B40'2302 Class

1
B40.2302 Class 11

• BM6 chapters 12.3, 33, 34
• 12.3 and non-BM6 material Agency problems,
  solutions
• 33 Mergers, takeovers
• 34 Corporate control, financial architecture
• Based on slides created by Matthew Will
• Modified 11/28/2001 by Jeffrey Wurgler

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Making Sure Managers Maximize NPV

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 12.3

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
3
Topics Covered

• The agency problem
• Evidence of its significance
• Solutions
• Incentives
• Other mechanisms (some not in book)

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The Principal-Agent Problem
The problem How do owners get managers to act
in their interests? (i.e. to maximize NPV)
Shareholders Owners Principals
Managers Control Shareholders agents
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The Principal-Agent Problem
How might managers interests differ from
shareholders interests?

• Low effort (slacking/shirking)
• Expensive perks (corporate jets)
• Empire building (overinvestment)
• Entrenching investment (to keep job)
• Avoiding risk (so as not to lose job)

6
Why does agency problem exist?

• Agency problem exists because of the separation
  of ownership and control
• Managers do not bear the full costs of their
  decisions, since they dont own 100 of firm
• Example Manager owns 10 of firm
• Can decide to buy corporate jet for 2 million,
  which is worth 400,000 to him and 0 to shhs
• Will mgr. buy it?
• Yes, since doesnt fully internalize costs of
  inefficient decisions
• Note if mgr owns 100, then no separation of
  ownership and control ? no agency problem ?
  wouldnt buy the jet

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Why does agency problem exist?

• Separation of ownership and control in modern
  corporation
• Benefits Limited liability, professional
  management, shareholder diversification (allows
  firm to exist!)
• Costs Agency problems

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Evidence on agency problems

• Hardly a competent worker can be found who does
  not devote a considerable amount of time to
  studying just how slowly he can work and still
  convince his employer that he is going at a good
  pace.
• - Frederick Taylor
• The Principles of Scientific
  Management (New York Harper, 1929)

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Evidence on agency problems

• Much evidence on agency problems is from event
  studies
• If managers announce actions (the event) that
  investors dont like stock price falls
• Thus, such actions must not maximize shhr value
• (This inference is not justified if the action
  indirectly conveys some other bad news.)
• There are many types of managerial actions that
  investors dont like

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Evidence on agency problems

• In the mid-1980s, integrated oil producers spent
  roughly 20 per barrel to explore for new
  reserves
• Even though could buy proven oil reserves in
  marketplace for 6 per barrel !!!
• Clearly NPVlt0, but managers wanted to maintain
  their large oil exploration activities
• At every announcement of a new exploration
  project, stock price dropped

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Evidence on agency problems

• refer to appendix slide 1 Investors also do not
  like it when managers adopt poison pills
• Poison pills are devices to make takeovers
  extremely costly without target managements
  consent
• Suggests that managers resist takeovers to
  protect their private benefits of control, rather
  than to serve shareholders

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Evidence on agency problems

• 2 Study of stock market reactions to sudden
  executive deaths (heart attack, plane crash)
• Shareholders often react positively to the news
  !!!
• Especially shareholders of major conglomerates,
  whose powerful founders built vast empires
  without returning much to investors
• Investors apparently believe the replacement
  manager will be better

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Evidence on agency problems

• On average, bidder returns on announcement of a
  takeover are negative
• This is especially true in firms whose managers
  hold little equity
• Or when the merger is diversifying

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Evidence on agency problems

• There is a voting premium
• Consider two shares with equal cash flow rights
  but different voting rights
• The one with superior voting rights trades at a
  premium !!!
• Indicates that control is valuable, i.e. if you
  have enough shares, you get other benefits of
  control (private jet) beyond just dividends
• In US, voting premium is small, but is 45 in
  Israel 6.5 in Sweden 20 in Switzerland 82
  in Italy
• suggests managers in Italy have significant
  opportunities to divert profits to themselves,
  not share them with nonvoting shhs

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Evidence on agency problems

• Manufacturing firms in Russia (at time of
  privatization) were estimated to have market
  values of 1 of comparable Western firms
• Yes, there is more regulation and taxation in
  Russia
• Poor management is also part of the story
• But equally important seems to be the ability of
  managers of Russian firms to divert profits and
  assets to themselves
• Stealing from shareholders is the ultimate agency
  problem!

