FINA 4463

1. FINA 4463 The Goal of the Firm and Agency Issues

2. 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

3. 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).

4. 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? How to raise money? Capital Structure Decision What to do with profits? Dividend Policy Decision Long term Investments Capital Budgeting Decision Short term Investments

5. 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: • Privately Owned Firm (sole proprietorship or partnership) • May have multiple goals • Income for owner • Perquisites of ownership: flexible hours, power/prestige, big office etc. • Different owners will have different emphasis

6. The Goal of the Firm 2) Gov’t Owned Firm (Crown Corp.) • Different goals: • Provide service to public • Provide employment • Revenue for gov’t • Diversify economy etc. • Goal(s) may vary from firm to firm and when gov’t changes

7. 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: • Firm should be run (by management) to serve interests of shareholders (the owners) Board of Directors appoint elect shareholders management

8. 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

9. 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: • Profitability of their investment • Stability of their investment (e.g. risk) • Both things will be reflected in the share price (assuming market is efficient)

10. 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)

11. 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

12. 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

13. 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…

14. 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 • 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

15. (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

16. (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

17. 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 • 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

18. (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

19. Possible Solutions to Agency Problems • 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

20. Possible Solutions to Agency Problems • 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

21. (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

22. 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

23. 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

24. 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

25. Shareholder-Debtholder Conflicts • 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 

26. Shareholder-Debtholder Conflicts • 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

27. Shareholder-Debtholder Conflicts • 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

28. 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

29. 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

30. 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”

31. 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

32. (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)

33. Partial Solutions to Shareholder-Debt 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: • 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

34. Partial Solutions to Shareholder-Debt Holder Conflicts • 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.) • Mezzanine Financing • Mezzanine financing = financing that is a hybrid of debt and equity

35. Different forms of mezzanine financing • Could be: • 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

36. 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

37. Example: • Remember that the price of share can be expressed as: • Where Dt is the dividend expected at year t, and r is the required return on the stock

38. (example continued) • If dividends are expected to grow at a constant rate, g: • What determines the growth rate, g?

39. 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