FIN438: EXAM 1

In general, there are four categories of real or opportunity costs incurred by shareholders designed to prevent, mitigate, or correct management-shareholder agency conflicts. They are: 1. Expenditures to minimize management's desire to act contrary to the best interests of shareholders 2. Expenditures to monitor management's activities 3. Expenditures to provide a bond against management dishonesty 4. The opportunity cost of lost profits Consider the following situation and identify both the category of the expenditure and the best device that might be used to prevent, reduce, or correct the agency conflict: A firm's plant manager is afraid that her facility may be closed and her job outsourced to a lower-cost country. To make herself look good, she sets lower-than-appropriate performance goals. 1.Expenditure category? 2.Most appropriate form of control device:

1. 4 2. Develop a management evaluation and compensation program that puts the burden on the management team to reduce shirking or excessive concern about job security.

Creditors lend funds at rates based on the firm's perceived risk which depends on

1.the risk of the firm's existing assets, 2.expectations concerning the risk of future asset additions, 3.the existing capital structure, and 4.expectations concerning future capital structure changes

Poison Pills

A security, the rights or cashflows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill.

Overpaying on takeovers:

Acquisitions often are driven by management interests rather than stockholder interests.

What three aspects of cash flows affect an investment's value?

Amount of expected cash flows (bigger is better) Timing of the cash flow stream (sooner is better) Risk of the cash flows (less risk is better)

Stock Option Compensation Plan

An additional form of employee compensation above and beyond cash salaries and cash bonuses in which the employee is granted call options on the firm's stock. Typical plans do not vest immediately but require that the employee stay with the company a specified period before exercising the option is permitted.

Agency Relationship

An agency relationship arises whenever one or more individuals, called principals, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision-making authority to that agent.

Effective Boards of Directors

CEO is not the chairman of the board and does not have undue influence over the nominating committee. (ex: Amazon--problem w/ non-founder CEO and chairman, BOD keeps CEO in check--conflict of interest) Board has a majority of outside directors (i.e., those who do not have another position in the company) with business expertise.

Regulatory Systems and Laws

Companies in countries with strong protection for investors tend to have: •Better access to financial markets •A lower cost of equity •Increased market liquidity •Less noise in stock prices

Is maximizing stock price good for society, employees, and customers?

Consumer welfare is higher in capitalist free market economies than in communist or socialist economies. Fortune lists the most admired firms. In addition to high stock returns, these firms have: •high quality from customers' view •employees who like working there

agency cost of debt

Creditors anticipate possible harmful actions by stockholders Creditors charge higher interest rate= this is used to protect themselves in case the company engages in activities that could cause risk Company's cost of capital goes up= costs you more to raise capital Value of company goes down= because it rejects the project that would have accepted ]

Corporate Finance

Every decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision. Defined broadly, everything that a business does fits under the rubric of corporate finance.

Example of Agency Relationship btw SH and Creditors

Firm borrows money then sells safe assets and invest in risky large project. If successful, benefits go to SH b/c creditor returns are fixed at original low risk rate if unsuccessful, the BH would take a loss

Stock Options in Compensation Plans

Gives owner of option the right to buy a share of the company's stock at a specified price (called the strike price or exercise price) even if the actual stock price is higher. Usually can't exercise the option for several years (called the vesting period). Can't exercise the option after a certain number of years (called the expiration, or maturity, date).

Borrowing more on the same assets

If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off.

Who bears the costs of the perks?

If the owner/manager owns all the stock, the owner/manager bears all costs. If there are also outside shareholders, they bear some of the cost due to the owner/manager's perks. Therefore, minority shareholders will pay less for shares of stock—this is an agency cost.

What should be management's primary objective?

In traditional corporate finance, the objective in decision making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.

Effective BOD

Is not an interlocking board (CEO of company A sits on board of company B, CEO of B sits on board of A). Board members are not unduly busy (i.e., set on too many other boards or have too many other business activities

Why would a firm be willing to establish an employee stock ownership plan (ESOP)? Check all that apply.

It is common for financial institutions to loan money to ESOPs at below-market interest rates. Cash dividends paid on ESOP stock are tax deductible if the dividends are used to repay the loan that established the ESOP.

Wight Worldwide's stock price is currently trading at $37.5 per share. The consensus among market analysts is that the stock should trade for $32.5 per share, given the amount, timing, and riskiness of the company's dividends. Is Wight Worldwide more or less likely to receive a hostile takeover bid?

Less likely

Problems with Stock Options

Manager can underperform market or peer group, yet still reap rewards from options as long as the stock price increases to above the exercise cost. Options sometimes encourage managers to falsify financial statements or take excessive risks.