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Potential solutions

• Incentives for managers
• Equity or stock options can give managers
  incentives to maximize shareholder value reduce
  agency problems
• Some believe that CEO incentives are not strong
  enough
• One study 3 CEO pay rises only 3.25 for every
  1000 of shareholder value created.
• Is this enough? Even this amount could generate
  big swings in CEO wealth (for a big firm)
• Others believe that incentives are poorly
  designed
• Why arent incentive contracts indexed to stock
  market?

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Potential solutions

• Monitor managers
• Shareholders delegate monitoring to the board of
  directors (especially outside directors)
• Auditors also perform monitoring on behalf of
  shhs
• Lenders also monitor (to protect their
  collateral)
• 4 poorly-performing managers do get fired
• Monitoring may prevent the most obvious agency
  costs (e.g. blatant perks, manager not showing up
  for work)
• But close monitoring is costly
• And manager has a lot of specialized knowledge
• Theres no way to tell if it is being used, just
  by watching

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Potential solutions

• Finance with debt
• Managers cant waste money if there is constant
  pressure to meet interest payments
• This commits managers to paying out free cash
  flow
• If they dont, default occurs, managers lose
  control
• Dividends, in contrast, are less of a commitment
  they can be cut whenever management wants
• Thus, agency problems are (like taxes) another
  reason to favor debt
• Especially in cash cow firms that generate cash
  but dont have good investment opportunities

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Potential solutions

• Others
• Takeover pressure
• If dont maximize share value, outsider may take
  over firm, fire management, run firm better,
  create value
• Managerial outside labor market
• If dont maximize share value, and subsequently
  get fired, hard to find a new CEO job, or get
  lucrative outside directorships
• Proxy fights
• Shareholders organize themselves to fight
  management

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Mergers

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 33

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
21
Topics Covered

• Sensible Motives for Mergers
• Some Dubious Reasons for Mergers
• Estimating Merger Gains and Costs
• Takeovers Unsolicited/hostile mergers

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1997 and 1998 Mergers
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Merger waves in US history

• 1893-1904 horizontal mergers to create monopoly
• Mergers of companies in same line of business
• 1915-1929 vertical mergers
• Mergers upstream (toward raw material) or
  downstream (to consumer)
• 1940s-1950s friendly acquisitions of small,
  privately-held companies
• 1935 Roosevelt passed soak-the-rich tax laws
  with high estate taxes so private firms put up
  for sale to avoid taxes
• 1960s-1970s conglomerate mergers
• Mergers across unrelated lines of business
• 1980s-1990s still unnamed
• Seem to be more underlying logic than
  conglomerate wave
• Deals are much larger, often done in cash, often
  hostile (especially in 1980s), premia have
  increased

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Sensible Reasons for Mergers

• Economies of Scale
• A larger firm may be able to reduce its per-unit
  cost by using excess capacity or spreading fixed
  costs across more units
• Motive for horizontal mergers

Reduces costs


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Sensible Reasons for Mergers

• Economies of Vertical Integration
• Merge with supplier (integrate backward) or
  customer (integrate forward)
• Control over suppliers may reduce costs
• Or control over marketing channel may reduce
  costs
• Motive for vertical mergers

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Sensible Reasons for Mergers

• Combining Complementary Resources
• Merging may result in each firm filling in the
  missing pieces of their firm with pieces from
  the other firm.
• A.k.a. synergies

Firm A
Firm B
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Sensible Reasons for Mergers

• Unused tax shields
• Firm may have potential tax shields but not have
  profits to take advantage of them
• After Penn Central bankruptcy/reorganization, it
  had billions of unused tax-loss carryforwards
• It then bought several mature, taxpaying
  companies so these shields could be used

