Lecture Chapter 1

Part II

Print off the Present Value Tables

for next class

1
“Evil” Corporations- Limited Liability- and
“Strategic Bankruptcy”

inclineco.com

2001online.com

Newsweek.com

2
belredcosmetic surgery.com businesstoday.in
 Principal Agent Problem

3
 Principal Agent Problem

• In the modern publicly-traded corporation,

professional managers and directors manage
the corporation — they are seen as the agents
of the shareholders who are the owners.

• It is possible for agents (management) to

pursue their own goals at the expense of the
principal (shareholder).

4
Principal-Agent Problem
 One potential solution is to tie management’s compensation
to firm performance- share price and or profit

• Stock grants

• Profit sharing plans

• Stock options

Talk about next lecture

Employee Stock Grants
• Management are given "restricted” stock that they
cannot sell until after a certain date (2-5 years- vesting
period- waiting period)

• After the vesting period they can hold or sell the

shares

• Also, can provide interest free loans to buy the shares-

better-”skin in the game”

• Management has an incentive to work hard to

increase the share price- alignment of
management/shareholder goals/interests
 Employee Stock Grants
• As the share price increases both shareholders
and management get richer-alignment of interests

• If the share price goes down, employee gets

poorer---but still has something of value (will not
be worth less than $0)

• Retention effect during the vesting period—if

leave company lose the stock

7
 Profit Sharing
• Management’s compensation is tied to the
profit targets---”share” in the profit

• If the company does well, the manager does

well—alignment of SH and management goals
 Employee Stock Options (“call” option)
“You can buy 100,000 shares for $5/share from
December 2020-December 2025”

2018 2020 2025

9

Vesting period Exercise period

Today trading price-$5

Option price- $5 (often more than current share price—i.e. $6)
• Not taxable----yet!!
• No cash outflow—just a letter to employee
• Presumably can pay less salary
• Employees will work hard to increase the share price
Stock Options Terms
Vesting period: the waiting period before the
employee can “exercise the option” ---can buy the
shares for $5 

Exercise period: this is the time frame when the

employee can purchase the company shares for $5.

“Option”--- you do not have to buy i.e. if the price

drops to say $3, do not have to buy for $5.

10
1
1

Employee Stock Options

“You can buy 100,000 shares for $5/share from
December 2020-December 2025”
Trading price
= $10
2018 2020 2025

Vesting period Exercise period

Buy for $5 and sell for $10- make $500,000

Buy for $500,000 and sell for $1,000,000

Are shareholders happy?

 Employee Stock Options

• As the share price increases both shareholder

and management get richer-alignment of
interests

• Has a retention effect during the vesting period

• If the market price goes below strike/exercise

price (underwater)—options are worthless---
lose retention effect

12
 Employee Stock Options-Retention

• If the employee leaves the company, they

usually lose their stock options

• If they are still within the vesting period, they

could “leave money on the table” if the market
price of the shares is above $5 in our example

• Since options are granted annually, managers

often leave money on the table when they leave
13
a company ---competitors need to offer $$$
1
4

Employee Stock Options Retention

“You can buy 100,000 shares for $5/share from

December 2020-December 2025”
$15-trading price

2018 2020 2025

Vesting period Exercise period

($15-$5) X 100,000 =$1,000,000

thedigeratilife.com
1
5

Employee Stock Options Retention

“You can buy 100,000 shares for $5/share from
December 2020-December 2025”
Trading price
= 50 cents
2018 2020 2025

Vesting period Exercise period

•Underwater---lose the retention effect

•Often new options reissued at today’s trading price
•Not so good for shareholders
1
6

Employee Stock Options-THERE IS A COST

Trading price
= $10
2018 2020 2025

Vesting period Exercise period

Buy for $5 and sell for $10- make $500,000

Buy for $500,000 and sell for $1,000,000

However….
There is a real cost for the company---either have to buy
shares for $10 from the market or issue new shares for
$5 (which they could have received $10 for on the open
market—opportunity cost)
 Employee Stock Options

• Both stock options and stock grants can be

based on performance
• i.e. ship model 3 by …. and receive XXX stock
grants

electrek.co

17
Agent Principal challenges

Michael Pearson is living every management consultant’s

dream: In 2008, he left McKinsey & Co. after 23 years to
take the helm of the emerging Valeant Pharmaceuticals
International Inc. Less than a decade later, he has nearly
$3-billion (U.S.) in stock and
options in the company, with the potential to own
hundreds of millions of dollars more.

