FIN 562FIN 562

Intermediate Financial Management (catalog Intermediate Financial Management (catalog name)name)

““Real” Name: Topics in Corporate FinanceReal” Name: Topics in Corporate FinanceProf. Daniel A. Rogers, PhDProf. Daniel A. Rogers, PhD

Key Points of SyllabusKey Points of Syllabus

• Objective

• Format

• Materials

• Workload

Course ObjectiveCourse Objective

• Provide more breadth and depth to your understanding of corporate finance

• Enable you to become a “user” of research in financial economics by developing your ability to “think about conceptual issues.”

Course FormatCourse Format

• Seminar

• Discussion of research– Focus on “practical” issues– View from senior financial executive

perspective– Prepare you for “big picture” issues to be

faced as career progresses

• Preparation is crucial

Course MaterialsCourse Materials

• Background and reference: FIN 551/561 textbook.

• Almost all articles available through PSU library electronic resources.

• Notes/Supplements available on my website.

• Suggested: student subscription to Journal of Applied Corporate Finance (JACF).

Course WorkloadCourse Workload

• A lot of reading (and some writing)!

• Class participation (35%)

• Exec summaries of selected research papers (3) – (30%)

• Research project (35%)

Course OverviewCourse Overview

• What are the consequences for analyzing corporate finance decisions in an environment characterized by “imperfect” markets?

• Topics considered:– Agency Problems– Capital structure– Payout policy

Course Overview – Topics (cont’d)Course Overview – Topics (cont’d)

– Basics of option valuation – Executive & employee compensation– Managerial incentives– Corporate governance– Ownership structure and its effect on firm

performance– Hedging/risk management– M&A and the diversification discount– Discussion of how the current financial situation is

related to many of the issues discussed during the course!

Fundamental Question of Fundamental Question of Corporate FinanceCorporate Finance

• How do corporate financing decisions affect firm value?– Already know that proper investment

decisions (i.e., positive NPV) have first-order effect.

– Corporate financing decisions = capital structure, payout, risk mgt, compensation & exec ownership policy, etc.

– Is there a framework for analyzing?

Birth of Modern Corporate Finance Birth of Modern Corporate Finance (Miller and Modigliani)(Miller and Modigliani)

• Perfect Capital Market Assumptions– No taxes or transaction costs (frictionless

markets)– Information symmetry (homogeneous

expectations)– No “big” market participants (atomistic)– Investment plans of firms are fixed and known– Capital structures of firms are fixed

The Primary Lesson of M&MThe Primary Lesson of M&M

• In an environment of perfect capital markets, corporate financial policies (i.e., capital structure decisions, payout policy, compensation decisions, hedging decisions, etc.) have NO effect on firm value.

• THEN, why do senior finance execs spend so much time & effort worrying about these issues?

Because Capital Markets Are Not Because Capital Markets Are Not PerfectPerfect

• “Real-world” violations of perfect capital market assumptions:– Frictionless markets

• Existence of corporate and personal taxes.• Variation of tax rates across investors (and firms).• Existence of transactions costs.• Differences in transaction costs across investors (and firms).

– Homogeneous expectations• Competing interests with claims on firm’s assets (shareholders,

managers, lower-level employees, debtholders, government, etc.) Information asymmetry creates environment for existence of agency costs.

– Atomistic market participants• Dominant investor (including the firm) may influence market value.

Real-world violations of PCM Real-world violations of PCM assumptionsassumptions

– Fixed investment programs• Protection of “strategic” information from competition precludes

firm’s managers from sharing information regarding future investment.

• If firm has risky debt, shareholders may choose to deviate from “optimal” amount of investment (underinvestment/overinvestment).

– Fixed financing programs• Shareholders have incentives to increase equity value includes

altering capital structure to make themselves better off at the expense of creditors.

• Obviously, many “problems” are created by separation of firm into differing “agency” classes (shareholders, managers, creditors). There must be benefits, RIGHT?!

Benefits of Separation of Benefits of Separation of Ownership & ControlOwnership & Control

• Allows manager to diversify holdings.

• Lowers manager’s risk.

• Allows for secondary market for ownership claims on the firm.

• Increased liquidity of firm’s shares translates to higher market value.

