Class Notes Week Viii: Reading Assignment GT Ch.18

CLASS NOTES
WEEK VIII
READING ASSIGNMENT
GT Ch.18
Alex Kane 1 IRPGEN422 Investments
The hardest Conflict: Management Vs. Shareholders
• First theoretical thesis: Jensen and Meckling,
Theory of the firm: managerial behavior, agency
costs and ownership structure, 1976
• Took more than 10 years to penetrate management
programs, even today, not many treat in depth
Issues: how decision should be/are made in view of:
– Whose interests is management actually looking after?
– Diffused ownership -- difficulty in oversight
– Management with controlling shares -- potential abuse?
(international studies of corporate governance and
control)
– Managerial control and capital structure
– Executive compensation
Alex Kane 2 IRPGEN424 Corporate Finance
How effective is the market discipline?
• GT: Text with copyright of 2002 (written in 2000-1
and published by 8/01) suggests:
• “Although these incentive issues probably cannot
be eliminated, financial markets have evolved in
recent years in ways that lessen the more significant
problems.” (Points to outside directors)
• We have seen that the interaction of better market
discipline combined with regulatory failure can
exacerbate the problem
• The principle of second best welfare plans
Management Constituents
• Who do they represent beside shareholders?
– Themselves
– Other constituents: debtholders, employees
• Public believes(?) employees must take top priority
• Behaviorists hypothesize: people with whom they
have most contact: employees (?) institutional
shareholders (?) suppliers/customers (?) Long-
serving mangers more inclined to balanced views
• Difference concept of management from the
Japanese quickly disappearing structure
Management ownership and control
• Median ownership of CEOs (1990) 0.25%. 80% of
of CEOs own less than 1.4%
• Outside shareholders even more diffuse creating a
free-rider problem as to monitoring. Reason?
diversification. Value of control may be less than
cost of non-diversification
• Proxy fights are not efficient (stacked against shs)
• Who protects shs?
– Institutional investors like CALPERS (few)
– Takeover threats (subject to social debate and policy)
Diversification and Monitoring (Ex.18.1)
• John can increase Axel Inc.’s value by $60M (from
$300M) over the next 5 years.
• Required investment: His entire wealth of $60M to
purchase 20% of the stock. IRR = rE + 4%
• Axel SD: 40%, Mkt Pf SD: 20%, rM –rf = 8%
• Reward-variability (Sharpe) measure:
• M: 8/20, Axel: (beta*8+4)/40
• Investment not acceptable, monitoring cost high
Improvement in corp governance
• Changes in early 1990s
– fuller disclosure of compensation
– shs access to copr shareholder files -- makes proxy
fights easier
• Greater emphasis on outside directors
– majority of outsiders up from 71% in 1979 to 86%
in 1989
– directors prob to be terminated 1983-1994 doubled
from 1971-1982, terminated directors more likely
from outside the corp
International perspective and current issues
• Governance is shown to affect value world wide
• Studies show that legal protection of shareholder
rights significantly affect share value
• However, even in the most advanced systems there
is a long way to go
– conflict of interests in the auditing business
– conflict of interests in investor services (exacerbated by
pricing difficulties)
– unsatisfactory transparency, e.g., SPEs, exacerbated by
taxation
Where do we find mgt with large holdings?
• Founders of corporations may hold large blocks of
shares despite diversification motive
– Tax issues (Gates)
– in countries where lack of legal protection makes it
difficult to find buyers (Mexico)
– in industries with greatest potential for management
incentive problems (media)
– industries with uncertainty about future create signaling
problems. Sale of stock signals disappointing future
(technology, computers)
Inside Ownership and Firm Value (Ex.18.2)
• Bates owns Bates Inc. Value tied to Bates efforts
– Bates wants to sell large fraction of shares
– Current value $100M
– Bates sells >50% => value falls to $80M
– Bates sells <33% => value falls to $90M
• How much will Bates sell?
– Sell 50% => get: cash=$40M stock=$40M
– Sell (1/3) => 30M 60M
– Depends on
– Interest in putting efforts into the firm
– Risk aversion
• Empirical evidence: entrepreneurs selling smaller
fraction receive higher price/share
Managers with Large Holdings
• The incentives argument
– These managers will try harder
• The abuse argument
– These managers have a better chance of creating
slack
• Question: Can we identify companies with
easier/harder access to slack? If so, will we find
managers with larger holdings and slack in
companies with easier access to slack?