Too much?

18
Employee Stock Options

19
Tesla
$50B
NYT 11/29/22

Musk’s 2020 grants are worth $24.8B (Feb

12, 2021)

Stock price up 743% in 2020

CNN Business

20
Blackberry-May 2015

….last year when CEO John Chen base salary was

$326,374 but topped up with more than $84
million in stock-based compensation.

But Chen also owns 13 million Blackberry shares

that have not yet vested, which at current market
rates are worth about $140 million. 
 Stock Based Compensation

2008 2009, 2010 2014

$1.1B $1.2B $1.4B $4.2B

6.3% of sales

2019 $11.7B 10.5% of sales

 Valuing Stock Options-Financial Statements

• Black Scholes Model

• Estimate
• Expense over vesting period---not when exercised

Bus251- “Matching Principle”—”Expense recognition”

cbc.ca
2
4

Employee Stock Option Advantages

• No cash outlay for employee or company

• Pay lower salaries---important for start ups

• Alignment with shareholder objectives

• Employees behave like owners

• Upside potential unlimited

• Retention- unvested

• Happy employees

• No downside for employee

2
5

Employee Stock Option Challenges

• Focus on short-term-i.e. cut R&D

• Underwater-reissued

• Valuing them is difficult

• Unintended consequences
fineartamerica.com

• Dilution of ownership due to distribution of shares

• “A rising tide lifts all boats”—2008-2016

• Sad employees

• No downside for employees- bad for shareholders

The Stock Market
 The Stock Market
• Primary market:
 Market for the sale of new securities by corporations
• Brokerage firms
• Pension funds
• Large investors
• Friends and family

dailymail.co.uk

• Secondary markets
 Market in which already issued securities are traded
among investors

27
Institutional Investors
 Institutional investors such as pension funds, hedge funds,
insurance companies, endowments, and foundations are active
investors in private and public companies

$27.2B $37.1B
 Institutional investors may invest directly in private firms or they
may invest indirectly by becoming limited partners in venture
capital firms or private equity.
 The Stock Market
• The main financial players in Canada are:
 Banks and other deposit-taking institutions;
 Insurance companies
 ETFs/mutual funds/hedge funds/private equity
 Pension/sovereign wealth funds:
• Caisse de Depot “The Caisse” -$152B
• Ontario Teachers Pension Plan $96B
• CalPERS- $260B
• Japan $1.4T
• China $1.6 T
• Hong Kong $456B
• Norway $1 trillion
WSJ
• Saudi Arabia- $700B
• United Emirates $1.3B
• CPP Investment board $497B
29
Pension Funds
– accumulate cash that will be paid out to members
in the future in the form of pension income
– money is invested until it is needed
– investments include stocks and bonds,
mortgages

nymag.com
colombia.com
 The Financial System-CPP Investment
Board

CPP Investments 2021 Annual Report

31
cleveland.com
 Intermediaries/Mutual Funds/ETFs/Index
Funds/Hedge funds

32
 Intermediaries
• ETFs
• Mutual Funds
• Banks
• Insurance Companies n ds
$ bo
• Pensions uy
st / b
e
• Hege Funds In v
• Sun Life
$ • RBC
• Fidelity-ETF/MF $
• Springfield Loa
Premiums Power Plant ns
Deposits Pension Fund
Investment
artsy.net
Contributions
 The Stock Market
• Mutual Funds
 Diversified
 Bonds/Equity
 End of day value mepbfinancial.com

