EXP 482
Corporate Financial Policy
Clifford W. Smith, Jr.
Winter 2007
Presentation 3
* Covers readings on course outline through Brickley/Smith/Zimmerman, Chap 14 and 15
EXP 482 – Overhead 3
Capital Structure Management
 Trade Off Hypothesis
 Pecking Order Hypothesis
 Market Timing Hypothesis
EXP 482 – Overhead 3
Pecking Order Hypothesis
 There is an important information asymmetry between
stockholders and managers
 “What you don’t know CAN hurt you”.
 If firm issues securities, those value depends on firm
value investors price-protect themselves.
 This cost is largest for equity, then risky debt; internally
generated capital is least expensive.
EXP 482 – Overhead 3
Pecking Order
 If there is an “optimal” capital structure, the
firm spends a lot of time away from it.
 Extreme Version: There is no optimal capital
structure – observed capital structure is just
the result of a sequence of myopic financing
choices.
EXP 482 – Overhead 3
Pecking Order
 Regression results are strong and robust.
 Look at tails of distribution.
EXP 482 – Overhead 3
Market Timing
 Firm only issues equity when it’s
overvalued
 There is no optimal capital structure
EXP 482 – Overhead 3
Strategic Capital
Structure Management
 Determine the optimal capital structure for
the economic balance sheet.
 Look at the trajectory of capital structure.
 Whenever the costs of deviating from target
exceed the cost of adjustment - adjust.
EXP 482 – Overhead 3
Adjustment Costs
Leverage
Target
Leverage
Time
EXP 482 – Overhead 3
Adjustment Costs
Firm Value
Target
Leverage
EXP 482 – Overhead 3
Leverage
Adjustment Costs
 Differ by transaction
─ Costs of share issues are higher than that for debt
─ Costs of share issues are higher than that of share
repurchases
 Exhibit fixed costs and scale economics
─ Equity offers are rare while bank loans are common
─ Optimal adjustment frequently involves overshooting
─ Most companies spend considerable time away from their
target
EXP 482 – Overhead 3
Strategic Capital
Structure Management
 But investment opportunities are not smooth
– they are lumpy and episodic.
 Suppose you have a large growth option – it
will increase firm value by 50% and take
three years to exercise.
 How do you finance this project?
EXP 482 – Overhead 3
EXP 482 – Overhead 3
EXP 482 – Overhead 3
Strategic Capital
Structure Management
 Pecking Order Hypothesis
 Market Timing Hypothesis
 Tradeoff Hypothesis
EXP 482 – Overhead 3
EXP 482 – Overhead 3
Executive Compensation
 Benchmark Compensation Plan
Suppose I offer a corporate manager a series of
prespecified salary payments -- from the time he is hired
until the time he retires -- with the only contingency that if
the firm goes bankrupt, he will be fired, and his salary
payments will be terminated.
 What are the conflicts of interest that will likely
arise between owners and managers under this
benchmark compensation plan?
EXP 482 – Overhead 3
Conflicts of Interest between
Owners and Managers

Effort Problem

Horizon Problem

Differential Risk Exposure Problem

Over Retention Problem (Payout Policy)

Under Leverage Problem
EXP 482 – Overhead 3
Potential "Solutions" to the
Owner/Manager Conflicts

EXP 482 – Overhead 3
Choice of Organizational Structure
Potential "Solutions" to the
Owner/Manager Conflicts

Choice of Organizational Structure
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers

EXP 482 – Overhead 3
Internal and External Labor Markets
Potential "Solutions" to the
Owner/Manager Conflicts
 The Market for Corporate Control
 Incentive based compensation contracts
–
explicit contracts
–
implicit contracts
EXP 482 – Overhead 3
“Suffice it to say that one is the result of an
extremely hostile takeover.”
EXP 482 – Overhead 3
"Fixed" Compensation
 Salary
 Pension
 Insurance
 Perks
EXP 482 – Overhead 3
Salary
 Typically largest component (but not always)
 Within contracting period salary is fixed
(close to our benchmark case)
 Implicit contract to renegotiate salary in good
faith based on performance
 No one in the firm determines his/her own
salary (compensation committee of board
comprised of outside boardmembers)
EXP 482 – Overhead 3
Pension Plans

