Corporate Finance Prof Ian Giddy New York University

Corporate Finance Prof. Ian Giddy New York University

What the Module is About. . . l Corporate finance: shareholder value can be affected by financial decisions: investment, financing choices, debt design & risk management u. Corporate investment decisions u. Corporate financing choices u. Designing debt u. Risk management Copyright © 1998 Ian H. Giddy Corporate Finance 4

The Decisions that Create Shareholder Value CORPORATE INVESTMENT DECISIONS Copyright © 1998 Ian H. Giddy CORPORATE FINANCING CHOICES CORPORATE PAYOUT POLICIES CORPORATE RISK MANAGEMENT CREATING CORPORATE ECONOMIC VALUE Corporate Finance 8

The Goal of Financial Management l What are firm decision-makers hired to do? “General Motors is not in the business of making automobiles. General Motors is in the business of making money. ” Alfred P. Sloan l l Possible goals: Size, market share, profits Three equivalent goals of financial management: u Maximize shareholder wealth u Maximize share price u Maximize firm value Copyright © 1998 Ian H. Giddy Corporate Finance 9

The Goal of Financial Management Value-based management drives our performance targets and incentives. We have set ambitious short and medium-term financial and operating targets and, to help meet these, have aligned the interests of management and employees with those of our shareholders and customers. Our incentive systems are linked to key aspects of shareholder value, such as margins and asset productivity. Our strategic focus is centred on profitable growth, better margins through innovation and higher productivity, improved asset management, and turnarounds in operations whose past performance has not been world class. Copyright © 1998 Ian H. Giddy One company’s statement Corporate Finance 10

First Principles l Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) u Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. u l l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. u l The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics Minimize unnecessary financial risks. Objective: Maximize the Value of the Firm Copyright © 1998 Ian H. Giddy Corporate Finance 11

The Objective in Decision Making l l l In traditional corporate finance, the objective in decision making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization. Copyright © 1998 Ian H. Giddy Corporate Finance 12

The Criticism of Firm Value Maximization l Maximizing stock price is not incompatible with meeting employee needs/objectives. In particular: - Employees are often stockholders in many firms u - Firms that maximize stock price generally are firms that have treated employees well. u l l Maximizing stock price does not mean that customers are not critical to success. In most businesses, keeping customers happy is the route to stock price maximization. Maximizing stock price does not imply that a company has to be a social outlaw. Copyright © 1998 Ian H. Giddy Corporate Finance 13

Why Maximize Stockholder Wealth? l l l Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational (are they? ), stock prices reflect the wisdom of decisions, short term and long term, instantaneously. The objective of stock price performance provides some very elegant theory on: how to pick projects u how to finance them u how much to pay in dividends u Copyright © 1998 Ian H. Giddy Corporate Finance 14

The Classical Objective Function STOCKHOLDERS Hire & fire managers - Board - Annual Meeting BONDHOLDERS Lend Money Protect bondholder Interests Maximize stockholder wealth Managers Reveal information honestly and on time No Social Costs SOCIETY Costs can be traced to firm Markets are efficient and assess effect on value FINANCIAL MARKETS Copyright © 1998 Ian H. Giddy Corporate Finance 15

The Agency Problem l l l The agency relationship Will managers work in the shareholders’ best interests? u. Agency costs u. Corporate governance u. Incentive issues Control of the firm -- there is a market for corporate control Copyright © 1998 Ian H. Giddy Shareholders Board of Directors Managers Allocation of Resources Corporate Finance 16

What Can Go Wrong? STOCKHOLDERS Have little control over managers BONDHOLDERS Lend Money Bondholders can get ripped off Managers put their interests over shareholders’ Managers Significant Social Costs SOCIETY Some costs cannot be traced to firm Delay bad news or Markets make provide misleading mistakes and can information overreact FINANCIAL MARKETS Copyright © 1998 Ian H. Giddy Corporate Finance 17

I. Stockholder Interests vs. Management Interests Theory: The stockholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors. l Practice: Neither mechanism is as effective in disciplining management as theory posits. l Copyright © 1998 Ian H. Giddy Corporate Finance 18