 Management fee-%- “professionally managed”

34
 The Stock Market
• Index Funds (mutual funds)
 Buy everything in S&P 500 (Standard and Poor’s) or
TSX 60 or a bond index medium.com

 Lower management fees

 End of day value
 Diversity

35
 The Stock Market
• ETFs (Exchange Traded Funds)
 “Shares that hold shares”
 Price of ETF goes up and down moment by moment as
underlying stocks change like a share-tracked on an
exchange
 Sell and buy like a share—no mgt fees/sales loads but
brokerage fees
 Lower operating expenses
 Tax efficiencies with respect to redemptions
 The Stock Market Blackrock

A “Consumer Staples” ETF

SHOPPERS DRUG MART CORP. 24.24 $8,962,331 XTSE Canada Consumer Staples
ALIMENTATION COUCHE TARD INC. CL B 19.32 $7,142,883 XTSE Canada Consumer Staples
SAPUTO INC. 13.06 $4,826,618 XTSE Canada Consumer Staples
METRO INC 12.12 $4,480,125 XTSE Canada Consumer Staples
LOBLAW COS. LTD. 9.67 $3,573,339 XTSE Canada Consumer Staples
GEORGE WESTON LTD. 7.34 $2,712,942 XTSE Canada Consumer Staples
EMPIRE CO. LTD. CL -A- 4.57 $1,688,325 XTSE Canada Consumer Staples
JEAN COUTU GROUP (PJC) INC. CL A 3.14 $1,160,210 XTSE Canada Consumer Staples
NORTH WEST CO. INC. 2.5 $922,896 XTSE Canada Consumer Staples
MAPLE LEAF FOODS INC. 2.4 $886,554 XTSE Canada Consumer Staples
COTT CORPORATION 1.59 $587,444 XTSE Canada Consumer Staples

“Collaborative Investment Series Trust has announced that it has a

FOMO (fear of missing out) ETF in registration.…: invests in stocks
anywhere in the world, as well as SPACs, other ETFs, derivatives,
volatility products and both leveraged and inverse ETFs.” CNBC Mar 15,
2021

37
 Mutual Fund Performance

SPIVA Canada, which compares the performance of actively managed

Canadian mutual funds against their relevant S&P indexes, has become the
de facto scorekeeper in the active-versus-indexing debate.

Based on asset-weighted returns for the five years from 2008 to 2012, it is a
clean sweep for the indexes. The majority of actively managed funds failed
to outperform their comparative indexes in all seven fund categories.

In the three critical categories, Canadian, U.S. and international equities, a

staggering 89.7%, 94.4% and 88.9% of the actively managed funds
respectively failed to beat their comparative indexes. The best showing was in
the Canadian small and mid-cap category, but even here 78.7% of the funds
underperformed the index. medium.com

Oct 11, 2013- Financial Post

38
 Mutual Fund Performance

By at least one measure, active fund management in

Canada has hit a new low.

A new report shows that the number of Canadian funds

focused on U.S. large-cap stocks that outperformed the
index over the past five years was precisely zero.

Not a single Canadian manager investing in U.S. stocks

delivered higher returns than the S&P 500 index over that
time, according to S&P Dow Jones Indices.

Globe and Mail Oct 13,2016

39
 Mutual Fund Performance
Stock Pickers Trailed Market Again in Roller Coaster 2020
Some 60% of U.S. large-cap stock-picking funds lagged behind S&P
500 in 2020, marking 11th straight year of underperformance

WSJ March 11, 2020

40
 Warren Buffet
Poof: $100 billion disappeared.
That’s the figure that Warren E. Buffett
 recently calculated that pension funds,
endowments and wealthy individuals have
lost over the last decade to hedge funds
and other money managers that charge
forbes.com sky-high fees.
Feb 27, 2017 New York Times

41
 Warren Buffet
For the past several years, Mr. Buffett has
told anyone who will listen to avoid
attempting to beat the stock market by
investing in hedge funds or actively
managed funds. Instead, he has
counseled buying a low-cost S. & P.
forbes.com
500 index fund. (He has said he plans
to advise the trustee of his estate after he
dies to invest 90 percent of it in an S. & P.
500 index fund and the rest into
government bonds on behalf of his wife.)