The Modern Corporation

Many shareholders, none who own a controlling interest in the company. Decision-making delegated by shareholders to an elected board of directors. Board delegates most decision-making to hired executives, who then hire other employees and delegate some decision-making. Potential agency conflict between shareholders and managers.

Corporate Governance Provisions Under a Firm's Control

Monitoring and discipline by the Board of directors (protect assurance of SH) Charter provisions and bylaws that affect the likelihood of hostile takeovers Compensation plans Capital structure choices Internal accounting control systems

If you are the only employee, and only your money is invested in the business, would any agency problems exist?

No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm's common stock, or the firm borrows. You own 100 percent of the firm.

Consider the following scenario and determine whether an agency conflict exists: Five years ago, Tae created a plant-care business that grew, stocked, and maintained fresh plants in office buildings throughout Houston. Over time, The Green Zone Inc. (TGZ) has grown from a proprietorship into a corporation, now reaching far beyond Houston. To finance and support this growth, TGZ issued shares that were sold to TGZ employees, Tae's family members, and selected outsiders. Tae is TGZ's chairman of the board of directors and CEO, but he is no longer the largest shareholder. At the latest annual meeting, two mutually exclusive proposals were placed on the ballot for discussion and vote. The first was put forth by Tae and TGZ's management team, and the second was proposed by a small group of other shareholders. Both groups are adamantly opposed to the other group's proposal, even though both proposals would likely have the same effect on TGZ's value and riskiness. Does an agency conflict exist between TGZ's management and the small group of opposing shareholders?

No; although an agency relationship exists between TGZ's management—including Tae as TGZ's chairman and CEO and the firm's shareholders—there is no agency conflict, because no expropriation or wasting of the shareholders' wealth has occurred.

Block Ownership

Outside investor owns large amount (i.e., block) of company's shares •Institutional investors, such as CalPERS or TIAA-CREF Blockholders often monitor managers and take active role, leading to better corporate governance

Golden Parachutes

Provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover

Bondholders often employ a variety of devices—including restrictive covenants in the company's bond indenture agreements—to protect their interests and constrain the actions of shareholders and the firm's managers. Which of the following are restrictive covenants often used to protect the firm's bond value and bondholder wealth? Check all that apply.

Provisions that prohibit reducing the firm's liquidity ratio below specified levels Provisions that prohibit the borrower from increasing debt ratios above specified levels

non classified board

SH have more power and can initiate change faster

What actions reduce agency cost of debt? (you cannot use other assets as collateral)

Securing the loan with company's assets. Placing restrictive covenants in debt agreements. The borrower must: Maintain profitability ratios and retained earnings at a certain level before making any distributions to shareholders. Maintain debt ratios at specified levels. Not issue more debt.

Borrowers vs lenders (in practice)

Stockholder and bondholders have different objectives. Bondholders are concerned most about safety and ensuring that they get paid their claims. Stockholders are more likely to think about upside potential

Two types of agency relationships

Stockholders and creditors Stockholders and managers

Greenmail

The (managers of ) target of a hostile takeover buy out the potential acquirer's existing stake, at a price much greater than the price paid by the raider, in return for the signing of a 'standstill' agreement

Red Snail Satellite Company recently created an ESOP. The company issued 200,000 new shares of stock at $50 per share, which it sold to the ESOP. The ESOP borrowed $10 million to purchase the newly issued shares from the company. The financial institution was willing to lend the money to the ESOP, because Red Snail Satellite Company signed a guarantee for the loan. The firm used the money from the ESOP to repurchase its shares on the open market at $50 per share. Which of the following statements describes the net effect of these transactions on Red Snail Satellite Company's balance sheet?

The amount of the firm's total liabilities and total shareholders' equity will remain the same.

It is reasonable to assume that a firm's management is going to be ultimately motivated to act in their own best interest. It can be a serious problem for shareholders if management's self-interests do not align with shareholders' self-interests. Select the statement that best describes the board of directors' actions in the following scenario: Green Penguin Pencil Company's board of directors has decided to buy back 200,000 shares of the company's stock on the open market. The board believes that this stock repurchase will increase the firm's earnings per share.

The board's decision will help align management's interests with the shareholders' interests.

What is Corporate Governance?

The set of laws, rules, and procedures that influence a company's operations and the decisions made by its managers. •Sticks (threat of removal) •Carrots (compensation)

The management of Fuzzy Button Clothing Company controls 58% of the company's stock. The firm did not meet any of its quarterly sales projections for the last year. Some of the firm's institutional investors are worried that the firm's poor performance is partly because management has not been focused on maximizing shareholder wealth. Which of the following measures would the institutional investors most likely want to see implemented?