Managers with Large Holdings: Random?
Type of business affects
holdings and incentives (1990)
Best incentives
Worst incentives
Empirical Evidence on Managerial
Control and Value of Shares
• Studies point out that
– Up to concentration of about 5% value increases
– Beyond about 5%, value falls with concentration
– Suggesting that greater control leads to abuse
– Criterion used is market-to-book value, sensitive to
tangibility of assets
• Closed-end funds
– Average fund discount is 14.2%
– Absent large shareholders, fund discount only 4.1%
• International studies: where abuse is easier, large
shareholders control decisions
Managerial Control and Investments
• Control of corporation beneficial to managers.
Hence, executives will choose investments that
enhance and preserve control
– Invest in business requiring their expertise (??)
– Implicit contracts (with key employees or Spielberg:-)
– Investing in fun business (Bronfman of Seagram)
– Short-term projects create quick recognition and slack
– Minimize risk (including sigma): bad outcome may cost
job (only 43% of CEOs and 46% of directors keep job in
BR)
– Large empires: invest in projects that increase size and
decrease sigma risk. Pay less dividends and reinvest
RJR Nabisco
• This large company emerged from the merger of
the tobacco (RJR) and food (Nabisco) giants
• A few years later it was taken private by its
management in a famous LBO
• Prior to the LBO, the company invested $2.8B in
a cost saving project at IRR≈5%
• After the LBO (management owns the firm), the
project was scaled back
Impact of Large, Outside Shareholders
• Incentives to affect investments that neutralize
management biases
• Allied Industry example: Choose the capital
intensive process that limits flexibility
• Flexibility is a valuable asset the greater the
corporate risk. Hence, significant loss of NPV
• Alternative: improve monitoring of management
• Result:
– benefit of discretion greater with uncertainty
– Monitoring preferred to discretion with less uncertainty
Debt and the Conflict between
Management and Large Shareholders
• Risk averse mangers will limit debt
• Large shareholders prefer more debt
– To avoid management over-expansion of firm (create
debt overhang)
– Increase motivation to take risk
– Increase incentives to perform (avoid BR)
• In a study of 124 manufacturing firms, positive
relationship between leverage and % of
– Compensation tied to performance
– Equity owned by management
– Investment bankers on the board of directors
– Ownership by large outside shareholders
Higher leverage to control CEO
• Tom and Charley want to invest in real estate
• Tom will manage the project, Charley in charge of
finance
• Both have resources hence can choose how large a
mortgage to take
• This decision is to be made by Charley
• Should Charlie go for higher or lower leverage?
• To limit Tom’s slack, choose higher leverage
Leverage Choice Problem (Ex. 18.3)
• Initial investment $100M. One year later, an
additional $100M may be needed for expansion
Value in State (mil.)
Good Medium Bad
Value with project 250 175 125
Value w/o project 50 50 50
Project NPV 100 25 –25
• New manager is expected to fund project
regardless of state of the economy
• How can financing of initial investment prevent
such outcome?
Choosing Appropriate Financing
• Project has negative NPV if economy is bad
• If initial investment is financed with equity,
manager can fund project with debt even in bad
economy (why?)
• The idea is to finance initial investment with
senior debt, so lenders will not buy junior debt
• Issue $25–75M of 2-year, senior debt (why?)
• Project can be financed in all but bad economy
• Note: Problem solved only if there are no
sufficient internal funds to finance the project
Persistence of Problem (Ex. 18.4)
• Suppose there are internal funds generated
Value in State (mil.)
Good Medium Bad
Value with project 250 175 125
Value w/o project 50 50 50
Internal CF 100 25 100
• The assumption is not much of a stretch, bad
economy may lead to liquidation of assets etc.
• Can senior debt financing of initial investment
solve this problem?
Limitation of Debt Financing
• To counter internal funds, need to issue 1-yr debt
• Suppose the firm takes on:
– Short-term (one-year) debt of $100M
– Long-term (two-year) senior debt of $25–75M
• Management will not fund the project in the bad
state. Why isn’t this a solution?
• Because management will also fail to fund in the
medium state when NPV is positive
• Result: Debt ratio is important, but cannot by
itself replace monitoring
Banks Vs. Diffused Bondholders
• Re-negotiation of debt is an important way to
resolve conflicts in bad states
• When debt is diffused, re-negotiation is
