Overview of Corporate Finance 1 What is Corporate

Overview of Corporate Finance 1

What is Corporate Finance? (Q 1) • 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 2

What is Corporate Finance? (Q 2) • 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? (Q 3) • 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 4

Main Activities of Financial Managers: Balance Sheet 5

The Goal of a Corporation • Possible Goals – Maximize sales? – Maximize earnings/profits? – Minimize risk/maximize risk? • Maximize the market value of shareholders equity 6

Wave I: Incoming MBA Wave II: After 1 st year Survey by the Aspen Institute 7 Wave III: Graduating MBA

How do we maximize shareholder wealth? ? ? Basic Principles 8

What is the value of any asset? Today’s value of expected future cash flows 9

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. 10

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. 11

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”? 13

Value of the Corporation: Perfect World • where NPV is the stand alone, equity financed value of each project (p) and there are P total project(s) 14

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 15

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 17

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 18

Organization of Economic Functions The firm is a way of organizing the economic activity of many individuals 19

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 20

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 22

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 23

Agency Problem of Outside Equity • Managers expropriate wealth from shareholders • Moral hazard problems – 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 – – 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 25

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? • • Managerial labor market Judicial Review Government: New role of regulators? 26 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? – – 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) 28

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)) 29

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: – Long-run valuation incentives for management – Easier short selling – Improved governance – ? ? 30

Agency Problem of Debt • Equityholders expropriate wealth from debtholders • Moral hazard problems – Overinvestment, risk shifting, asset substitution – Debt overhang, underinvestment – Claim dilution – Take the money and run! 31

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 – – Debt: $50 Management: $30 Employees: $20 Shareholders: $0 • Realized Profit = $0 – – • 100 -50 -30 -20 =0 Debt: $0 Management: $0 Employees: $0 Shareholders: $0 • 0 -50 -30 -20=-100 – BANKRUPT! • Realized Profit = $300 – – Debt: $50 Management: $30 Employees: $20 Shareholders: $200 • 300 -50 -30 -20 = 200 • Realized Profit = $400 – – Debt: $50 Management: $30 Employees: $20 Shareholders: $300 • 400 -50 -30 -20 = 300 32

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) 33

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 34

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%) 36

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 shareholders 38

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 • Mc. Connell, Servaes and Lins (2003) http: //papers. ssrn. com/sol 3/papers. cfm? abstract_id=470927#Paper. Download 39

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