SF_1 UNIT1 Agency&Corp Val

The Agency Problem

SFDM – UNIT1

FIRDAUS KHAN, Associate Professor - ICBM-SBE

• An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an "agency problem," arises when there is a conflict of interest between the needs of the principal and the needs of the agent.


• In finance, there are two primary agency relationships:

• Managers and stockholders

• Stockholders and creditors


1. Stockholders versus Managers

• If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists.

• Managers may make decisions that conflict with the best interests of the shareholders.

• Eg. managers may grow their firms to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.


2. Stockholders versus Creditors• Creditors decide to loan money to a corporation based on the

riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is a creditors' main concern.

• Stockholders, however, have control of such decisions through the managers. Since stockholders will make decisions based on their best interests, a potential agency problem exists between the stockholders and creditors.

• Eg. managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Shareholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows.


Motivating Managers to Act in Shareholders' Best Interests

• There are four primary mechanisms for motivating managers to act in stockholders' best interests:

• Managerial compensation• Direct intervention by stockholders• Threat of firing• Threat of takeovers


1. Managerial Compensation• Managerial compensation should be constructed not only to

retain competent managers, but to align managers' interests with those of stockholders as much as possible.

This is typically done with an annual salary plus performance bonuses and company shares.

• In India, company shares are typically distributed to managers either as:

a. Restricted Stock Units (RSU)

b. Employee Stock Options (ESOP)

c. Employee Stock Purchase Plan (ESPP)


RESTRICTED STOCK UNIT • When an employer offers RSU to its recruits, it is in effect

offering Stocks to them without any strings attached except for the fact that the Stocks have a vesting period. Vesting period is basically the term period for which the employee has to wait before he becomes eligible to own the stock.

• A 500 RSU with 3 year vesting period means that the employee can claim the 500 shares after he has successfully continued in his job for a minimum of 3 years. Once the employee owns the stock he or she is at liberty to hold it or sell it off.

• Eg Wipro has given RSUs to 1200 senior managers in 2012, worth 4.5 million shares


EMPLOYEE STOCK OPTION• ESOP is about ‘options’. This basically means that the employee has the

option to purchase stock of the company at a future date at a pre-determined price. If the market price of the stock is above the procurement price, the employee stands to gain by selling it off immediately. If however the price is below the agreed price level, the employee has the option to set aside his option and not exercise it.

• Eg: if a particular employee is offered 1000 ESOPs by his employer with a vesting period of 3 years from 1st September 2013. The price agreed upon is Rs. 100 per stock. On 1st September 2016 the employee is entitled to exercise his option and purchase 1000 of the company’s stock at the pre-determined price of Rs. 100.

• If MP > Exercise Price, say MP = Rs150, employee exercises option and buys stock.

• IF MP < Exercise Price, say MP = Rs. 80, employee does not exercise the option

• Recently, in Aug-Sept 2014, HDFC Bank, YES Bank, Axis Bank and ICICI have issued ESOPs to their managers.


EMPLOYEE STOCK PURCHASE PLAN• Under ESPP, the employee has the right to purchase company stocks at a

discounted price. Conceptually ESPP is like a Systematic Investment Plan

• Here the employee contributes a part of his salary (between 1 % & 15%) for a fixed period of time. Once this period is over and a corpus has been formed, the amount so accumulated can be utilized for purchase of the company’s stock at a discounted price.

• Eg: Co. XYZ offers ESPP to an employee for the period i5 Nov 2014 to 5 May 2015. Employee opts for 5% salary deduction every month starting November 2014. So on 5th May 2015, XYZ would have accumulated some money and it will purchase the shares of XYZ in employee’s name. The discount given typically is 15% of lower stock price value of 5 Nov 2014 or 5 May 2015. Assume, on 5 Nov 2014 stock price = 60Rs and on 5 May 2015 stock price = 87Rs, employee will get the stocks at 15% less of 60Rs = 51Rs.

• Once the shares are deposited in employee’s account, there are no restrictions and he/she can either hold them or sell them immediately.

