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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 firm’s 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 firm’s 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

Cash PayablesReceivables Bank loansInventories Short-term debt

Long-term debtPhysical assets Retained earningsIntangible assets Shares outstanding

Working capital management; capital budgeting; capitalfinancing.

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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

7Wave 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?

Today’s value of expected future cash flows

)(r)+(1

CF

=)(T

0=tt

t GOPV

NPVakaAssetValue

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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

• NPV>0: 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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• 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”?

T

0=tt

t

r)+(1

CF =Wealth

Is maximizing shareholder wealth optimal?

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Value of the Corporation: Perfect World

P

1ppNPVFirmV

• 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 (NPV’s 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 firm’s assets and/or cash flows

– Equity contracts: Claim on the firm’s 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 principal’s 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 (NPV<0)

• 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

• Firm’s 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• CFO’s 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• M&A’s: Large loss deals (>$1 billion lost)

– For every $1 spent, they lost $2.31 in shareholder wealth at the announcement (Moeller, Schlingemann and Stulz (2005))

Aggregate dollar return to acquiring-firm shareholders

-160

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-40

-20

0

20

40

1980

1982

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lion

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lars

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Manage Agency Problem of Overvalued Equity

• Not an obvious, incentive based answer– Can’t 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

• 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 = $400– Debt: $50

– Management: $30

– Employees: $20

– Shareholders: $300• 400-50-30-20 = 300

• Realized Profit = $300– Debt: $50

– Management: $30

– Employees: $20

– Shareholders: $200• 300-50-30-20 = 200

Expected Profit=$200 with two possible outcomes

Possible Outcomes: $100 or $300 Possible Outcomes: $0 or $400

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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 (<8

outperformed >14 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– Firm’s 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/concentrated ownership?

• Ownership level doesn’t 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

• Ownership<5%: Value increases with increase in ownership• 5%>Ownership<25%: Value decreases with increase in ownership• Ownership>25%: 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=470927#PaperDownload

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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 don’t 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