ECONOMICS 3200M Lecture 3 January 19, 2011

1. ECONOMICS 3200MLecture 3January 19, 2011

2. Existence of Firms Transactions costs: • Costs in using markets • Search costs – suppliers, prices • Negotiating, writing, monitoring and enforcing contracts • Classical firm as nexus of contracts – hub/spoke • Duration of contracts and increasing complexity • Uncertainty re. future states • Increasing number of contingencies – increasing complexity • Incomplete contracts – trade-offs between more complex contracts/higher costs and simpler, incomplete contracts • Opportunistic behaviour – incentives to breach contracts • Proprietary rights to information – investment ideas, market demands, product design, service innovations, etc. • Value depends on package of rights and other factors – cannot contract for all factors

3. Existence of Firms • Advantages of engaging in market transactions – outsourcing a new term for an old idea, namely, using the market to acquire inputs or sell outputs • Specialization/focus for firm • Market prices serve as reference points for internal transfer pricing • Economies of scale – ability to serve 3rd party customers • Link between performance/rewards

4. Existence of Firms Value Chain and Internalization Primary Activities: • Inbound Logistics  Operations (Manufacturing  Outbound Logistics  Marketing  After-Sale Service • Operations can be sub-divided into • Fabrication of Materials  Production of Parts  Sub-assembly  Final Assembly • For service activities, the value chain would look different

5. Existence of Firms Value Chain and Internalization Support Services, which overlay the Primary Activities: • Firm Infrastructure – finance, planning, legal • Human Resource Management • Technology Development • Procurement

6. Existence of Firms Options • Markets and firms alternative means for completing related sets of transactions • Short-term contracts – costs, uncertainty re. supply • Long-term contracts – opportunistic behaviour • Ownership/control – internalization

7. Existence of Firms • Internalization (insourcing)– avoid using marketplace by ownership of inputs, expansion of value-added activities conducted within firm • Bargaining power vis a vis market – credible threat to shift production • Inefficiencies as firm becomes larger • Control problems associated with bounded rationality (limits to information any person can absorb and massage); weak incentives (difficulty in measuring direct contributions of individuals or divisions to overall financial performance of company); distortion as information (decisions) pass through more levels within organization

8. Existence of Firms Internalization • Vertical integration, horizontal diversification • Reduce transactions costs • Economies of scale, scope • Transferability of source of competitive advantage (design, marketing, costs, superior management, reputation) • Proprietary information • Tax advantages – transfer pricing • Quality control – minimize liability risks • Entry deterrence

9. Existence of Firms Optimal size of firm • MC of internalizing vs. MC of external transactions • Diseconomies of scale vs. economies of scale/scope • Technological change (communications, transportation, organization) • Optimal size differs across industries, time, location (country-specific characteristics) • Optimal size different question than why do firms grow

10. Ownership and Control Why go public? • Private companies – no separation of ownership and control • Financing investment opportunities • Dual share structure to retain control • Diversification and estate planning • OPM and perks • Outliving the founder to enhance the value of brand names and reputation • Attract management talent by offering equity stakes

11. Ownership and Control Agency • Definition • Problem – aligning interests • Compensation and incentives

12. Objective of Firms • Profit maximization/value maximization • Profit measure: profit margin, profit per unit, rate of return on invested capital, rate of return on equity? • /E = {/PQ}*{PQ/K}*{K/E} •  = {P-AC}*Q • Increasing K/E increases bankruptcy risk • Miller-Modigliani theorem, and optimal capital structure • Short-term, long-term – definition of time concepts

13. Objective of Firms • Separation of ownership and control • Management and control by founder or founding family (dual share structure) • Control/power • Maximize personal wealth • OPM • Independent management, no controlling shareholder • Maximize personal wealth • Control/power

