Transcript ECONOMICS 3150B

ECONOMICS 3200B
Lecture 4
Ch. 2, 3
October 1, 2013
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Ownership and Control
Why go public?
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Private companies – no separation of ownership
and control
Financing investment opportunities
Dual share structure to retain control
Diversification and estate planning
OPM and perks
Outliving the founder to enhance the value of
brand names and reputation
Attract management talent by offering equity
stakes
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Ownership and Control
Agency
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Definition
Problem – aligning interests
Compensation and incentives
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Objective of Firms
• Profit maximization/value maximization
– Profit measure: profit margin, profit per unit, rate of
return on invested capital, rate of return on equity?
– /E = {/PQ}*{PQ/K}*{K/E}
•  = {P-AC}*Q
• Increasing K/E increases bankruptcy risk
• Miller-Modigliani theorem, and optimal capital
structure
– Short-term, long-term – definition of time concepts
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Objective of Firms
• Separation of ownership and control
– Management and control by founder or founding family
(dual share structure)
• Control/power
• Maximize personal wealth
• OPM
– Independent management, no controlling shareholder
• Maximize personal wealth
• Control/power
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Governance of Firms
Agency – executive compensation, ad agencies, investment
banks, lawyers, management consultants, etc.
• Agency problem: separation of ownership and control –
why should management have objective to maximize
shareholder value?
– Objectives of senior management (agents) may differ from those of
shareholders (principals) – maximization of personal wealth vs.
maximization of value (equity) of company
– Maximization of value of equity of company may not necessarily
maximize value of debt of company – conflicts between equity
holders and debt holders
– Agency problem may be non-existent with private companies
where senior management owns company – possibility that
different family members have different goals and objectives
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Governance of Firms
• Principal-agent
– Board of Directors (principal) – functions, fiduciary
responsibilities, compensation, liability
– CEO (agent) – functions, compensation
• Alignment of interests of owners and managers
• Importance of incentive (compensation) contracts
to align objectives of senior management and
shareholders
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Governance of Firms
• Compensation contracts
– Mix of salary, bonuses, long-term compensation (including postretirement benefits)
– Duration of contracts
– Fixed endpoint problem: weak incentive for senior managers to
perform as they near end of contract
– How many years to learn whether senior managers better than
average or worse than average in ability?
– Information requirements to assess talent of management – how
long a contract? How long a track record? Luck or talent?
– Firing senior officers when record indicates below average talent
becoming more common
– Type I and Type II errors – re-hiring below average senior officer;
firing above average senior officer
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Governance of Firms
• Nature of bonus: measurement problems  linked to
aggregate profits; profit rate (what rate? operating margins,
return on assets, return on equity); growth in profits; value
of company; thresholds
– Problems in multi-divisional enterprises – basis for bonus,
incentives to ensure synergies among divisions realized
– Re-coupment of bonuses if performance falters in future time
periods
• Payment of bonus
– Short-term vs. long-term payoffs
– Annual cash payments
– Partial payments in equity
• Low interest loans to acquire shares and forgiveness of
loans owing to company (restricts diversification if
acquisition of equity is mandatory)
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Governance of Firms
Stock options
• Pricing of stock options – indexing of exercise price to
reward holders of options for superior relative performance
only (selection of companies to comprise index?)
• Meet performance targets and have right to exercise
options at original strike price or some pre-set premium
over the original strike price
• Re-pricing of options that are underwater – argument that
such options no longer provide incentive; threat of losing
talented senior managers
• Magnitude of stock option grants; scope of eligibility for
stock options
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Governance of Firms
Are incentives required?
• Market for managers: super stars
– Free agency and signing bonuses
– Information requirements to determine whether a manager is a
super-star
– Incentive to perform to maximize value in free agency market
• Nature of signing bonuses – cash, salary, stock options
• Younger managers – ability to declare free agency again
• Older managers – no further opportunity for free agency,
important to link signing bonus to performance of
company
• How to motivate losers? – economic rents and threat of
losing jobs
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Governance of Firms
Market for corporate control: takeovers
• Outsiders (raiders, private equity firms, hedge funds) acquire poorly
performing companies (potentially undervalued companies) and
replace senior management with good management to increase value
of company
– Pershing Capital and Canadian Pacific
• Outsiders also acquire companies to engage in financial engineering
(increasing debt to equity and selling off divisions and/or assets) to
create value and then spin off companies (IPOs) to realize value – why
doesn’t management do these things?
• Fear of losing job (and associated economic rents – value of reputation
reduced) sufficient incentive to perform and achieve best results for
shareholders
• How effective – poison pills (new shares available to existing
shareholders at bargain prices if bid made for company), scorched
earth policy (sell crown jewels), golden parachutes
• Managerial myopia to prevent takeovers
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Compensation in Multi-Division Firms
• Synergies from cooperation
– Sharing value created through cooperation
– Compensation linked to increase in value –
how?
– Compensation linked to performance of
division – bonuses
– Long-term incentives paid in company shares
(options, SARs)
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Corporate Governance
Boards of Directors
• Whom does a Board represent?
– Shareholders, but which ones?
