Fm Ch1 Introduction

8/2/2019 Fm Ch1 Introduction

1/25


2/25

Introduction 1-2

morevalue.com, 1997

1. ISSUES IN CHAPTER 1

! What are the different legal forms offor-profit organization?

! Does it make a difference as to who owns & runs a business?

! What should your objective, as a financial manager, be?

! If you, as a manager, are not meeting the objective, what can and/orshould happen to you?

2. CHAPTER OUTLINE

2.1 TYPES OF OWNERSHIPadvantages & disadvantages

2.2 WHAT "SHOULD" THE OBJECTIVE OF A MANAGER BE?

why, how, problems?

Alex Tajirian


3/25

Introduction 1-3

morevalue.com, 1997

3. TYPES OF OWNERSHIP

3.1 SOLE PROPRIETORSHIP

# One Owner

# All you need to do is just start operating

# Advantages (

! Easy and inexpensive to form! Few government regulations & reporting requirements! No corporate income tax, only personal income tax

# Disadvantages ;! Hard to obtain large amounts of borrowing! Unlimited liability (owner liable for total debt)! Difficult to transfer ownership

Alex Tajirian


4/25

Introduction 1-4

morevalue.com, 1997

3.2 PARTNERSHIP

# An agreement (verbal or written) between owners as to:

! % of capital invested by each partner! How are profits shared?! How is it dissolved and/or ownership transferred?

# Same advantages and disadvantages as above

# Usually larger enterprise than sole proprietorship.

Alex Tajirian


5/25

Introduction 1-5

morevalue.com, 1997

3.3 CORPORATION

# Needs to be registered with a state as a legal entity,

irrespective of who owns it.

# Owners receive shares in corporation! Shareholders, who dont necessarily know much about

managing the company, electboard of directors1. Boardmembers are expected to oversee the proper running of thecompany.

! Board of directors appoints managers, generally differentfrom owners, and is expected to ensure that managers act inthe best interest of shareholders.

# Advantages(! unlimited life! easy transfer of ownership; just call your broker

! limited liability; maximum loss is your investment incompany

! Easier to raise capital; more info is publicly available oncompany

# Disadvantages;! double taxation: corporate earnings & dividend received

! increase in Securities and Exchange Commission (SEC)regulation and reporting.

Alex Tajirian


6/25

Introduction 1-6

morevalue.com, 1997

CORPORATE ORGANIZATION

BOARD OF DIRECTORS

Shareholders

Elect

Appoint

CEO

Owners

Managers

Alex Tajirian


7/25

Introduction 1-7

morevalue.com, 1997

ORGANIZATIONAL FORMS

71%

20%9%

Proprietorship

Corporations

Partnerships

90%

6%4%

Corporations

Partnerships

Proprietorship

PROPORTIONS SALES DOLLAR

Alex Tajirian


8/25

Introduction 1-8

morevalue.com, 1997

4. OBJECTIVE OF FIRM/MANAGER2

L In this class:

! firm / company / corporation

! managers not necessarily same as shareholders

! managers are agents of the shareholders

4.1 WHAT?3

Alex Tajirian


9/25

Introduction 1-9

morevalue.com, 1997

4.2 Maximizing Market Value Comes From:

#Making "best use" of existing operations/projects through re-engineering of products and processes.

# Creating additional market value by undertaking all "profitable"investment projects such as:

! expansion into new areas of business! expansion of existing line of business!

correct sizing

# choosing "best" dividend policy

# choosing "best" mix of financing sources

# choosing "best" organizational structure: flat vs. hierarchy

Alex Tajirian


10/25

Introduction 1-10

morevalue.com, 1997

4.3MANAGERS WHO DO NOT MEET OBJECTIVE

FACE DISCIPLINING FROM:

# Pressure From Within The Company

! threat of being fired by shareholders or board of directorsR proxy fight

! compensation: foregone salary increases and bonuscompensations

Disciplining comes in the form of threat of losing their job and/orcompensation

Alex Tajirian


11/25

Introduction 1-11

morevalue.com, 1997

# Sources Outside The Company

! threat of firm being taken-over by another firm through:R hostile takeover by purchasing stock of the target

companySSon open marketStender offer

Illustration of the threat:Step 1: Suppose a manager is not maximizing the price of

the company stock, say, producing inefficiently ata total cost = $30,000.

Step 2: Now a new manager, also referred to ascorporate raider, buys the company, reducescost from $30,000 to $20,000. Y An extra valueof $10,000 can be created, net of any costsassociated with acquiring the company

! firm can go bankrupt

In a Nutshell:The above discussion of shareholder wealth maximization suggeststhat managers are actually meeting the objective, otherwise theywould be out of the job.