14. Governance of Firms Agency – executive compensation, ad agencies, investment banks, lawyers, management consultants, etc. • Agency problem: separation of ownership and control – why should management have objective to maximize shareholder value? • Objectives of senior management (agents) may differ from those of shareholders (principals) – maximization of personal wealth vs. maximization of value (equity) of company • Maximization of value of equity of company may not necessarily maximize value of debt of company – conflicts between equity holders and debt holders • Agency problem may be non-existent with private companies where senior management owns company – possibility that different family members have different goals and objectives

15. Governance of Firms • Principal-agent • Board of Directors (principal) – functions, fiduciary responsibilities, compensation, liability • CEO (agent) – functions, compensation • Alignment of interests of owners and managers • Importance of incentive (compensation) contracts to align objectives of senior management and shareholders

16. Governance of Firms • Compensation contracts • Mix of salary, bonuses, long-term compensation (including post-retirement benefits) • Duration of contracts • Fixed endpoint problem: weak incentive for senior managers to perform as they near end of contract • How many years to learn whether senior managers better than average or worse than average in ability? • Information requirements to assess talent of management – how long a contract? How long a track record? Luck or talent? • Firing senior officers when record indicates below average talent becoming more common • Type I and Type II errors – re-hiring below average senior officer; firing above average senior officer

17. Governance of Firms • Nature of bonus: measurement problems  linked to aggregate profits; profit rate (what rate? operating margins, return on assets, return on equity); growth in profits; value of company; thresholds • Problems in multi-divisional enterprises – basis for bonus, incentives to ensure synergies among divisions realized • Re-coupment of bonuses if performance falters in future time periods • Payment of bonus • Short-term vs. long-term payoffs • Annual cash payments • Partial payments in equity • Low interest loans to acquire shares and forgiveness of loans owing to company (restricts diversification if acquisition of equity is mandatory)

18. Governance of Firms Stock options • Pricing of stock options – indexing of exercise price to reward holders of options for superior relative performance only (selection of companies to comprise index?) • Meet performance targets and have right to exercise options at original strike price or some pre-set premium over the original strike price • Re-pricing of options that are underwater – argument that such options no longer provide incentive; threat of losing talented senior managers • Magnitude of stock option grants; scope of eligibility for stock options

19. Governance of Firms Are incentives required? • Market for managers: super stars • Free agency and signing bonuses • Information requirements to determine whether a manager is a super-star • Incentive to perform to maximize value in free agency market • Nature of signing bonuses – cash, salary, stock options • Younger managers – ability to declare free agency again • Older managers – no further opportunity for free agency, important to link signing bonus to performance of company • How to motivate losers? – economic rents and threat of losing jobs

20. Governance of Firms Market for corporate control: takeovers • Outsiders (raiders, private equity firms) acquire poorly performing companies (potentially undervalued companies) and replace senior management with good management to increase value of company • Outsiders also acquire companies to engage in financial engineering (increasing debt to equity and selling off divisions and/or assets) to create value and then spin off companies (IPOs) to realize value – why doesn’t management do these things? • Fear of losing job (and associated economic rents – value of reputation reduced) sufficient incentive to perform and achieve best results for shareholders • How effective – poison pills (new shares available to existing shareholders at bargain prices if bid made for company), scorched earth policy (sell crown jewels), golden parachutes • Managerial myopia to prevent takeovers

21. Compensation in Multi-Division Firms • Synergies from cooperation • Sharing value created through cooperation • Compensation linked to increase in value – how? • Compensation linked to performance of division – bonuses • Long-term incentives paid in company shares (options, SARs)

22. Corporate Governance Boards of Directors • Whom does a Board represent? • Shareholders, but which ones? • Externality • Confidence in the equity markets and the financial system in general • Responsibility to ensure that there are no blow-ups which threaten the macroeconomy

23. Corporate Governance Possible Reforms • Role of Boards • Hiring a CEO and negotiating the employment contract; • Supervising the strategic planning process and approving the plan; • Monitoring the performance of the CEO • Independence • Training in risk assessment and management • Full-time job • Term limits • Compensation