Corp-fi 2

Briefly explain how a corporate board that has the majority of outside directors could become a captured board.

A captured board is board whose monitoring duties have been compromised by connections or perceived loyalties to management. Even though outside directors are expected to act as watch dogs, their monitoring duties could be compromised in the following circumstances: When long serving CEO is also the chairman, most of the independent directors may have been nominated by the CEO. Management may have an influence in appointing outside directors. Outside directors may have business ties with the company.

Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.

According to tradeoff theory, a tax shield adds value while financial distress costs reduce a firm's value. The financial distress costs for a real estate investment are likely to be low, because the property can generally be easily resold for its full market value. In contrast, corporations generally face much higher costs of financial distress. As a result, corporations choose to have lower leverage

Describe the benefits and costs of delaying an investment opportunity

By delaying, you delay the benefits of taking on the project and your competitors might take advantage of this delay. However, by delaying, uncertainty can be resolved, so you can become better informed and make better decisions.

Describe under investment

Where a firm does not engage in a + NPV project because of agency costs between shareholders and debt holders.

What are some examples of agency problems?

Examples of agency problems are excessive perquisite consumption (more company jets/company jet travel than needed, nicer office than necessary, etc.). Others are value-destroying acquisitions that nonetheless increase the pecuniary or non-pecuniary benefits to the CEO on net.

Briefly explain the prediction of 'adverse selection' in relation to new equity issues.

Firms that issue new equity have private information about the quality of their future projects. However, due to adverse selection and lemon principle, buyers are reluctant to believe management's assessment of new projects and therefore are willing to buy new shares at a heavily discounted price. Knowing this, managers of companies with good future prospects are unwilling to sell new equity. In other words, the managers who have bad information about their future prospects issue new equity. Because of this belief, investors respond negatively for a new equity issue announcement and as a result, such announcements are associated with price declines.

The existing empirical evidence suggests that the adoption of golden parachutes is associated with an increase in firm value. How do you justify the above finding in the context of takeover defences?

Golden parachutes are used by corporate managers as a takeover defence strategy. It is an extremely lucrative severance package that is guaranteed to a firm's senior management in the event that the firm is taken over and the managers are let go. In this context, the adoption of golden parachutes should reduce the firm value as it avoids the managers to be disciplined by the market for corporate control. However, an opposite view is that if a golden parachute exists, management will be more likely to be receptive to a takeover, lessening the likelihood of managerial entrenchment.

When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of bankruptcy?

No. Some of these losses are due to declines in the value of the assets that would have occurred whether or not the firm defaulted. Only the incremental losses that arise from the bankruptcy process are bankruptcy costs.

Is it necessarily true that increasing managerial ownership stakes will improve firm performance?

No. There are two counterarguments here. First, as Demsetz and Lehn (1985) argue, there is no reason to expect a simple relation between ownership and performance. There are many dimensions to the corporate governance system and a one-size-fits-all approach is too simplistic; the correct ownership level for one firm may not be the correct level for another. Second, some studies have shown a non-linear relationship between firm valuation and ownership—specifically that increasing ownership is good at first, but that in a certain range, managers can use their ownership level to partially block efforts to constrain them, even though they still own a minority of the shares. In this "entrenching" range, increasing ownership could reduce performance.

How does a board become captured by a CEO?

Over time, a long-standing CEO can maneuver the nomination process so that his or her associates and friends are nominated to the board. Additionally, board members representing customers, suppliers, or others who have the potential for business relationships with the firm will sometimes compromise their fiduciary duty in order to keep the management of the firm happy. This desire to keep the CEO happy or a reluctance to challenge him or her interferes with the board's primary function of monitoring the management.

Although the major benefit of debt financing is easy to observe—the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.

Overinvestment: investing in negative NPV projects; underinvestment: not investing in positive NPV projects; cashing out: paying out dividends instead of investing in positive NPV projects; employee job security: highly leveraged firms run the risk of bankruptcy and so cannot write long-term employment contracts and offer job security.

Explain how the controlling shareholders use pyramid structures to transfer wealth from minority shareholders to themselves.

Pyramid Structure is a way for an investor to control a corporation without owning 50% of the equity. The investor first creates a company in which he has a controlling interest. This company then owns a controlling interest in another company. The investor controls both companies, but may own as little as 25% of the second company. The controlling shareholder could move profits (and hence dividends) away from companies in which he has relatively less cash flow rights toward firms in which he has relatively more cash flow rights ("up the pyramid"). This is called tunnelling.