But are they actually doing it ?!

Alex Tajirian


12/25

Introduction 1-12

morevalue.com, 1997

5. PROBLEMS WITH "OUGHT TO" ANALYSIS

Motivation:

There is evidence that managers are not maximizing value, yetthey are still with the firm and making lots of money. Anexplanation for this and a solution to the problem is referred to asthe agency issue.

"Principal-Agent" problem:# Definition: Managers (as agents) can have different interest

than shareholders (principal), such as:

more leisure, prestige (e.g. "empire building"), myopia,risk attitudes4, high pay

# Implications: Managers, as rational individuals, seek to lookfor their own self-interest. Thus, if they are leftalone, will not act in the best interest of

shareholders Y they need to be monitored and

given incentives.

# Problem: Shareholders incur costs5 associated with monitoringmanagement behavior.

# Solution: Principal needs to write a compensation contract6

that specifies the performance expected from theagents, and how it will be measured. One such contract

is an executive stock option7.

Alex Tajirian


13/25

Introduction 1-13

morevalue.com, 1997

# Why does management disciplining fail?

! Myopia is indirectly encouraged8

" management compensation has traditionally been basedon short-term performance9

" short-term job tenure

" Limited "patient capital"10 (few exceptions likeWarren Buffet, ...)

! Board of directors not very effective!

! No major shareholder (core investor11) to monitor &discipline incompetent management.12 Thus, with a large

number of shareholders it becomes extremely hard to

coordinate action demanded by dissatisfied shareholders.

! Managers might not want to share information withoutsiders.

Managers have better access to information about thecompany than outsiders, including shareholders. Thus,managers and shareholders have asymmetricinformation. Y Outsiders do not know that managersare not maximizing wealth YManagers would notnecessarily be fired.

Alex Tajirian


14/25

Introduction 1-14

morevalue.com, 1997

! takeover threat fails" Mechanism itself does not work as supposed to! (Ch ?)

Illustration:To takeover another company, raiders have hadto pay on average 20% higher price than the pre-acquisition. Moreover, cost of outside legal andfinancial advice contribute an additional 2%.

Thus, even if managers are maximizing only up to78% of potential value, there would be noprofitable takeover. Thus, bad managers have acushion equal to about 23% of the maximumpotential value of the firm.

" Management has developed anti-takeover mechanismsuch as golden parachutes, poison pills, and

greenmail to protect them.13

! It is extremely hard to write 100% effective contracts as itrequires predicting all possible future outcomes andscenarios.

Alex Tajirian


15/25

Introduction 1-15

morevalue.com, 1997

## What is being done to remedy the problem?

! SEC! Pressure groups! Within company action:

R Shareholders activism14

R Executive bonuses are being based on stock priceperformance rather than a fixed salary.

R Executive stock options! Markets: corporate re-structuring (LBOs, spin-offs, etc.)

Alex Tajirian


16/25

Introduction 1-16

morevalue.com, 1997

6. Conflict of Interest Between Creditors and

Shareholders

# Plausible source: Shareholders borrow $10,000 and distributeit to themselves Y trouble for creditors.

# Creditors Should be Proactive:! Creditors need to write a contract to protect themselves (i.e.

reduce adverse risk) against games played by shareholders

! However, there are potential problems with contracts:Contract can be very restrictive to firm Y very costly tofirm; for example, a contract prohibiting any futuredebt financing, even if debt is desirable!

# Lesson: Creditors-shareholders need to design a contract that iswin-win.

; Do Questions: 1-13 (

Alex Tajirian


17/25

Introduction 1-17

morevalue.com, 1997

SUMMARY

T FORMS OF ORGANIZATION! Sole Proprietorship! Partnership! Corporation

G Double Taxation

G Limited liabilityG Easier access To Financial Markets

T Objective of firm/manager should be to :Maximize shareholders' wealth ] Maximize price of stock

T Objective of manager might be: high pay, prestige, leisure, and high dislike for risk

T Theoreticaljustification ofshould be is:threat of hostile takeover, bankruptcy, & firingYmanager would lose her job if doesnot meet objective.

T Agency problem has to do with monitoring of management & design ofincentives to inducemanagers to act in the best interest of shareholder.Y ownership does matter

T Problems in practice with should be:G

managers have more information about the health and the expected performance ofthe firm than outsiders do. Managers need not have an incentive to share "bad"

information.G Anti-takeover techniques: poison pills, greenmail, and golden parachuteG No core investor to monitor and discipline managementG Corporate structure has built in biases that encourage short-term management

behavior (myopia).G Limited patient capital

CONCEPTS

Managers' objective is to maximize the price of the stock]

maximizing the wealth of owners(shareholders)

Managers need to be monitored and provided incentives. Otherwise they would not act in the bestinterest of shareholders. This is called the agency issue.

