy an overvalued company, drop the
stock price and make money
• Possible solutions:
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–
–
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Long-run valuation incentives for management
Easier short selling
Improved governance
????
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Agency Problem of Debt
• Equityholders expropriate wealth from
debtholders
• Moral hazard problems
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–
–
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Overinvestment, risk shifting, asset substitution
Debt overhang, underinvestment
Claim dilution
Take the money and run!
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Debt can encourage excess risky investments
Expected Profit=$200 with two possible outcomes
Possible Outcomes: $100 or $300 Possible Outcomes: $0 or $400
• Realized Profit = $100
–
–
–
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Debt: $50
Management: $30
Employees: $20
Shareholders: $0
• Realized Profit = $0
–
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–
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• 100-50-30-20 =0
Debt: $0
Management: $0
Employees: $0
Shareholders: $0
• 0-50-30-20=-100
– BANKRUPT!
• Realized Profit = $300
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Debt: $50
Management: $30
Employees: $20
Shareholders: $200
• 300-50-30-20 = 200
• Realized Profit = $400
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Debt: $50
Management: $30
Employees: $20
Shareholders: $300
• 400-50-30-20 = 300
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Manage Agency Problem of Debt
• Protective Debt covenants
• Restrictions on
– Investment and disposition of assets
– Shareholder payouts
– Issuance of more senior debt
• Security design
– Convertible debt
– Callable debt (reduce probability of
underinvestment)
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Elements of Effective Governance
• Ownership and Control: Incentive versus
Entrenchment
• Monitoring: What makes an effective monitor?
• Signaling: What makes the signal more
credible?
– Costly
– Verifiable
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Empirical Evidence: Effective Governance
• Board Composition: Should have a majority of
outside directors, i.e. independent board
– For specific events, the firm performs better
• Independent board acquirer outperforms (-0.07% compared to
-1.86%, announcement return)
• Independent board target outperforms (62.3% compared to
40.9%, inception to completion)
• CEO/Chairman should be separate role
– Only tested in large companies Number of boards a
director sits on
• Number of boards a director sits on
– Reasonable number of boards are fine for directors with
strong reputations/skills
35
Effective Governance
• Board committees: audit, nominating, and
compensation
– Some evidence that independent audit committees
make earnings announcements more reliable
– Perceived positively when CEO is not influential in
director nominations
• Board size
– Bigger boards are more dysfunctional (<8
outperformed >14 based on multiples)
– Announcement of significant size decrease, stock
price increases by 2.9% (conversely, size increase,
price decreases by 2.8%)
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Effective Governance: Compensation
• Compensation Structure
– Salary: Too High? Too Low? Perverse Incentives?
– Bonuses: Fair? Unfair?
• Levels
• Timing
• Option compensation
– In general seems to be a good policy (for managers and
directors)
– There are instances where large option grants appear to
be timed before favorable announcements
– Firm’s with high option holdings may increase
exposure to total risk
37
Governance: Concentrated Ownership
• Large shareholders provide a monitoring function for
smaller, disperse shareholders
• Large shareholders may behave sub-optimally
– May control too much and discourage management from
behaving optimally
– May control the firm to their personal wealth management
• Timing
• Assume less risk because they are not well diversified
– Higher likelihood of expropriation, capturing private benefits
• What if the large shareholders are also top management
(insider ownership)?
– Entrenchment Effect: Greater likelihood of behaving suboptimally
– Incentive Effect: Goals are aligned with other shareholders38
Is there an optimal level of
managerial/concentrated ownership?
• Ownership level doesn’t affect value
– Level of ownership is a joint optimization of ownership and value
• For example, 5% ownership is not always better than 10%
– Changes will not increase value (et. al., Demsetz, 1983)
• All firms are currently at the optimal level so any change, all else being equal,
would decrease value
• Ownership level affects value
– Level and changes in ownership matters
• Ownership<5%: Value increases with increase in ownership
• 5%>Ownership<25%: Value decreases with increase in ownership
• Ownership>25%: Value increase with increase in ownership
– Morck, Schleifer and Vishney (1988)
– Curvilinear relationship: Value increases in ownership up to a point after
which further increases in ownership reduce value
• McConnell, Servaes and Lins (2003)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=470927#PaperDownload
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Governance: Too Little, Too Late?
• U.S. Markets
– Liquidity (Investor Protection) versus Governance (Bhide (1994))
– Insider ownership, disclosure rules
– Blockholder and Institutional regulation and constraints don’t
allow for concentrated ownership
• Other countries: Japan and Germany
– Blockholders account for 20% of market capitalization
– Close relationship between large shareholders, debtholders and
management
• Solutions?
– Non-public markets
– Change regulations
40