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Sensible Reasons for Mergers

• To Use Surplus Cash
• If your firm is in a mature industry with no
  positive NPV projects left, acquisition may be a
  decent use of funds (assuming you cant/wont
  return cash directly to shareholders by dividend
  or repurchase)

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Sensible Reasons for Mergers

• To Eliminate Inefficiencies in the Target
• Target may have unexploited investment
  opportunities, or ways to cut costs or increase
  earnings
• Replace firm with better management
• Here, there is no synergy
• Goal is simply to improve the target
• Most likely requires replacing the target
  management
• Many hostile deals fall in this category

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Sensible Reasons for Mergers

• To Eliminate Inefficiencies in the Target
• Easier said than done Warren Buffet says
• Many managers were apparently over-exposed in
  childhood years to the story in which the
  imprisoned, handsome prince is released from the
  toads body by a kiss from the beautiful
  princess Consequently, they are certain that
  their managerial kiss will do wonders for the
  profits of the target company Weve observed
  many kisses, but very few miracles. Nevertheless,
  many managerial princesses remain confident about
  the potency of their kisses, even after their
  corporate backyards are knee-deep in unresponsive
  toads.

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Dubious Reasons for Mergers

• Diversification
• Investors should not pay a premium for
  diversification if they can do it themselves!
• Diversification discount
• Diversified firms sell, if anything, at a
  discount
• Makes sense only to the extent that reduces costs
  of financial distress
• Which allows merged firm to take on more debt,
  take advantage of tax shields

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Dubious Reasons for Mergers

• Increasing EPS
• Some mergers undertaken simply to raise EPS

Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio
After merger, acquiring firm has short term EPS
rise
Long term, acquirer will have slower than normal
EPS growth due to share dilution.
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Dubious Reasons for Mergers

• Lowers cost of debt
• Merged firm can borrow at lower interest rates
• This happens because when A and B are separate,
  they dont guarantee each others debt
• After the merger, each one does guarantee the
  others debt if one part of business fails, bhhs
  can still get money from the other part
• But this is not a net gain
• Now, A and Bs shhs have to guarantee each
  others debt
• This loss to shhs cancels the gain from the safer
  debt

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Estimating Merger Gains

• There is an economic gain to the merger only if
  the two firms are worth more together than apart
• Gain PVAB (PVAPVB) D PVAB

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Estimating Merger Costs

• Calculation of merger cost depends on whether
  payment is made in cash or in shares.
• If A pays for B in cash, then easy
• Cost cash paid - PVB
• Usually shares of B are bought at a premium, so
  this cost is positive

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Merger Decision

• So merger is a positive-NPV to A if
• NPV Gain Cost DPVAB-(cash-PVB)gt0
• Notice gain is in terms of total increase in
  pie
• While cost is concerned with the division of the
  gains between the two companies

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Merger Decision

• Example
• PVA200m, PVB50m
• Merging A and B allows cost savings of 25m
• So Gain PVAB (PVAPVB) D PVAB 25m
• Suppose B is bought for cash for 65m
• a 15m (30) premium, not unusual
• So Cost cash paid - PVB 65 50 15m
• Note Bs gain is As cost
• NPV to A Gain Cost 10m
• Prediction Upon announcement of merger, Bs
  stock will rise to 65m, As will rise by 10m

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Estimating merger costs

• When merger is financed by stock, cost
  calculation is different
• Cost depends on value of shares in new company
  received by shareholders of selling company
• If sellers receive N shares, each worth PAB ,
  then
• Cost N PAB - PVB
• to illustrate, return to previous example

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Merger Decision

• Example
• PVA200m, PVB50m, suppose A has 1m shares
  outsdg.
• Gain is still PVAB (PVAPVB) D PVAB 25m
• Suppose B is bought for .325m shares (not cash)
• Cost to A is not .325200 50
• since As share price will go up at the merger
  announcement
• Need to calculate post-deal share price of A
• New firm will have 1.325m shares outstdg., will
  be worth 275m
• So new share price is 275/1.325207.55
• Cost .325207.55 50 17.45m
• NPV to A Gain Cost 25 - 17.45 7.55m