Alex Tajirian


18/25

Introduction 1-18

morevalue.com, 1997

Large ownership of stocks can impact the value of a firm through monitoring. Thus, ownership

matters.

VOCABULARYsole proprietorship, partnership, corporation, limited liability, raiders, proxy fight, hostiletakeover, poison pill, golden parachute, principal-agent.

Alex Tajirian


19/25

Introduction 1-19

morevalue.com, 1997

ADDITIONAL SUGGESTED READING

Porter, M. "Capital Disadvantage: America's Failing Capital Investment System,"Harvard BusinessReview. September-October 1992, pp 65-82.

Rapoport, C. "Why Japan Keeps on Winning." Fortune, July 15, 1991, pp. 76-85. (Handout)

"Can a Keiretsu Work in America?" Harvard Business Review. September 1990, pp. 180-197.

On the impact of foreign ownership of U.S. Companies, see:

Reich, Robert B. "Who Is Us?," Harvard Business Review. January-February 1990, pp. 53-64.

A general reference on Japanese political, economic, and social life. Note that some of the

political discussions are controversial.

van Wolferen. The Enigma of Japanese Power. Vintage 1990.

Concerning some issues related to "emerging democracies," see:Clague and Rausser. The Emergence of Market Economies in Eastern Europe, Blackwell, 1992.

On Corporate governance comparisons between U.S. and Japan, see Journal of Applied

Corporate Finance, Winter 1994.

Alex Tajirian


20/25

Introduction 1-20

morevalue.com, 1997

1. See articles in NEWS Vol 2. Also see B. K. Boyd " Board Control and CEO compensation,"

Strategic Management Journal, Vol 15, 5, June 1994, pp. 335-344.

2. Although wealth maximization is the objective that all employees should seek, sometimes it is

hard to use it to motivate employees. "Beat Honda" as a "stated" objective might work better.

3.

Plausible Objective Limitations

Increase profit 1. Profit is not well defined. Should the

increase be 10%, 20, 50%, ...?

2.Profit has problems too:Doesnt say if they are short-term or long-term; ignores risk; and can be legallymanipulated by, say, amortizing advertising

expenditure over several years as opposed toexpensing them. A practice, though legal,

was used by America Online (AOL).

Maximizing market share Having a large market share does notnecessarily mean that the firm is actually

profitable. For instance, a company cancapture most of a particular market if it sellsthe product below cost.

Thus, the objective of a manager is to maximize the wealth of shareholders. But since ashareholders wealth is calculated as the (market price of the stock) x (the number of shares

owned), maximizing the market price becomes equivalent to maximizing the wealth ofshareholders.

4. Typically, managers are less likely than shareholders to accept a risky project. Shareholders

tend to own stocks in a large number of companies, i.e., they are diversified. Thus, failure of one

risky project doesnt result in ruin as it is likely that another risky project performs better thanexpected. On the other hand, managers tend to have the major source of their livelihood

dependent on the performance of the company. Hence, a project that fails, even if the source offailure were outside the control of the manager, can have dire consequences on the managerscompensation, and thus, her livelihood.

Endnotes

Alex Tajirian


21/25

Introduction 1-21

morevalue.com, 1997

5. Company audits, by outside accounting firms, is part of the monitoring cost. The cost would

also include stock options and other incentives. It should be noted that it is hard to place anaccurate value on this cost!

6. Note that the course is not about designing contract but about why we need to write contractsthat involve financial variables.

7. An option is a contract that gives the executive the right to buy a specific number of company

stocks at a discount if the market price of the stock reaches a target level.

8. See J. H. Dobrnyski, "More Than Ever, It's Management For The Short-term,"Business Week,

1986 (November 2), pp. 92-93, and Karen Penner, "Is the Financial System Short Sighted,"Business Week, 1986 (March 3), pp. 82-83.

9. On CEO compensation see SFC p.E8 and p.E12. See For SEC action see LAT 6/24/92 p.

E20. On executive stock options, see LAT 4/8/93 p. E23. For international salary comparisonssee WSJ 10/12/92 p. E22.

10. Donald Frey, "The U.S. Needs Patient Investors,"Fortune, 1986 (July 7), pp. 125-126.

11. For example, suppose you held 1,000 shares of IBM in July of 1991. At the stock price then

prevailing, that holding would have been worth $98,000. Because there were over 592 millionshares of IBM stock outstanding, however, your ownership claim would have been only

0.000168% of the total. Thus, if you exerted enough effort in monitoring to increase theprofitability of IBM by $1, you would have gotten back only .000168 cents. Therefore, onlyinvestors with a relatively large stake will be inclined to do significant amounts of monitoring.