Feb 27, 2017 New York Times

42
 Sovereign Wealth Funds (SWFs)
 Pools of money controlled by a government
 Usually raised from royalty, resource revenue, or taxes that have been collected
 SWFs play an active role in the private equity market and are the largest limited
partners in global private equity markets

 Norway $1 trillion
 Abu Dhabi $828B
 Kuwait Investment Board $524B
 Alberta Heritage Trust Fund $17.2B
 China $1.6T
 Saudi Arabia- $700B
 United Emirates $1.3B
 CPP Investment board $265B

23-43
Hedge Funds
 Hedge Funds (Pershing Square/Sprott/Bridgewater
$80B)
• For “sophisticated” investors- SEC/OSC
accredited
• Leverage/vulture/short position/arbitrage
• Restructure- CP/JC Penny/Dell
• Active investors
• Partners keep 2/20%--2% of investment and
20% of profit
• May need to wait 6-90 days for redemptions
 Hedge Funds
20.5% loss 2015
25.6% loss Q1 2016 d!
at e
ti c
his
o p
S
Pershing Square 
has spent about $50 milli
on
 making its case against
Herbalife — Ackman’s not
relishing any victories.
That said, his fund
registered a 40.2% gain in
grubstreet.com
45 2014, earning him kudos
Hedge Funds-Valeant/Pershing Square-Globe and
Mail-March 14, 2017

After waging a costly and outspoken public defence

of the controversial drug maker, Mr. Ackman said
late Monday that he sold his entire stake and that he
would leave the board.

…..Mr. Ackman’s Pershing Square Capital Management

may have lost $4-billion as of November 2017
 Hedge Funds
BREAKING|121,134 views|Mar 25, 2020,08:42am EDT-Forbes

Billionaire Bill Ackman Made 100-Fold Return On

margaritaville.com

Coronavirus Hedge That Yielded $2.6 Billion

2020 return:70.2% return

2019 return:59% return
Bloomberg.com

“He’s Back!”
Hedge Funds

($4.5B)
 Mr. Buffett’s hedge fund wager
Warren Buffett has long railed against the fees that hedge funds and
money managers collect from investors.
A decade ago, he made a $1 million wager that an index fund that
tracks the S.&P. 500 would outperform a basket of hedge funds over
the next 10 years.

The bet is now complete and Mr. Buffett won. The S.&P. 500 index
fund that Mr. Buffett picked is up nearly 126 percent, easily
outpacing the returns of five funds of hedge funds, which were up
2.8 to 87.7 percent.

NYT 24 feb 2018

49
 $102B
$39B
Private Equity Firms
 Organized very much like a venture capital firm, but it invests in
the equity of established firms rather than start-up companies-
charge fees
 Private equity firms find public companies and purchase the
outstanding equity, thereby taking the company private in a
transaction called a leveraged buyout (LBO).
 In most cases, the private equity firms use debt as well as equity
to finance the purchase.
 Much larger dollar amounts ($B)---buying public and private
companies

Copyright © 2015 Pearson Canada Inc.