They would want to change the corporate charter to allow cumulative voting instead of noncumulative voting.

True or False: A small number of institutional investors are often able and motivated to bring direct shareholder pressure on a firm's management in an effort to reduce potential agency conflicts.

True

Risk Shifting

When a firm takes riskier projects than those agreed to at the outset, lenders are hurt. Lenders base interest rates on their perceptions of how risky a firm's investments are. If stockholders then take on riskier investments, lenders will be hurt

A dividend/buyback surge

When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash.

Anti-Takeover Provisions

When managers do not fear stockholders, they will often put their interests over stockholder interests -greenmail golden parachute poision pills overpaying on takeovers

Would hiring additional people create agency problems?

Yes, An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them. If owner of small business hires people to do small task to operate to maximize own welfare by selling some of the stock to outsiders--- a potential conflict of interest arises

Consider the following scenario and determine whether an agency conflict exists: Last week, an investigative reporter for a major metropolitan newspaper discovered that the doctors conducting clinical trials of a new cancer treatment drug are also the principal shareholders in Cancer Solutions Inc. (CSI). CSI is the company developing and attempting to market the drug. Upon being interviewed by federal authorities, the doctors acknowledged their conflict of interest but reported that they were sold the shares at a 75% discount by CSI's chief financial officer. The CFO was concerned that CSI might not be able to meet its annual performance objectives and in turn pay his anticipated multimillion-dollar bonus. Does an agency conflict exist between CSI's CFO and the company's shareholders?

Yes; CSI's CFO engaged in unethical conduct to manipulate the firm's short-term earnings and improve the likelihood of receiving his annual bonus.

To prevent, reduce, or correct these conflicts between their managers and themselves, shareholders often have to incur additional real costs called ________costs.

agency

Agency conflicts are a special example of a conflict of interest; specifically, they are created by the relationship between ________ , and result from inconsistencies or disputes between the interests and motivations of the different parties. The magnitude of these conflicts may be made larger or smaller by the environment in which they occur and the availability of techniques or events to prevent, reduce, or rectify them.

an agent and a principal

WACC

average rate of return required by all of the company's investors

___________ generally receive fixed payments regardless of how well the firm does, while ________ earn higher returns when the firm's earnings are higher.

bondholders, stockholders

Sole Proprietorship

business owned and operated by one person

Managers' personal goals may compete with shareholder wealth maximization. However, managers can be motivated to act in their stockholders' best interests through (1) reasonable __________ packages, (2) firing of underperforming managers, and (3) the threat of hostile takeovers. If a firm's stock is undervalued, corporate raiders will see it as a bargain and will attempt to capture the firm in a hostile takeover.

compensation

Consequently, bondholders attempt to protect themselves by including __________ in bond agreements that limit firms' use of additional __________and constrain _______actions.

covenants, debt, managers'

Agency Conflict

creditors allocating decision making authority to someone else--- creates a conflict

In addition, the use of additional ______ increases stockholder/debtholder conflicts.

debt

If managers undertake projects that increase the riskiness of the firm and its cash flows, then the wealth of the firm's bondholders will be ______ , while that of the firm's shareholders will be ________

decreased, increased

Bondholder=

fixed return(coupon pmt + principal)

While the agency conflicts between managers and shareholders tend to receive the most press, they are not the only type of agency conflict affecting the modern corporation. Another equally important type of agency conflict is sometimes observed between a firm's common shareholders and its creditors, or bondholders. As with conflicts between managers and shareholders, the basis of conflicts between shareholders and bondholders is divergent concerns and motives. In general, bondholders purchase corporate securities that provide a _________return, whereas shareholders purchase shares that are likely to provide a return that _____________ the riskiness of the firm.

fixed, fluctuates with

partnership

has roughly the same advantages and disadvantages as a sole proprietorship.

Creditors

have claims on firm's earnings stream and claims assets in the event of bankruptcy

Shareholders

have control of decisions that affect riskiness

In addition, potential bondholders may require a __________interest rate on the firm's soon-to-be-issued bond as compensation for the risks that cannot be adequately protected against using the restrictive covenants.

higher

Corporate governance

is the set of rules that control a company's behavior towards its directors, managers, employees, shareholders, creditors, customers, competitors, and community. Corporate governance can help control agency problems.

If the company invests in more risky project

it will benefit SH

Corporation

legal entity separate from its owners and managers. File papers of incorporation with state. •Charter Bylaws

For the past 40 years, companies have attempted to attract, retain, and encourage managers by developing attractive compensation packages. These compensation packages have also been intended to reduce potential agency conflicts between these managers and the firm's shareholders. In the best interest of shareholders, compensation packages should be structured in a way such that managers have an incentive to maximize the ____________value of the company's common stock price.

long term

Annual meetings are also tightly scripted and controlled events

making it difficult for outsiders and rebels to bring up issues that are not to the management's liking.

