FINA 4463
The Goal of the Firm
and Agency Issues
What is Finance?
• Finance is the science of decision making
• There are many ways to make decisions, some good
and some not-so-good
• The discipline of finance is a set of techniques for
making logical, rational financial decisions in order
to meet a goal
What is Finance?
• If you use the correct techniques to make decisions, will
things always work out?
• NO!
• Sometimes, even if you made the “correct”
decision given the information you had at the time,
things simply do not go as expected
• This is the essence of risk
• Financial decision making should account for risk
when decisions are made (i.e. include the fact that
you do not know exactly how things will turn out).
What types of decisions will we
look at in this course?
Goal of the Firm:
What the firm is trying to achieve
What to invest in?
Long term
Investments
Capital Budgeting
Decision
How to raise money?
Capital Structure
Decision
Short term
Investments
What to do with profits?
Dividend Policy
Decision
The Goal of the Firm
•
In order to make good decisions, need to know what
your goal is
•
The goal may depend on the type of organization you
are looking at:
1)
Privately Owned Firm (sole proprietorship or
partnership)
• May have multiple goals
i) Income for owner
ii) Perquisites of ownership: flexible hours,
power/prestige, big office etc.
• Different owners will have different emphasis
The Goal of the Firm
2)
Gov’t Owned Firm (Crown Corp.)
• Different goals:
i) Provide service to public
ii) Provide employment
iii) Revenue for gov’t
iv) Diversify economy
etc.
–
Goal(s) may vary from firm to firm and when
gov’t changes
The Goal of the Firm
3)
Non-profit organization:
• Provide some type of service
• Sometimes difficult to quantify and differs from one
to another
4)
Publicly Traded Corporation:
• Owned by shareholders:
Board of Directors
elect
shareholders
appoint
management
• Firm should be run (by management) to serve
interests of shareholders (the owners)
Goal of the Firm
• This course concentrates on publicly traded corporations
• Serving shareholders’ interests can be boiled down to
one point:
Goal of a Publicly Traded Corp.
= maximize shareholder wealth
• A single goal makes decisions easier to analyze
quantitatively
Publicly Traded Corp.s
•
Management should make decisions that increase
share price
• “Good” decisions should result in an increase in
share price if the market is efficient
•
Maximizing share price incorporates two goals of
shareholders:
1. Profitability of their investment
2. Stability of their investment (e.g. risk)
Both things will be reflected in the share price
(assuming market is efficient)
•
• Note: share price reaction can be thought of as the
market’s “report card” on firm decisions
Example: Firms buys a division from a competitor
– When purchase announced, stock price of
acquiring firm falls
– The market thinks (i.e. the consensus opinion)
that the decision was a bad one
• Managers often have more info than the market,
however, the market tends to (but not always) be right
(even if managers disagree)
• See, for example, Kaplan and Weisbach (Journal
of Finance, 1992)
Goal of the Firm
• Using stock price maximization as a goal of the firm
serves shareholders’ interests
• However, it ignores others who may have an interest in
what the company does:
• Employees
• Community
• Suppliers/customers
• Society in general
• etc.
• Debate about stockholders vs. stakeholders
• In this course we will assume share price maximization
is the goal that should drive management decisions
Agency Problems
• Agency problems can interfere with management
working to maximize shareholder wealth
• Agency problem = managers act in their own interests,
which are sometimes different from interests of owners
(shareholders)
• Agency problems arise because of separation of
ownership and control in a corporation
• Allows management to act as if they were the
private owners of the company, even though the
shareholders own it
Examples of Agency Problems
– Consuming excess perquisites
– Wasting company money on big offices, corporate parties
etc.
– Empire Building
– Increasing firm size unnecessarily
– Top management pay tends to be relate to firm size
– Managers get power/prestige from larger firm
– Management may invest in NPV<0 projects simply to
increase size
– Management may have “pet projects”
– Overly diversifying the firm
– Managers more exposed to firm specific (non-systematic)
risk than shareholders, so may try to diversify firm
– Others…
Possible Solutions to Agency
Problems
•
Agency problems can be mitigated either internally
through how the firm is set up (its corporate
governance), or externally through the market
1.