 $102B
Private Equity Firms
 Often have some turn around strategy

 New management/downsize

 Take public again

indiewire.com

dealbreaker.com
 Who owns big corporations-You, I
and hedge and mutual funds
Holder Shares % Out Value* Reported
Vanguard Holder Shares % Out Value* Reported
Total Stock
146,803,658 1.44 3,404,376,829 Jun 30, 2013 Vanguard
Market Index 11,283,848,4
Fund Group, Inc. 486,582,514 4.78 Jun 30, 2013
99
Vanguard 500 (The)
99,038,154 0.97 2,296,694,791 Jun 30, 2013
Index Fund State Street 9,352,947,41
403,318,129 3.96 Jun 30, 2013
Vanguard Corporation 1
Institutional
Index Fund- 98,280,228 0.97 2,279,118,487 Jun 30, 2013
BlackRock
Institutional Institutional
6,342,029,25
Index Fund Trust 273,481,210 2.69 Jun 30, 2013
9
SPDR S&P Company,
94,843,810 0.93 2,194,685,763 Aug 31, 2013
500 ETF Trust N.A.
Income Fund Capital World 4,555,406,49
68,066,500 0.67 1,578,462,135 Jun 30, 2013 196,438,400 1.93 Jun 30, 2013
of America Inc
Investors 6
Dodge & Cox
54,106,075 0.53 1,254,719,879 Jun 30, 2013 Northern
Stock Fund 3,805,463,53
Franklin Trust 164,099,333 1.61 Jun 30, 2013
2
Custodian Corporation
50,000,000 0.49 1,159,500,000 Jun 30, 2013
Funds-Income 3,752,450,79
Fund FMR, LLC 161,813,316 1.59 Jun 30, 2013
8
College Bank of New
Retirement 3,609,641,95
45,018,220 0.44 1,040,821,246 Mar 31, 2013 York Mellon 155,655,108 1.53 Jun 30, 2013
Equities Fund- 4
Stock Account Corporation
Price
Spartan 500
42,570,376 0.42 985,078,500 Aug 31, 2013 (T.Rowe) 2,252,684,46
Index Fund 97,140,339 0.95 Jun 30, 2013
Associates 1
Washington Inc
Mutual 38,900,000 0.38 902,091,000 Jun 30, 2013
Investors Fund BlackRock
2,184,678,30
Fund 94,207,775 0.93
2
Jun 30, 2013
Advisors
Dodge & Cox 2,146,218,47
92,549,309 0.91 Jun 30, 2013
Inc 5
52
 Who owns big corporations?

Not me, dude! I don’t buy mutual funds!

53
semanticsscholar.org
 Intermediaries
• ETFs
• Mutual Funds
• Banks
ds
• Insurance Companies $ bo n
uy
st / b
• Pensions-CPP/Private e
In v
• Sun Life
$ • RBC
• Fidelity-ETF/MF $
• Springfield Loa
Premiums Power Plant ns
Deposits Pension Fund
Investment
Contributions
 Some CPP Investment Board
 

Canadian Holdings Market Value 

)  (CAD $ millions
     

Agrium Inc 174

Aimia Inc M 21
0
Valeant 2 851
0
$
Air Canada 25
Alimentation Couche-
238
Tard Inc
BCE Inc 150
Bank of Montreal 534
Bank of Nova Scotia 810
Barrick Gold Corp 96
BlackBerry Ltd
55
53
Some CPP Investment Board International
Holdings

$219M

$383M
$412M

$634M

$12M
$99M $144M

56
Pattern Energy to be acquired, taken private by
CPPIB in $2.63-billion deal-Financial Post Nov
4, 2019

financialpost.com

1-57
680news.com
The Stock Market

• Largest Stock Markets

 New York Stock Exchange (NYSE Euronext US)
• Market Makers/Specialists
• Recently combined electronic trading with the trading on the
floor

 NASDAQ
• Does not meet in a physical location

 Bid Price versus Ask Price

• Bid-Ask Spread
 Transaction cost

Copyright © 2015 Pearson Canada Inc. 1-58

The Stock Market
• Toronto Stock Exchange (TSX)

 Most stock trading in Canada, particularly by value,

takes place through the TSX

 Generally trades the securities of larger firms (senior)

 A lower value of trading in the securities of junior and

early-stage firms occurs through TSX Venture
Exchange, owned by the TSX.

Copyright © 2015 Pearson Canada Inc. 1-59