Overview of Corporate Finance

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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 firms 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 firms
  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

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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
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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 Wave III Graduating MBASurvey by the
Aspen Institute
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How do we maximize shareholder wealth???Basic
Principles
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What is the value of any asset?

• Todays value of expected future cash flows

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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
• NPVgt0 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?

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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?

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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)

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What are other possible sources of value
creation/destruction?

• Capital structure
• Created through market imperfections
• Inter-project relationships (NPVs 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
• ???

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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 firms assets
  and/or cash flows
• Equity contracts Claim on the firms residual
  assets and/or cash flows
• Other stakeholder contracts Customers,
  government, community, employees, etc.
• Shareholders (principals) and management team
  (agents) contract

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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
  principals 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
• Effort aversion
• Excessive perquisite consumption
• Underinvestment due to risk aversion/short
  horizon
• Entrenchment
• Accept poor investment projects (NPVlt0)
• Empire building
• Hubris
• Free Cash Flow (FCF) Hypothesis (Jensen (1986))

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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

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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
• Firms 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?
• Monitoring function Debt, Institutional
  Investors, Blockholders

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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)

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Earnings Game

• CFOs 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)

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Empirical evidence

• Enron, Nortel and other companies
• MAs Large loss deals (gt1 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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Manage Agency Problem of Overvalued Equity

• Not an obvious, incentive based answer
• Cant buy an overvalued company, drop the stock
  price and make money
• Possible solutions
• 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
• 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 Profit200 with two
possible outcomesPossible Outcomes 100 or 300
Possible Outcomes 0 or 400

• Realized Profit 100
• Debt 50
• Management 30
• Employees 20
• Shareholders 0
• 100-50-30-20 0

• Realized Profit 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

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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

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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 (lt8
  outperformed gt14 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
• Firms with high option holdings may increase
  exposure to total risk

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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 sub-optimally
• Incentive Effect Goals are aligned with other
  shareholders

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Is there an optimal level of managerial/concentrat
ed ownership?

• Ownership level doesnt 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
• Ownershiplt5 Value increases with increase in
  ownership
• 5gtOwnershiplt25 Value decreases with increase
  in ownership
• Ownershipgt25 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
  470927PaperDownload

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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 dont 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