Thus, the concentration of share ownership can affect a firm's value.

12. Some pension plan sponsors are putting pressure on companies. See LAT 1/23/93 p.E5 , and

3/11/93 p. E3.

13. See LAT 3/28/92 p. E25, 3/24/92 p. E202 , and glossary on PacMan, poison pill, white

knight, and greenmail.

14. See "A Perspective of the New Shareholder Activism," JACF, Vol 6, 2, Summer 1993, pp.35-38.

Alex Tajirian


22/25

Introduction 1-22

morevalue.com, 1997

GUIDELINES TO AGREE/DISAGREE-EXPLAIN QUESTIONS

Agree1. From xyz theory2. From definition of ...3. from empirical evidence4. from relationship between variables5. A combination of above

Disagree

1. contradicts ( or no support) xyz theory2. contradicts definition3. contradicts empirical evidence4. wrong causal direction:

If x causes y, then y does not necessarily cause x5. counter example

Suppose: if x increases then z increases, and if y increases, then zincreases too. However, if z increases does not

necessarily mean than x has increased. It could be that yhas increased!

Note. XYZ does not refer to a specific theory.

Alex Tajirian


23/25

Introduction 1-23

morevalue.com, 1997

7. QUESTIONS

Agree/Disagree-Explain

! Explain both Agree & Disagree! When using graphs, always label your axis! "H" next to a question number indicates "hard," i.e. I will not ask it in an exam.

1. There are no advantages to being incorporated, since a company would be double taxed.

2. We do not see a large number of takeovers, because firms are maximizing shareholders'wealth.

3. Management (CEO) compensation has been effective in disciplining management behavior.

4. The second-hand car market provides a good example of "asymmetric information."

5. The agency problem is a cost to the firm.

6. There can be no conflict of interest between management and shareholders.

7. Raiders are anti-takeover repellents.

8. Maximizing EPS is a sound objective of a firm.

9. Maximizing market share is a sound objective of a firm.

10. Stock price maximization is equivalent to shareholders' wealth maximization.

11.H Sole proprietorships have hard time raising capital because they are risky.

12. The purpose of a poison pill is to make a company prohibitively expensive to takeover.

13. Greenmail is blackmail that involves green $.

Alex Tajirian


24/25

Introduction 1-24

morevalue.com, 1997

10. ANSWERS TO QUESTIONS

1. Disagree. The advantages include: easy transferability, limited liability, and easier access to

capital markets.

2. Disagree. A takeover is not easy to analyze. Moreover, existence of asymmetric informationbetween managers and outsiders, anti-takeover repellents adopted by management, diminish

the frequency of takeovers and managers are not maximizing shareholders' wealth.

3. Disagree. There is evidence that U.S. CEOs are paid too much based on their talent andeffort, and not commensurate with firm performance. For example, Japanese CEOs get paid

much less. U.S. managers have also been accused of being short-term profit driven.

4. Agree. There is asymmetric information in such a market. The seller/owner knows moreabout the car than a potential buyer does.

5. Agree. The shareholders have to incur a cost in monitoring the behavior of management.

Moreover, bondholders have to make sure that the firm adheres to the bond contract. Thus,reducing the agency problem reduces cost of monitoring.

6. Disagree. Agency problem, which is ....., see p. 12.

7. Disagree. Corporate raiders try to buy companies that seem undervalued. It usually is donethrough a hostile takeover.

8. Disagree. EPS = (Earnings/# of shares outstanding).(a) Earnings ignore risk and opportunity cost (more on these issues later)

(b) A company can artificially increase EPS by buying back its own shares. No value iscreated. Actually a cost is incurred.

9. Disagree.(a) As a trivial argument, a firm can sell its products at a loss. Thus it increases its market

share.

(b) Anti-trust consideration( c) What is your competitor's response? It cannot be ignored

Alex Tajirian


25/25

Introduction 1-25

morevalue.com, 1997

10. Agree. A shareholder's wealth is (Price of stock x # of shares owned). If price is maximized,then wealth is also maximized as # of shares is held constant.

11. Disagree. Even if they are risky, there is an appropriate reward/return for whoever is doingthe lending. In this case, it is hard for the lending parties to come up with a good assessment

of risk. Moreover, it is very costly to gather relevant information on individual smallcompanies/investors. Thus, is would be hard for these companies/investors to borrow at a"fair" rate.

12. Agree. This is the purpose of poison pills.

13. Disagree. See definition of greenmail.

Alex Tajirian

Documents

Fm Ch1 Introduction