What is the generally observed relationship between board size and firm performance?

Researchers have found the surprisingly robust result that smaller boards are associated with greater firm value and performance. The likely explanation for this phenomenon comes from the psychology and sociology research, which finds that smaller groups make better decisions than larger groups.

What are the advantages and disadvantages of increasing the options granted to CEOs?

The advantages are that, since options increase in value when the firm's stock price increases, the CEO's wealth and incentives will be more closely tied to the shareholders' wealth. The disadvantage is that option grants can increase a CEO's incentives to game the system by timing the release of information to fit the option granting schedule or to artificially smooth earnings.

Explain the role of the board of directors in corporate governance.

The board of directors is the primary internal control mechanism and the first line of defence against the mismanagement of corporate resources. The boards are expected to mitigate the agency conflict between shareholders and managers and ultimately prevent corporate fraud. The boards are empowered to hire and fire managers, set compensation policies, approve major financial decisions and decide the direction of corporate strategy.

What are the advantages and disadvantages of the corporate organizational structure?

The corporate organizational form allows those who have the capital to fund an enterprise to be different from those who have the expertise to manage the enterprise. This critical separation allows a wide class of investors to share the risk of the enterprise. However, as mentioned in the answer to question 1, this separation comes at a cost—the managers will act in their own best interests, not in the best interests of the shareholders who own the firm.

What inherent characteristic of corporations creates the need for a system of checks on manager behavior?

The corporation allows for the separation of management and ownership. Thus, those who control the operations of the corporation and how its money is spent are not the same who have invested in the corporation. This creates a clear conflict of interest and this conflict between the investors and managers creates the need for investors to devise a system of checks on managers—the system of corporate governance.

What are the costs and benefits of prohibiting insider trading?

Trading is how prices come to reflect all material information about a company's prospects. By restricting a set of investors from trading, we decrease the efficiency of the prices because it will take longer for the prices to reflect that private information. We rely on efficient prices to make sure that capital is allocated to its best use. While that is a cost of prohibiting insider trading, there is also a benefit. In order for a capital market to fulfill its function, uninformed investors must be willing to invest their money—providing liquidity and lowering the cost of capital. If investors thought that the stock market was just a fool's game where they lost to insiders, they would be unwilling to invest or would price their expected loss into their required return. This increases the cost of capital for companies and slows economic growth.

Explain cashing out

When shareholders have the incentive to withdraw cash in terms of special dividend due to agency costs between shareholders and bondholders.

What is an internationally integrated capital market? What is the implication of an internationally integrated capital market for investments in foreign projects?

When the capital markets are internationally integrated, any investor can exchange currencies in any amount at the spot or forward rates and is free to purchase or sell any security in any amount in any country at its current market prices. With internationally integrated capital markets, the value of an investment does not depend on the currency used.

Briefly explain the implication of investing in foreign projects when the markets are internationally integrated.

When the capital markets are internationally integrated, any investor can exchange currencies in any amount at the spot or forward rates and is free to purchase or sell any security in any amount in any country at its current market price. The implication for investments in foreign projects is that the value of an investment does not depend on the currency used to evaluate it. The NPV of the project in domestic currency will be the same irrespective of whether it is evaluated from host country investors' perspective or from home county investors' perspective.

What are some of the negative effects of using stock grants and stock options to reward managers?

While increasing managerial ownership may reduce perquisite consumption, it also makes managers harder to fire. More recent literature find evidence of a non-linear relationship between managerial ownership and firm performance - Managerial ownership may be beneficial up to a particular threshold and the value of the firm may decline thereafter. Often options are granted "at the money," meaning that the exercise price is equal to the current stock price. Managers therefore have an incentive to manipulate the release of financial forecasts so that bad news comes out before options are granted (to drive the exercise price down) and good news comes out after options are granted. Studies have found evidence that the practice of timing the release of information to maximize the value of CEO stock options is widespread.

How do the targets use recapitalisation as a defensive strategy?

With recapitalization, a company changes its capital structure to make itself less attractive as a target. For example, companies might choose to issue debt and then use the proceeds to pay a dividend or repurchase stock.