The Best Boards. . . Copyright © 1998 Ian H. Giddy Corporate Finance 19

And the Worst. . . Copyright © 1998 Ian H. Giddy Corporate Finance 20

Illustration: Overpaying on Takeovers l l l The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover. The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms. Stock prices of bidding firms decline on the takeover announcements a significant proportion of the time. Many mergers do not work, as evidenced by a number of measures. The profitability of merged firms relative to their peer groups, does not increase significantly after mergers. u An even more damning indictment is that a large number of mergers are reversed within a few years, which is a clear admission that the acquisitions did not work. u Copyright © 1998 Ian H. Giddy Corporate Finance 21

II. Stockholders' Objectives vs. Lenders' Objectives In theory: there is no conflict of interests between stockholders and lenders, including bondholders. l In practice: Stockholders may maximize their wealth at the expense of debtholders. l u. Increasing leverage dramatically u. Increasing dividends significantly u. Taking riskier projects than those agreed to. Copyright © 1998 Ian H. Giddy Corporate Finance 22

1. Increasing leverage dramatically and making existing bonds less valuable Copyright © 1998 Ian H. Giddy Corporate Finance 23

2. Increasing Dividends Significantly EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES 0. 5 0 t: - -12 -0. 5 15 -9 -6 -3 0 3 6 9 12 15 CAR (Div Up) CAR (Div down) -1 -1. 5 -2 Day (0: Announcement date) Copyright © 1998 Ian H. Giddy Corporate Finance 24

The Modified Objective Function l For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected: u l For publicly traded firms in inefficient markets, where bondholders are protected: u l Maximize stockholder wealth: This will also maximize firm value, but might not maximize the stock price For publicly traded firms in inefficient markets, where bondholders are not fully protected u l Maximize Stock Price: This will also maximize firm value Maximize firm value, though stockholder wealth and stock prices may not be maximized at the same point. For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not) Copyright © 1998 Ian H. Giddy Corporate Finance 25

Finance in the Corporation Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operations Officer (COO) Vice President Finance (CFO) Vice President Marketing Controller Treasurer Cash Manager Capital Expenditures Copyright © 1998 Ian H. Giddy Vice President Production Credit Manager Financial Planning Tax Manager Cost Accounting Manager Financial Accounting Manager Data Processing Manager Corporate Finance 26

“Internalization”: Is an activity best done within the company, or outside it? Issue: why are certain economic activities conducted within firms rather than between firms? l As a rule, it is more costly to build than to buy —markets make better decisions than bureaucrats l Hence there must be some good reason, some synergy, that makes an activity better if done within a firm l Eg: the production of proprietary information l Often, these synergies are illusory Copyright © 1998 Ian H. Giddy Corporate Finance 27

Takeovers as a Solution to “Agency Problems” l l There is a conflict of interest between shareholders and managers of a target company—Eg poison pill defenses Individual owners do not have suffcient incentive to monitor managers Corporate takeover specialists, Eg KKR, monitor the firm's environment and keep themselves aware of the potential value of the firm under efficient management The threat of a takeover helps to keep managers on their toes—often precipitates restructuring. Copyright © 1998 Ian H. Giddy Corporate Finance 28

Who Gains What? Target firm shareholders? l Bidding firm shareholders? l Lawyers and bankers? l Are there overall gains? l Changes in corporate control increase the combined market value of assets of the bidding and target firms. The average is a 10. 5% increase in total value. Copyright © 1998 Ian H. Giddy Corporate Finance 29

The Price: Who Gets What? Copyright © 1998 Ian H. Giddy Corporate Finance 30

A Case Study: Kodak - Sterling Drugs l Eastman Kodak’s Great Victory Copyright © 1998 Ian H. Giddy Corporate Finance 31

Earnings and Revenues at Sterling Drugs Sterling Drug under Eastman Kodak: Where is the synergy? 5, 000 4, 500 4, 000 3, 500 3, 000 2, 500 2, 000 1, 500 1, 000 500 0 1988 1989 Revenue Copyright © 1998 Ian H. Giddy 1990 1991 1992 Operating Earnings Corporate Finance 32

Kodak Says Drug Unit Is Not for Sale (NYTimes, 8/93) Eastman Kodak officials say they have no plans to sell Kodak’s Sterling Winthrop drug unit. l Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as “massive speculation, which flies in the face of the stated intent of Kodak that it is committed to be in the health business. ” l Copyright © 1998 Ian H. Giddy Corporate Finance 33