• Eg Cisco – 2yr plan, 10% salary deduction and 15% discount on price (lower of opening and ending price) – purchase of stock from NASDAQFIRDAUS KHAN, Associate Professor - ICBM-

SBE

CEO Compensation – Elon Musk• Tesla Motors CEO Elon Musk was paid just under $70,000 in 2013

(base salary of $33,280 and an additional $36,709 in company bonuses)

• Tesla says Musk, the billionaire founder of PayPal and rocket-building company SpaceEx, only accepts $1 and returns the rest to the company.

• Musk could someday rake in much more from the company he helped found in 2003. Under a compensation package approved in 2012, Musk was awarded options to buy nearly 5.3 million shares of Tesla stock at $31.17 each. Tesla stock is currently trading at $207.86, making Elon’s shares worth about $900 million.

• The plan is supposed to compensate Musk over a 10-year period, but only if the company meets performance goals. Musk can't exercise all the shares, for example, unless Tesla's shares reach a total value of $43.2 billion. The company's shares are currently worth $25.6 billion.

• Musk would also have to meet milestones for production of Tesla's planned Model X electric SUV and its Generation Three vehicle.


2. Direct Intervention by Stockholders• Today, the majority of a co.'s stock is owned by large

institutional investors, such as mutual funds, hedge funds and pension funds.

• These institutional stockholders exert influence on managers and consequently, on the firm's operations.

• In June-July 2014, institutional investors of Tata Motors rejected Board’s proposal seeking excess remuneration (aggregating Rs. 20.28 crore) to its executive directors. Nearly 64% of Inst Investors and 41% of ordinary shareholders voted against the resolution

• In 2013 at the AGM, GE’s shareholders voted for a proposed requirement for senior executives to hold until retirement at least 25% of the shares they are given in their pay packages.


Shareholder Activism in India• DECEMBER 2008

Institutional investors successfully blocked Satyam-Maytas deal• FEBRUARY 2012

Vedanta prevented from restructuring Sesa Goa & Sterlite Industries• AUGUST 2012

TCI (London based investor – The Children’s Investment Trust) challenges sale of coal by Coal India on Govt. orders below market price, in fact at 70% discount to international mkt. price

• JULY 2013Minority shareholders oppose Ambuja Cements increasing royalty to parent co. Holcim

• JANUARY-FEBRUARY 2014Minority shareholders oppose plan for Maruti Suzuki to buy cars from new plant set up by Suzuki when it has the cash to build its own plant

• FEBRUARY 2014Institutions oppose Alstom India’s sale of its transport division to its parent French company at less than the divisions’ 12-month sales figure FIRDAUS KHAN, Associate Professor - ICBM-

SBE

3. Threat of Firing

• If stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may re-elect a new board of directors that will accomplish the task.

• Steve Jobs famous example.

• Netflix, Reed Hastings (ouster and split of CEO –Chairman post advocated by institutional investors, rejected by ordinary shareholders)


4. Threat of Takeovers

• If a stock price deteriorates because of management's inability to run the company effectively, competitors or stockholders may take a controlling interest in the company and bring in their own managers.


CORPORATE VALUATION


Reasons for doing Valuation

• For purchase or sale of companies –

Buyer – indicates highest price expected

Seller – indicates lowest price demanded

• To compare share’s market price with intrinsic value, spotting undervalued stocks

• At the time of IPO, it helps fix offer price


Reasons for doing Valuation

• For quantifying value creation attributable to CEO.

• To identify value drivers

• To take restructuring decisions (M&A, split-up, spin off, etc)


Valuation Concepts

• Book Value

• Market Value

• Intrinsic/Economic Value

• Liquidation Value

• Replacement Value

• Salvage Value

• Fair Value


Valuation• Valuation is the task of estimating the economic

worth/value of an asset or security or business under certain assumptions and limiting conditions, subject to the data available on the valuation date.