• Reasons for monumental failure in 2008
• Externality
– Confidence in the equity markets and the
financial system in general
– Responsibility to ensure that there are no blowups which threaten the macroeconomy
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Corporate Governance
Possible Reforms
• Role of Boards
– Hiring a CEO and negotiating the employment contract;
– Supervising the strategic planning process and approving the plan;
– Monitoring the performance of the CEO
– Risk management
• Independence
• Training in risk assessment and management
• Full-time job
• Term limits
• Compensation
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Mergers & Acquisitions
• Objective: Maximize shareholder wealth
– Benefits (advantages) must outweigh premium paid to
acquire control of assets
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Mergers & Acquisitions
• Increase market power
– Eliminate competitor benefits all surviving firms in industry
– Long-run possibility of reducing competition given Schumpeterian
competition?
• Cost improvements – economies of scale, scope,
internalization, access to lower cost inputs
• Bargaining leverage with suppliers, distributors (complete
product offerings)
• Acquire superior talent
• Undervalued assets because of poor management, limited
distribution capabilities – leverage competitive advantage
• Internalization – Microsoft and Nokia
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Mergers & Acquisitions
• Diversification to reduce business risks
– Ability of shareholders to diversify at lower cost and more
completely
– Hedging against various types of business risks – economic
shocks, interest rates, currencies, commodity shocks
• Eliminate excess capacity
– Benefits all competitors – why not wait for company’s assets to be
liquidated?
– Does capacity disappear when companies eek bankruptcy
protection?
• Tax advantages – tax losses, transfer pricing across
countries with different tax rates
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Mergers & Acquisitions
• Preventing mergers – why?
– Supermajority
– Greenmail
– Poison pills
• Should shareholders approve of management’s
recommendations?
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Competition
• Carlton & Perloff : “Even though perfect competition is rarely, if ever,
encountered in the real world, we study the perfect competition model
because it provides an ideal against which to compare other models
and markets.”
• Assumptions:
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Homogeneous, perfectly divisible product
Perfect information (consider Internet again)
Price takers
Zero transactions and search costs (eBay)
No externalities
Free entry and exit
No entry barriers
U-shaped ATC
No advantage
Equilibrium: no economic profits, D/S
Entry/exit process
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Competition
• Price determination
– Some degree of market power for each firm because of search costs
– High degree of substitutability – firm elastic demand curve
– How is initial price point established?
• Long-run equilibrium
– Economic profits or losses as signal for entry/exit – definition of
economic profits
– Rate/speed of adjustment – how long does it take to get from short-run to
long-run?
– Perfect information, zero transactions costs and free entry and exit
• Incentives to innovate – technological change
– Perfect information, zero transactions costs and free entry and exit
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Competition
• Contestability
– “If there is free entry into and exit from a market instantaneously
(no sunk costs), firms have an incentive to enter whenever price
exceeds average cost. Markets with free instantaneous entry and
exit are called perfectly contestable.”
– Assumes no sunk costs, zero entry/exit costs, reactions of
incumbents, possible competitive advantages of incumbents,
speed/number of entrants
– Solid waste collection – competitive bids every year
• Relocation costs, experience, lobbying
– Airline industry – city-pairs assumed to be contestable
• Start-up costs, competitive advantages of incumbents’ networks
• Porter Air and Billy BishopAirport
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Competition
• Barriers to entry
– Absolute cost advantages of incumbents
– Access to customers – access to distribution channels,
switching costs
– Access to inputs, technology – role of patents
– Product differentiation – importance of reputation,
brand names
– Scale of entry and capital requirements
– Exit costs
– Strategic behavior of incumbents – reputation of
incumbents
– Number of potential entrants
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Competition
• Scale, speed of entry
– Information re. economic profits
– Information re. production, distribution, consumer tastes, etc.
– Access to inputs at same prices as incumbents, including access to
capital and management talent
– Start-up costs – sunk costs
– Time required to enter – develop strategies, acquire facilities and
resources
– Actions of other potential entrants
– Actions of incumbents
– Willingness of external investors to finance entry
– Expected growth
– Excess capacity
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Competition
Schumpeterian competition and dynamic efficiency
• Competition that counts is not price competition, but competition from
new products, new technology, new sources of supply, new types of
organization
• Dynamic change and efficiency gains result of strategic behavior and
risk-taking (decision-making under uncertainty – absence of full
information) – technological change, productivity growth
• Pursuit of economic profits (above-average returns on investment)
motivates risk-taking
• Investments anticipate payoffs commensurate with the risks
(probability of failure) – VC model
– Small number of winners in each time period/round
– Monopoly power short-lived because of dynamic nature of competition
– Strategic behavior to solidify monopoly position
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Competition
• Experiment: 10 players with same stakes and equal
chances of winning each game (draw a number from an
earn)
– Within short period of time, one or two players will have amassed
large stakes and others will have little left
– Eventually one ends up with entire stake
– In this experiment: Pr (winning) = h (luck) [probability of winning
is a function of luck only]
• In real world: Pr (winning) = h (management talent,
strategy, luck)
– Talent in short supply, thus expect each industry to be dominated
by one or two companies
– Financial performance = h (management talent, strategy, luck)
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Markets
• Defined by rules
• In absence of rules set and enforced by
“government”, players will establish and
enforce own rules
– Consider illegal activities – illegal because of
rules
– Drugs, loan sharking, prostitution
– Power critical
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Rent Seeking
• Governments set and enforce rules
– Lax enforcement as good as no rules except for
reputation effects
– Governments change rules periodically
• Winners and losers
• Rent seeking to influence rule makers and
enforcers of rules
– Persuade governments to change rules in one’s favor
– Costs vs. expected benefits
– Corruption
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