Sanofi to Get Part of Kodak Drug Unit (6/94) l Taking a long stride on its way out of the drug business, Eastman Kodak said yesterday that the Sanofi Group, a French pharmaceutical company, had agreed to buy the prescription drug business of Sterling Winthrop, a Kodak subsidiary, for $1. 68 billion. Shares of Eastman Kodak rose 75 cents yesterday, closing at $47. 50 on the New York Stock Exchange. u Samuel D. Isaly an analyst , said the announcement was “very good for Sanofi and very good for Kodak. ” u “When the divestitures are complete, Kodak will be entirely focused on imaging, ” said George M. C. Fisher, the company's chairman and chief executive. u Copyright © 1998 Ian H. Giddy Corporate Finance 34

Smithkline to Buy Kodak’s Drug Business for $2. 9 Billion Smithkline Beecham agreed to buy Eastman Kodak’s Sterling Winthrop Inc. for $2. 9 billion. l For Kodak, the sale almost completes a restructuring intended to refocus the company on its photography business. l Kodak’s stock price rose $1. 25 to $50. 625, the highest price since December. l Copyright © 1998 Ian H. Giddy Corporate Finance 35

Goals of Acquisitions Rationale: Firm A should merge with Firm B if [Value of AB > Value of A + Value of B + Cost of transaction] l Synergy l Gain market power l Discipline Example: l Taxes Ciba-Geigy/ l Financing Sandoz Copyright © 1998 Ian H. Giddy Corporate Finance 36

Most Value is Created on the Asset Side (Operational Restructuring) Discounted Cash Flow (DCF) analysis for project evaluation l Value-Based Management for performance evaluation l Wärtsilä NSD (from Wärtsilä Diesel & New Sulzer Diesel ? Copyright © 1998 Ian H. Giddy Corporate Finance 37

Wärtsilä NSD: Consolidating Production and Distribution Wärtsilä NSD now has the world’s most extensive portfolio of heavy duty engines. Its 4 stroke engines are mainly Wärtsilä design, while the 2 stroke engines are based on Sulzer design. The engine range consists of lean burn gas engines, dual fuel engines and gas diesels. Market share is strong and production is being consolidated or out-sourced, particularly for low-speed engine technologies. Copyright © 1998 Ian H. Giddy Corporate Finance 38

Wärtsilä NSD: Gains Market Power Copyright © 1998 Ian H. Giddy Corporate Finance 39

Sometimes, Too Late is Too Little 30 Peruvian Banks: Market Share by Deposits, % 25 BBV ACQUISITION 20 SANTANDER ACQUISITION 15 10 Copyright © 1998 Ian H. Giddy Nuevo Mundo Santander Lima Del Sur Latino Interbanc Continental Wiese Credito 0 Banco de la Nacion 5 Corporate Finance 40

Framework for Assessing Restructuring Opportunities Current market overpricing or underpricng Current Market Value 1 Company’s DCF value 2 5 Restructuring Framework Operating improvements Total restructured value Financial structure improvements (Eg Increase D/E) 4 3 Potential value with internal improvements Copyright © 1998 Ian H. Giddy Maximum restructuring opportunity Disposal/ Acquisition opportunities Potential value with internal + external improvements Corporate Finance 41

Using The Restructuring Framework ($ Millions of Value) $1, 000 $ 25 $ 975 $ 300 Current perceptions Gap: “Premium” Company value as is Current Market Price 1 2 5 Restructuring Framework Strategic and operating opportunities Potential value with internal improvements Disposal/ Acquisition opportunities Optimal restructured value Financial engineering opportunities 4 3 $ 1, 275 Maximum restructuring opportunity $ 635 $ 1, 635 $ 10 Eg Increase D/E Potential value with internal and external improvements $ 1, 625 $ 350 Copyright © 1998 Ian H. Giddy Corporate Finance 42

First Principles of Corporate Finance l Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) u Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. u l l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. u l The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Manage financial risk Copyright © 1998 Ian H. Giddy Corporate Finance 43

www. giddy. org Ian Giddy NYU Stern School of Business Tel 212 -998 -0332; Fax 212 -995 -4233 ian. giddy@nyu. edu http: //www. giddy. org Copyright © 1998 Ian H. Giddy Corporate Finance 47