Board of Directors
•
•
Main role of B of D: select and hire management,
monitor them, replace them if necessary
If B of D doing job effectively, this should reduce
possible agency problems
(Board of Directors, continued)
• Problem: management often has a lot of influence over
who is on the Board
• Top managers often on the B of D themselves
• Shareholders elect B of D, but they are often
nominated by CEO/President
• Board members may be friends, business
associates of CEO
• Sometimes B of D is more aligned with
management than with shareholders
• Structuring the B of D to avoid this is an important topic
(Board of Directors, continued)
• Investors, especially large institutional investors, have
put a lot of pressure on companies to adopt good
corporate governance practices
• Securities Regulators now have guidelines on what
constitutes an effective B of D
• Many of guidelines centre on having a majority of
independent directors
• No relationship to firm, so can be unbiased
• See National Policy 58-201
• Guidelines are only on a “comply or explain” basis
• Overall, a lot of pressure on firms recently to create
effective Boards, to avoid agency problems
Possible Solutions to Agency
Problems
2.
Compensation
– Another internal method to reduce agency problems
– Compensate managers (i.e. pay them) in such a
way as to give them an incentive to do the right
thing
(a) Bonuses: give bonus for meeting certain goals (e.g.
X% in ROE, $X in sale etc.)
• Gives incentive to work hard, make good
decisions
• Problem: empirically it has been found that
bonuses for top managers tend not to vary
much even if firm performs poorly….bonuses
often become just like base pay
(Compensation, continued)
(b) Stock or Stock Options
• Give managers stock in company (or make them buy it)
• Usually restricted stock = not allowed to sell it for a certain
number of years
• Gives manager incentive to try to increase stock price
• i.e. make the manager an owner, by serving their own interests
they will now serve other shareholders as well
• Also accomplished by giving managers call options on the firm’s
stock, with exercise date a few years in the future
• Note: have been some controversial cases of B of D
“adjusting” the strike price on options so that they pay off
even if firm’s share price has gone down, or “backdating”
options so that they are already in-the-money when given out
• Sometimes members of Board are paid in restricted stock, or
required to hold stock in the firm
Possible Solutions to Agency
Problems
3.
Threat of Takeover
• An “external” solution to agency problems
• Takeover = one firm (the bidder) buys control (51%
or more) of another firm (the target)
• If stock price of target is low because of bad
management:
• Bidder buys target, replaces management
• Bidder profits by value of target increasing
with better management
• The potential of losing their jobs through takeover
gives managers incentive to run firm properly
Possible Solutions to Agency
Problems
4. Block Shareholders
•
Some firms have “atomistic” shareholders
• Lots of shareholders, and each one owns only a
small number of shares
• If shareholders do not like management it is hard
to coordinate things to force a change, and it is
not worth the effort for a small shareholder to go
to the effort
(block shareholders, continued)
• A block shareholder owns a significant percentage of
the shares in the firm
• Usually an institutional shareholder
• Because they have a lot of money at stake, it is
worth it for them (and they have the resources) to
become activist shareholders
• Closely monitor the firm and try to force through
changes they think necessary
Other Types of Conflict in the Firm
• We have looked at agency problems which are a conflict
between shareholders and management
• Another important type of conflict in the firm is between
shareholders and debtholders
• Debt holders could be owners of bonds, or bank,
or any one else to whom money is owed
• The source of the problem is the basic difference
between the two types of securities
Shareholders vs Debt Holders
Debt:
• Get their money first from profits
• Entitled to a fixed payment
Stock:
• Gets residual claim
• Shareholders get what is left after paying debt
holders
• Shareholders control firm: shareholders may take
actions that result in a “wealth transfer” from debtholders
to them
• i.e. no new value is created, but shareholders gain
at expense of debt holders
• Can even be situations where shareholders take actions
that lower the overall value of the firm (e.g. debt + equity)
but raise the value of equity
• Actions may be socially inefficient in that they
destroy value
• NPV<0 projects
• Shareholders are able to gain because they “rip
off” debt holders
Shareholder-Debtholder Conflicts
1.
Dividend Policy
• Shareholders may want most of firm’s cash paid
out to them as dividends
•
Then debtholders cannot get it if the firm defaults
•
Increases the probability of default, and reduces
what the debtholders can get from firm in
bankruptcy
» Risk of bonds 
» Value of bonds 
Shareholder-Debtholder Conflicts
2.
Other direct actions of the firm that increase risk to
debt holders:
–
Firm might take on substantially more debt
–
Firm might attempt to somehow remove assets from
the firm that previously acted as collateral for the
debt
–
Both actions would increase the risk to debtholders
Shareholder-Debtholder Conflicts
3.
Underinvestment
•
Firms may not invest as much as they should
(forego NPV>0 projects) if they have debt in their
capital structure and a reasonably high
probability of bankruptcy
Simple Example of Underinvestment:
• Firm has $800 cash and $1200 debt coming due
• Will go bankrupt if it does nothing
• Potential investment: invest $800 and get $900
back immediately
• Will shareholders make investment?