impossible because of the free-rider problem
• Result: A firm may not be able to sell desired-
size bond issue to the public
• Banks may be able to solve this problem
• Problem in example 17.4 could be solved if it
were understood that debt would be negotiated in
the medium state
• Banks are also an alternative to a large outside
shareholder monitoring management. They also
neutralize the asset substitution problem
• Banks can be trusted with confidential info.
Public debt requires prospectus
The Principal Agent Problem
• The elements
– Uncertainty
– Unobservable efforts
– Agency cost: value of perfectly managed firm less actual
• Oldest solution: share cropping. Optimal?
• Only if farmer risk-neutral and has subsistence
• Contemporary solution: Design incentive contracts
• Example: Should you equalize risk of agent to
principal?
• Answer: No! Principal’s wealth and risk sharing
• Question: is stock compensation adequate? No.
It’s amazing how pervasive this solution is!
Executive Compensation and Share Value
• The elements: Fixed, profits and stock returns
• The study of 2505 CEOs over 1974-1988 shown
in Exhibit 18.1
• Fact: Corp jet costs $10M, it cost to:
– Wasserman of MCA = .0701x10M = $701,000
– To Chandler of Kodak = .00008x10M = $800
• Question: will Wasserman avoid the purchase?
• Study conclusion: too little performance
compensation, not too much
Executive Compensation and Performance
• Exec promised 30% of k=(E-E*) over next 5 years
• Suppose mangers doubles earnings, as revealed by
first-year results
• Manger’s compensation up in each year by .3k
• Stock will go up by about 100%, then behave
normally
• Result, low correlation between annual
compensation and stock return
• Longer-term study shows sensitivity 10x larger than
the calculation in the Table (Jensen and Murphy)
Adequacy of pay/performance schemes
• Difficult in large firms. Sensitivity of pay to
performance much larger in smaller firms
• High-growth firm are expected to show higher
sensitivity of pay to performance. But the risk is
too large for managers
• Study (1999) shows that less volatile firms are
more likely to tie pay to performance
• Recent evidence: dramatic increase in
performance compensation, mostly through
options
Compensation and Stock Returns
• Event studies examine response of stock prices to
the adoption of performance pay schemes
• 42 plans adopted during 1970s:
– Between 7 months prior to adoption to adoption date
– Stock prices increased by 20% on average
• Cross section relating Market-to-book value to
performance pay plan finds positive correlation
• These studies do not prove causality! It is possible
that such schemes are adopted on the heels of, or
prior to, stock-price increases (Ex.18.5)
One Example of
Relative Performance Compensation
• Johnson Controls (JC) plan for two top executives
Annual base amount: A = 300,000 and 100,000 times X
0 < X < 1.50
X = Annual 10-year return on: JC stock/peer group stock
– Peer group: Fortune 500 firms in same business
– $A invested each year in JC stock
– Value of accumulated stock paid out after 7 years
• Problem with such plan: managers gain from losses
of other firms. Incentive for super-aggressive
competition. Reason for scarcity of such plans
Relative performance
• Study of 177 large U.S. firms shows the
frequency of relative-performance pay
– 25% of the 125 industrial firms
– 57% of the 52 financial service firms
– 42% of utilities
• One reason this scheme is not as prevalent in
industrial firms may be its incentive to hurt
competitors
Stock Based Vs. Earning Based Plans
• Earning-based variables: E, CF, EVA.
• In example 18.6, GT argue that a flaw in stock
based plans is that stock price reflect
expectations from managers prior to hire.
Hence, prices will not reflect year-by-year
success.
• This argument is tenuous. What is wrong with a
plan tied to better-than-expected performance?
• Real problem with stock-based plans is
systematic risk
• Problem with E-based plans: what benchmark?
Was IRR high or was it just scale?
Value Based Management Methods
• Contribution of the 1990s
• The principle is to evaluate performance of a unit
against a charge for capital used
• These methods (although far from perfect) have
the decisive advantage over stock-based plans of
avoiding the unnecessary systematic risk and
pitfalls of stock vs. flow problems associated
with stock-price changes (since compensation is
a flow)
• Compensation is one reason for spin-offs and
undesirability of conglomerates

Class Notes Week Viii: Reading Assignment GT Ch.18

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Class Notes Week Viii: Reading Assignment GT Ch.18

Uploaded by

Copyright:

Available Formats

CLASS NOTES

You might also like