Agency problem

managers may act in their own interests and not on behalf of owners (stockholders)

Firms must provide the right incentives if they are to get _______to focus on long-run value maximization. Conflicts exist between managers and stockholders and between stockholders (represented by managers) and __________

managers, debtholders

The quickest and perhaps the most decisive way to impoverish stockholders is to

overpay on a takeover.

Agency costs

real and opportunity costs incurred in the prevention, reduction, and correction of agency conflicts.

Agency Cost

reductions in a company's value due to agency conflicts. In companies with high agency costs managers' are not pursuing the main objective of the firm which is maximizing the wealth of shareholders.

Investments in ________ventures, that have great payoffs to stockholders if successful but threaten bankruptcy if they fail, create conflicts

risky

Left unaddressed, these conflicts can produce significant real and opportunity costs that the firm's shareholders and other stakeholders must bear. Examples of management behaviors that are not in the best interests of the firm's shareholders include shirking, an excessive consumption of perquisites, an excessive concern with job security, reduced or excessive risk taking, and/or undertaking activities that are principally intended to expand or enhance a manager's ego, prestige, or power. For example, in businesses managed by professional managers, managers frequently have less financial and emotional commitment to the business than the firm's owners (the firm's common shareholders). The __________of ownership and management and the ___________ of decision making by the owners to the professional managers create an environment in which these conflicts can take root.

separation, delegation

Free cash flows

the cash flows that are available (or free) for distribution to all investors (stockholders and creditors). FCF = sales revenues - operating costs - operating taxes - required investments in operating capital.

Agency conflicts can decrease

the value of stock owned by outside shareholders. Corporate governance can mitigate this loss in value.

Borrowers vs lenders (theory)

there is no conflict of interests between stockholders and bondholders. (no relationship btw BH)

Why the focus is on stock price?

¨Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). ¨ ¨If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.

WACC is affected by:

•Capital structure (the firm's relative use of debt and equity as sources of financing) •Interest rates •Risk of the firm •Investors' overall attitude toward risk

What do we call the price, or cost, of equity capital?

•Cost of equity = Required return = dividend yield + capital gain

Disadvantages of a corporation

•Double taxation •Cost of set-up and report filing

Sole Proprietorship Advantages

•Ease of formation •Subject to few regulations •No corporate income taxes

Direct transfer

•Example: A corporation issues commercial paper to an insurance company.

Through a financial intermediary

•Example: An individual deposits money in bank and gets certificate of deposit, bank makes commercial loan to a company (bank gets note from company).

Through an investment banking house

•Example: In an IPO, seasoned equity offering, or debt placement, company sells security to investment banking house, which then sells security to investor.

Six Potential Problems with Managerial Behavior

•Expend too little time and effort. •Consume too many nonpecuniary benefits. •Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company. •Reject risky positive NPV projects to avoid looking bad if project fails •take on risky negative NPV projects to try and hit a home run. Avoid returning capital to investors by making excess investments in marketable securities or by paying too much for acquisitions.

Corporate finance provides the skills managers need to:

•Identify and select the corporate strategies and individual projects that add value to their firm. •Forecast the funding requirements of their company, and devise strategies for acquiring those funds.

After the loan is originated, borrowers can make decisions that affect the lender:

•Invest in risky projects. •Who benefits most if there is a small payoff, medium payoff, or big payoff? •Who loses most if there is a small loss (SH), medium loss, or big loss(BH)? •Take on additional debt

Sole Proprietorship Disadvantages

•Limited life •Unlimited liability •Difficult to raise capital to support growth

The power of stockholders to act at annual meetings is diluted by three factors

•Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings. •Incumbent management starts off with a clear advantage when it comes to the exercise of proxies. Proxies that are not voted becomes votes for incumbent management. •For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.

Election mechanisms make it easier for minority shareholders to gain seats:

•Not a "classified" board (i.e., all board members elected each year, not just those with multi-year staggered terms) •Board elections allow cumulative voting

Initial Public Offering (IPO) of Stock

•Raises cash •Allows founders and pre-IPO investors to "harvest" some of their wealth Subsequent issues of debt and equity

What do we call the price, or cost, of debt capital?

•The interest rate

Advantages of a corporation

•Unlimited life •Easy transfer of ownership •Limited liability Ease of raising capital

Employment growth is higher in firms that try to maximize stock price. On average, employment goes up in:

•firms that make managers into owners (such as LBO firms) •firms that were owned by the government but that have been sold to private investors