– NO.
– Firm will still go bankrupt, so why bother?
– No benefit to shareholders
• Investment is obviously NPV>0, but shareholders
do not take it because bond holders would get all
the benefit
• Debt holders lose because shareholders “underinvest”
• Project would benefit firm as a whole, but bond
holders would get benefit, not shareholders, and
shareholders get to make the decisions
• See handout for another example
• Shareholders end up paying the cost of underinvestment
– When debt holders initially lend money, they know this
possibility could arise
– Will charge higher interest rates today to compensate
for possible conflict with shareholders in the future
– Firm ends up paying higher interest rates
• Firms (and shareholders) could actually benefit by
getting lower rates if they could commit themselves to
not doing this in future (i.e. “charge us a lower rate and
we promise not to rip you off”)
– Unfortunately, virtually impossible to make this a
credible commitment
– First, hard to define exactly what a “good” project is,
so hard to write a contract on it
– Second, even if firm promises not to underinvest,
there is an incentive to break the promise
• Like a “Prisoner's Dilemma”
Shareholder-Debtholder Conflicts
4. The Default Option and Risky Projects
Simple example:
– Say a firm is currently close to bankruptcy
– Can choose to invest in a risky project or a safe
project
– If chooses safe project, it will pay off but firm will still
go bankrupt
– Debt holders will get the benefit of the safe
project
– If chooses risky project then there is big chance it will
lose money
– Firm will go bankrupt…but it would have gone
bankrupt anyway, so no difference to
shareholders
– If risky project does pay off, then firm may be saved
and shareholders get the benefit
(default option, comtinued)
• Main Point: when close to bankruptcy, firms will tend to
invest in riskier projects
• May even take NPV<0 projects that have a small
chance of a big payoff
– i.e. desperate attempt to save firm
• Debt holders would rather the firm did not invest in these
highly risky projects, but shareholders have control
• See Handout for another example
• Again, shareholders end up paying for this possible
behaviour as creditors will charge higher interest rates
when they initially make the loan (to compensate for the
fact that this behaviour may happen if the firm gets in to
trouble)
Partial Solutions to ShareholderDebt Holder Conflicts
•
It is in everybody's interest to solve conflicts between
shareholder-debtholders
• If lenders know that shareholders will not act selfishly, then
they will charge lower interest rates initially
•
Some possible solutions:
1.
Covenants in the debt contract
–
Debt contracts contain covenants placing restrictions on the
firm
–
E.g. can only pay certain level of dividends, must keep
debt/assets below certain level, minimum level of working
capital, etc.
–
If a firm violates one of the covenants it is in default on the
loan
–
However, not possible to write a contract that covers all
contingencies
Partial Solutions to ShareholderDebt Holder Conflicts
2.
Protective Put
• Bonds may include put option in which bond can be
sold back to firm for a set price if certain events
occur (e.g. takeover of firm, actions of the firm such
as paying a large dividend, etc.)
3.
Mezzanine Financing
• Mezzanine financing = financing that is a hybrid of
debt and equity
• Different forms of mezzanine financing
• Could be:
i) Convertible bonds
• Bonds can be converted into shares
• If shareholders try to gain at expense of
bondholders, bonds can be converted into equity
so that bondholders get some of the gain too
ii) Creditors hold both bonds and stock
• if there is a wealth transfer from debt holders to
shareholders they get some of the benefit too
Alternative Financial Goals for the
Firm
• Rather than stating firm goals as max.ing share price or
max.ing shareholder wealth, firms often state other goals
that they believe are correlated with long term
shareholder wealth
• E.g.
– increasing market share
– Increasing profit growth
– Increasing sales
– etc.
• BUT…these goals do not always translate into increased
shareholder wealth
• Alternative goals such as these are only valid
insofar as that they will actually lead to increases
in share price
Example:
– Remember that the price of share can be
expressed as:

Dt
P0  
t
t 1 (1  r )
– Where Dt is the dividend expected at year t,
and r is the required return on the stock
(example continued)
• If dividends are expected to grow at a
constant rate, g:
D1
P0 
rg
• What determines the growth rate, g?
• Common way to estimate future growth rates:
g=b(ROE)
• Where b = retention ratio
= percentage of Earnings per share (EPS)
retained each period
= 1 - Dt/EPSt
=1 – payout ratio
• And ROE is the return (to shareholders) expected to be
earned on reinvested earnings
• Now, consider the example in the handout.
• Conclusion:
• growth in and of itself is not necessarily good
• Alternative goals for the firm (growth, increasing
sales, or whatever) are only good if they lead to
increased share price