• Under business valuation, the valuation is done of –

Tangible assets (plant & machinery, land & bldg)

Intangible assets (goodwill, brands, trademark)

Human resources (managerial, technical or R&D) FIRDAUS KHAN, Associate Professor - ICBM-

SBE

BOOK VALUE

• BV(assets): Value at which assets are shown in the balance sheet

• BV (asset) = Initial acquisition cost of asset

(-) Accumulated depreciation

• BV (co.) = Total BV of all assets (excluding fictitious assets & deferred revenue exp.) (-) all external liabilities (including preferred share capital)


MARKET VALUE

• MV(asset) = Price at which asset can be sold in the market……exists only for tangible assets

• MV (co.) = aggregate MV (as per stock market quotation) of all equity shares outstanding

• Thus MV is relevant only to listed companies


INTRINSIC / ECONOMIC VALUE

• IV (asset) = present value of incremental future cash inflows likely to accrue on acquiring the asset, discounted at the appropriate required rate of return. It is used in Capital Budgeting decisions

• IV (co.) = PV of incremental future cash inflows after taxes, likely to accrue to the acquiring firm, discounted at the relevant risk adjusted discount rate as applicable to the business


LIQUIDATION VALUE

• LV (asset) = price at which asset can be sold if business operations are discontinued in the wake of liquidation of the firm.

• LV (co.) = Realizable value of assets (+) cash & bank balances (-) payments required to be made to discharge all external liabilities.

• Generally, liquidation value will be the lowest valuation for any co.


REPLACEMENT VALUE

• RV (asset) = cost of acquiring a new asset of equal utility & usefulness.

SALVAGE VALUE

• SV (asset) = realizable/scrap value on the disposal of assets after the expiry of its economic life (usually done for plant & mach.)

• SV is considered as net of removal costs


FAIR VALUE

• It is hybrid in nature and often is calculated as the average of BV, MV & IV. In India fair value concept has evolved from case laws & therefore is more statutory in nature

• It is usually applicable to specific transactions such as payment to minority shareholders


A closer look…• One approach is a ‘flow’ concept while all

others are ‘stock’ concept….which one?

• Which approach is best for accounting and taxation purposes?

• Which approach is appropriate for arriving at share exchange ratio?

• Which approach provides an insight into maximum loss, in the event of winding up of operations?


METHODS OF CORP. VALUATION• BALANCE SHEET APPROACH OR ASSET BASED

METHODS: BV, Adjusted BV, LV

• DISCOUNTED CASHFLOW METHOD: Equity cash flow, Dividend capitalization, FCF method

• COMPARABLE CO. APPROACH: Multiples per Sales, per BV of assets, per EBDIT

• EARNINGS BASED APPROACH: P/E multiples

• VALUE CREATION: EVA, CFROI, Economic profit


• Depreciation

• Investments (LT/ FA or Curr. Op. Costs/WC)


GUIDELINES FOR DOING CORP. VAL.

1. Understand how the different approaches compare

2. Use at least 2 different approaches

3. Work with a value range (precision is rare, hence define alt scenarios and assess value)

4. Go behind the numbers to look at value drivers – K invested, ROIC, k0 , co. growth rate

5. Factor in flexibility in management policy decs.


DCF TECHNIQUE• Estimate free cash flow that firm is expected to

earn in explicit period (t)

• Calculate discount factor (WACC)

• Discount cash flows to present value for explicit period

• Use stable growth rate to calculate cash flow in (t+1) period

• Discount [cft+1 / k-g ]* PVIF

• Value of firm = PV (explicit period) + …………………………PV (continuing period)


ESTIMATING FREE CASH FLOW

FCFF

OP. FCF

NOPLAT

Net Income

DEPNON-OP.

CF

LESS

ADD


Net Operating Profit less adjusted Taxes

• NOPLAT refers to total operating profits for a firm with adjustments made for taxes. It is used as an input, in place of Net Income, while creating DCF valuation models.

• It represents the profits generated from a company's core operations after subtracting the income taxes related to the core operations.

• It depicts de-levered profits by removing the effects of a debt tax-shield i.e. PAT + Interest paid (1-t)


SF_1 UNIT1 Agency&Corp Val

Economy & Finance

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