Firm as a “Nexus of Contracts”Firm as a “Nexus of Contracts”

• In environment of perfect markets, objective is “maximize firm value.”

• Jensen and Meckling (1976) highlight a broader notion of “ownership structure” with various stakeholder groups: insider owners, outside shareholders, creditors, government.

• Example: insider owner gains utility from consuming assets of the firm for personal utility gain (to the detriment of outside shareholders).– Creates need for contracting: incentive-based

compensation contract. Goal: provide incentives for insider owner to maximize equity value.

Agency CostsAgency Costs

• Costs borne because contracting parties act in own self-interest to the detriment of overall firm value.

• Agency costs are the sum of:– Monitoring costs– Bonding costs– Residual loss

• These reflect the trade-off between maximizing the objectives of contracting parties.

• The practical nature of most contracting problems in corporate finance is to design solutions that minimize the agency costs.

A Simple ExampleA Simple Example

• Suppose I own a building (owner = principal)• I hire you to manage my building (i.e., find tenants,

collect rent, maintain structure, etc.) (manager = agent)• As manager, you have incentives to take actions that

may not be in my best interest (i.e., use “prime” rental space for your office, etc.)

• I must expend time and effort to ensure that you do not do things that make me worse off.

• Because of such monitoring costs, the value I receive from my ownership of the building may be lower than if I managed it myself.

• I have to view this economic loss against benefits obtained by freeing up most of my time!

Some Examples Highlighting Agency Costs Some Examples Highlighting Agency Costs of Managerial Discretionof Managerial Discretion

• Perquisite consumption• Manipulation of financial statements• Empire building• Excess diversification• Lack of long-term focus• Underutilization of debt• Managerial entrenchment & board appointments

• Basic point: execs like more compensation and/or lower firm-specific risk.

Agency costs of debtAgency costs of debt

• Given agency costs associated with separation of ownership and control, why don’t we observe firms owned by a manager with the remainder of capital supplied by fixed claimants?– Incentive effects associated with debt– Monitoring costs created by manager’s

incentives– Bankruptcy costs

Manager’s incentivesManager’s incentives

• Equity = call option when firm is levered.• Call option’s value increases at higher levels of

volatility.• Thus, manager’s incentives are to invest in

projects with more risk (NOTE: not unlimited…why not?).

• This incentive would hurt bondholders negatively affects how much they will pay for bonds.

• This value reduction is one source of agency costs of debt.

Monitoring, bonding, and Monitoring, bonding, and bankruptcy costsbankruptcy costs

• Monitoring– Financial covenants

• Bonding– Audited financial statements

• Bankruptcy costs

Jensen and Meckling’s Theory Jensen and Meckling’s Theory of Ownership Structureof Ownership Structure

• When deciding how much outside equity and debt, owner-manager trades off agency costs of outside equity vs. debt.

• When deciding how much outside capital to issue, owner-manager takes into account additional agency costs borne by issuing additional outside capital relative to her need for additional financing.

Another agency cost of debt – Another agency cost of debt – UnderinvestmentUnderinvestment

• According to Jensen and Meckling, issuing outside capital to fixed claimants may cause investors to invest in overly risky projects. This is commonly called the “overinvestment” problem.

• Myers (1977) illustrates that shareholders requiring debt financing to fund a positive NPV project may reject it because too much of the project’s value is captured by the creditors.

So, what’s the point?So, what’s the point?

• We can use “agency” cost arguments as a major point in analyzing many corporate financing decisions. Examples include:– Capital structure (week 2).– Payout policy (week 3).– Executive compensation (week 4).– Managerial ownership and firm performance (week 6).– Risk management (weeks 7 & 8).– M&A / corporate diversification (week 9).

Some important questions – background Some important questions – background from Jensen (2001)from Jensen (2001)

• Does shareholder value maximization mean “taking advantage” of other stakeholders?– Are stockholders and stakeholders “opponents?”

• Should value maximization be the “goal” of corporations?– Question 1: Why are we in business?– Follow-up question: How do we determine success?

• Does maximizing corporate value maximize social welfare?– Externalities– Role of governments

• Do managers REALLY prefer stakeholder theory?• What does “long-term” market value mean?