Overview of Corporate Finance 1 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 2 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 3 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 4 Main Activities of Financial Managers: Balance Sheet Cash Receivables Inventories Physical assets Intangible assets Payables Bank loans Short-term debt Long-term debt Retained earnings Shares outstanding Working capital management; capital budgeting; capital financing. 5 The Goal of a Corporation • Possible Goals – Maximize sales? – Maximize earnings/profits? – Minimize risk/maximize risk? • Maximize the market value of shareholders equity 6 Wave I: Incoming MBA Wave II: After 1st year Survey by the Aspen Institute 7 Wave III: Graduating MBA How do we maximize shareholder wealth??? Basic Principles 8 What is the value of any asset? Today’s value of expected future cash flows AssetValue(aka NPV ) = T CFt PV (GO) t t = 0 (1+ r) 9 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. 10 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. 11 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”? 12 Is maximizing shareholder wealth optimal? • 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 CFt Wealth = t (1 + r) t =0 13 Value of the Corporation: Perfect World P VFirm NPVp p 1 • where NPV is the stand alone, equity financed value of each project (p) and there are P total project(s) 14 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 15 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 • ??? 16 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 17 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 18 Organization of Economic Functions The firm is a way of organizing the economic activity of many individuals 19 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 20 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 21 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 22 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 23 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)) 24 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 25 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? 26 Monitoring function: Debt, Institutional Investors, Blockholders 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) 27 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) 28 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)) 40 20 20 00 19 98 19 96 19 94 19 92 19 90 19 88 19 86 19 84 -40 19 82 0 -20 19 80 Billion dollars Aggregate dollar return to acquiring-firm shareholders -60 -80 -100 -120 -140 -160 29 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 ???? 30 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! 31 Debt can encourage excess risky investments Expected Profit=$200 with two possible outcomes Possible Outcomes: $100 or $300 Possible Outcomes: $0 or $400 • Realized Profit = $100 – – – – Debt: $50 Management: $30 Employees: $20 Shareholders: $0 • Realized Profit = $0 – – – – • 100-50-30-20 =0 Debt: $0 Management: $0 Employees: $0 Shareholders: $0 • 0-50-30-20=-100 – BANKRUPT! • Realized Profit = $300 – – – – Debt: $50 Management: $30 Employees: $20 Shareholders: $200 • 300-50-30-20 = 200 • Realized Profit = $400 – – – – Debt: $50 Management: $30 Employees: $20 Shareholders: $300 • 400-50-30-20 = 300 32 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) 33 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 34 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 35 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%) 36 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 37 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 suboptimally – Incentive Effect: Goals are aligned with other shareholders38 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 39 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 40