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Takeover Vocabulary

• Some useful vocabulary
• Tender offer bidder A offers to buy target Bs
  shares on open market, usually at some premium
• Goes over the head of Bs management
• Straight to Bs shareholders
• Hostile takeover the tender offer is unsolicited
• Merger/Friendly takeover agreement between A and
  B management

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Takeover Vocabulary

• White Knight - Friendly acquirer sought by a
  target company threatened by an unwanted bidder.
• Poison Pill - Measure taken by a target firm to
  avoid acquisition for example, the right for
  existing shareholders to buy additional shares at
  a very low price as soon as a bidder acquires 20
• Greenmail Bribe paid to unwanted bidder to get
  him to go away (a targeted share repurchase
  since target buys back only shares of raider, and
  usually at a big premium)
• Very upsetting to target shareholders!

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Takeover Vocabulary

• Why does B management resist if A is offering B
  shareholders a premium?
• Maybe to hold out for a higher bid
• More likely Agency problem !!!
• B managers dont want to lose job
• One solution pay a bribe to B managers so that
  they wont encounter this conflict of interest
• Golden parachute generous payoff if manager
  loses job as result of takeover

43
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Control, Governance, and Financial
  Architecture

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 34

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
44
Topics Covered

• Leveraged Buyouts
• Spin-offs and Restructuring
• Conglomerates

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Definitions

• Corporate control the power to make investment
  and financing decisions.
• Corporate governance the set of mechanisms by
  which shhs exercise control over managers
• They are the potential solutions to agency
  problems in chapter 12.3
• Financial architecture the whole picture who
  has control, what governance mechanisms, what is
  capital structure, what is legal form of
  organization, etc.
• Financial architectures differ a lot across
  countries
• Partly because agency problems differ across
  countries

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Leveraged Buyouts

• LBOs differ from ordinary acquisitions
• A large fraction of the purchase price is
  financed by debt.
• The LBO goes private, so its shares are no longer
  trade on the open market they are held by a
  partnership of (usually institutional) investors
• If group includes member of existing management
  team, called MBO

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Leveraged Buyouts

• Main sources of value in LBOs
• Better incentives
• Constant debt service forces a focus on cash
  flows
• Management often takes a higher equity stake
• Buyout specialist organizing it will serve as
  monitor
• All the debt generates tax shields
• Inefficiencies are cut
• Capex plans are more closely scrutinized
• New mgmt. may find it easier to fire unnecessary
  employees?

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Leveraged Buyouts
10 Largest LBOs in 1980s and 1997/98 examples
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Spin-offs, etc.

• Spin-off new, independent company created by
  detaching part of a parent company.
• Carve-out similar to spin offs, except that
  shares in the new company are not given to
  existing shareholders but sold in a public
  offering.
• Privatization the sale of a government-owned
  company to private investors.

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Conglomerates
The largest US conglomerates in 1979
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The death of U.S. conglomerates

• What were they supposed to achieve?
• Diversification
• Which we mentioned is a dubious motive
• Creation of internal capital markets
• Free cash flow in mature industries could be used
  to fund growing industries
• But, this avoided discipline of outside markets
• Centralized, presumably improved management
• Didnt work
• On average, conglomerates have market values
  12-15 less than stand-alones

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15 years from now

• You have just seized control of Establishment
  Industries, a blue-chip conglomerate, after a
  takeover battle.
• What advice can I give you to add value? (I.e.,
  how do we use this class to get rich?)
• 1. Spin off the neglected divisions
• Spinoffs go for a premium
• Better incentives all around
• Avoid mess of internal capital market
• Avoid diversification discount

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15 years from now

• 2. Perhaps sell mature, cash cows to LBO
  partnerships.
• No growth there for you
• Again want to reduce size of internal cap. mkt
• But valuable to LBO due to its better incentives
• 3. Focus on core business
• Possible leveraged restructuring (debt-for-equity
  recapitalization) to improve incentives there
• Give employees, managers equity incentives