Defined Benefits vs defined
contribution plans

Vested vs nonvested plans (ERISA)
EXP 482 – Overhead 3
Tax Deferral Effect of Pensions
Salary
Pension
Raise
+100.00
Taxes
-50.00
Interest
+5.00
Taxes
-2.50
Total
52.50
EXP 482 – Overhead 3
Contribution
+100.00
Interest
+10.00
Taxes
-55.00
Total
55.00
Stock Option Plans

Stock options granted to managers
–
Typically have approx. 5 years to expiration
–
European options (cannot be exercised early)
–
Restricted (cannot be sold before expiration)
–
The option is actually a warrant (when
exercised, the number of shares outstanding
increases), but dilution effect is small.
EXP 482 – Overhead 3
Stock Option Plans
Impact of option plan on:
–
effort problem
–
horizon problem
–
risk exposure
problem
–
payout problem
Stock
Option
S*
X
EXP 482 – Overhead 3
Other Stock-Based
Compensation Plans
 Stock Appreciation Rights (SARs)
 Restricted Stock
 Phantom Stock
 Dividend Units
 Base manager's pay on "abnormal" stock
return
EXP 482 – Overhead 3
Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have
some form of bonus plan)
Pool of Available Funds
Contributions
to Pool
Earnings
EXP 482 – Overhead 3
Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have
some form of bonus plan)
Pool of Available Funds
Contributions
to Pool
Earnings
EXP 482 – Overhead 3
Accounting-Based
Performance Plans
Bonus
(over 90% of medium to large size firms in US have
some form of bonus plan)
Pool of Available Funds
Contributions
to Pool
Earnings
EXP 482 – Overhead 3
Bonus Plans

Impact of bonus plan on
– effort problem
– risk exposure problem
– payout problem
– horizon problem

Long-term performance plans -- similar to
bonus plans, but based on 3 to 7 year earnings
performance

Performance units
EXP 482 – Overhead 3
Bonus Plans

The use of accounting numbers vs stock prices
for incentive compensation plans
–
–
–

Accounting numbers allow disaggregation of
performance measures
Accounting numbers can provide perverse
incentives
Accounting numbers subject to manipulation
Top managers (who set accounting policy)
typically compensated with stock-based plans.
Lower level managers more likely to receive
bonus.
EXP 482 – Overhead 3
Potential "Solutions" to the
Owner/Manager Conflicts

Choice of Organizational Structure
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers

EXP 482 – Overhead 3
Internal and External Labor Markets
Bonus Plans
What determines where a divisional manager's
bonus payment falls along this spectrum?
Divisional
Performance
EXP 482 – Overhead 3
Firm
Performance
Investment Opportunity Set
Assets in
Place
Growth
Opportunities
Leverage
High
Low
Compensation
Level of Pay
Low
High
Conditional on
Performance
Low
High
EXP 482 – Overhead 3
Level of
Compensation
Use of
Stock
Options
Use of
Bonus Plans
Growth Options (Merck)
Higher
Higher
Lower
Credence Goods (Eastern)
Higher
Higher
Higher
Product Warranties (Yugo)
Higher
Higher
Higher
Future Product Support
(Yugo/Wang)
Higher
Higher
Higher
---
---
---
Closely Held Firm
Higher
Higher
Higher
Size
Higher
Higher
Higher
Regulation
Lower
Lower
Lower
Tax Credits
---
---
---
Marginal Corporate Tax Rate
---
Lower
Lower
Marginal Personal Tax Rate
---
Higher
Higher
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Firm Characteristics
Supplier Financing (Campeau)
EXP 482 – Overhead 3
Investment Opportunity Set
Cost of Debt
Assets in
Place
Growth
Opportunities
Low
High
High
Low
High
Low
(Underinvestment)
Benefits of Debt
(Free Cash Flow)
Predicted Leverage
EXP 482 – Overhead 3