Corporate Finance Objective Function Notes PDF

I wrote these notes for you in a bit more detail than previous notes for a couple of reasons. First, I enjoy discussing these topics with my classes, as I find the conversations quite interesting and productive. Second, the recent Zoom / Wi-Fi technical difficulties frustrate the heck out of me (and...

I wrote these notes for you in a bit more detail than previous notes for a couple of reasons. First, I enjoy discussing these topics with my classes, as I find the conversations quite interesting and productive. Second, the recent Zoom / Wi-Fi technical difficulties frustrate the heck out of me (and probably you), and I want to make sure that you understand this material. So, I decided to spend a decent amount of time writing these lengthy notes to compensate for our remote environment. Like always, please excuse my quick, colloquial writing style -- I am not proofing this for publication! Traditional Corporate Finance topics discussed in textbooks, "FIN 101" and many finance theories typically carry a host of fundamental assumptions. You have probably heard something along the lines of managers focusing on "increasing shareholder value" -- that this should be their objective function. Personally, I don't like to say this when talking with non-finance people. I understand that not everyone knows why this objective is stated this way, so I prefer to say something more general, like managers should focus on "increasing firm value" (or, just "creating value"). This has a better ring to it, and it's mostly consistent with increasing shareholder value if certain assumptions hold. Remember, managers are hired by those with operating control of the company, namely the shareholders. Managers aren't hired by bondholders (well, maybe if the company is in bankruptcy or something, in which case they are basically owners). Customers, vendors, employees, etc. don't hire the managers, unless they are also owners (shareholders). When people take issue with the "increasing shareholder value" objective function, their criticism typically stems from the fundamental assumptions (although they typically don't understand these assumptions very well). We've all heard things suggesting that firms should also focus on the employees, or customers, or whomever, and not solely focus on the owners. This sentiment ebbs and flows, but it has gained more steam as of late. However, it's a false dichotomy to assume that increasing firm value will necessarily have a negative effect on other stakeholders, or vice versa. On the contrary, treating employees, customers and others poorly can have a detrimental effect to shareholder value. Last summer, you may have heard about a "Business Roundtable" group with heads of over 180 U.S. companies, including Amazon, JP Morgan and American Airlines issuing a "statement of purpose" that basically said that companies should put social responsibility above profits. It was purely symbolic, a great "sound bite," and had no teeth to it. As Jaime Dimon (CEO of JP Morgan) stated, "Major employers are investing in their workers and communities because they know it is the only way to be successful over the long term." In other words, firms and investors can "do well, by doing good." Further, maximizing shareholder value typically assumes that other stakeholders are "protected." There are many examples of shareholders transferring value from other parties for their benefit. For instance, if bondholders are not protected, shareholders can essentially "rip them off" by extracting value from them (more below). Remember, EV = MVE + MVD (assuming no excess cash). We typically assume that bondholders are protected, and if the firm is financially healthy, then we use the book value of debt (BVD) as a proxy for the market value of debt (MVD). If shareholders can extract value from bondholders, then if an increase in MVE is associated with a larger decrease in MVD, then the EV decreases. This is bad -- the shareholders benefit by taking a value destroying project. But, as you can see, if debtholders are protected, then an increase in firm value (EV) corresponds to an increase in shareholder value (MVE). This is where the classic objective function comes from. Additionally, there are examples of managers exploiting inefficient markets (perhaps misleading the market), which does not conform with most traditional corporate finance theories. There are examples of firms creating negative externalities whereby society bears a sizable cost (pollution, noise, etc.). Again, this is like a value transfer -- taking value away from society and giving it to a firm. We need a way to properly think about these problems, and I describe them in more detail below. I believe that this set of topics is under-represented in both the undergraduate and graduate business schools' curricula. We learn the important tools of valuation such as the "NPV Rule," which essentially states that if the net present value of an investment is positive (increases value), then accept it; if the NPV is negative (destroys value), then reject it. This is nothing more than a detailed cost-benefit analysis where we examine time-weighted, expected incremental cash flows. However, before we delve into the weeds of building intelligent financial projections and estimating intelligent discount rates, we must keep our eyes on the big picture -- first things first. If the overarching investment environment is such that maximizing value is not the primary objective function, then NPV and other useful tools that we learn may no longer apply. The NPV decision rule is firmly grounded under the assumption that maximizing value is *the* objective function, so if we can no longer trust the underlying assumption, then we might find that certain "positive NPV" projects are rejected and/or some "negative NPV" projects are accepted. In your future careers in business (likely in some sort of management role), your ability to identify and intelligently communicate these conditions to others will certainly allow you to stand out from the crowd. Traditional Corporate Finance theories typically assume that the conflicts described below are not prevalent (or, alternatively, that if these conflicts exist, then they are mitigated or resolved). Keep in mind that each of these topics are deeply researched in the literature -- they are very important topics that can help explain some otherwise peculiar behaviors. These quick notes cannot possibly cover all the material sufficiently, but I hope that they provide you with a solid foundation that helps you view situations a bit differently. Also, an important side goal of this course (and consequently, these notes) is to provide you with the language and vernacular used in industry. ***Agency Conflicts*:** The "NPV Rule" assumes that the decision makers (agents, or managers) act in the best interest of the shareholder (principals, or owners). If managers' and shareholders' incentives are improperly aligned, then guess what? Managers (CEOs and other decision makers) might behave in ways that do not increase firm value. We typically assume that people will seek to maximize their own utility (happiness). For example, managers will prefer higher compensation (rather than lower), they will prefer to have more job security (rather than stress about losing their position), they will prefer more perquisites (like flying on corporate jets, athletic club memberships, etc.), and they might prefer to engage in value-destroying acquisitions such that they can manage a bigger, more powerful firm (termed "empire building"). Of course, this is merely a short-list of examples, but I'm guessing that you get the point. Many students might wonder about the statement, "We typically assume that people will seek to maximize their own utility (happiness)." Yes, this sounds like we assume that people are "selfish." It might even sound like "ethical" considerations are swept under the rug. Keep in mind that this does not have to be the case. We can always incorporate a "reputational cost" in an individual's objective function. For instance, let's say that a manager can take a project that destroys overall value, but provides a +\$100 private benefit to the manager. If the manager does not participate in the overall value destruction (he or she does not own a percentage of the firm) also has little to no reputational cost, then he or she should be expected to take this project. However, if we want to incorporate some sort of "ethical boundaries" or "reputational costs," then we can include this in the objective function. If these costs are higher than \$100, then the manager would reject the project. The problem is that "reputational costs" are highly individual, unobservable and likely dynamic (not a static quantity over time or situation). You can probably imagine that these ethical / reputational considerations are very important in the principal-agent problem discussion. I have never once tried to quantify these, but I keep them in mind in my business relationships. Unfortunately, I've seen good people do bad things, and I've seen people misunderstand that "just because you can, doesn't mean that you should." I have found that anticipating potential conflicts and recognizing that people's "reputational costs" are dynamic is crucial to effectively mitigating agency conflicts. There are several potential mechanisms with which to help alleviate agency concerns. We discussed shareholder annual meetings. In theory, stockholders who are dissatisfied with managers can not only express their disapproval at the annual meeting, but also use their voting power to keep managers in check. In practice, annual meetings can be ineffective. First, these meetings tend to be tightly scripted and controlled events, often with a "PR flare" to them. This makes it difficult for outsiders and rebels to raise issues at odds with management's wishes. Additionally, most small stockholders will not rationally attend the meetings, as the cost outweighs the potential benefits of attending. Also, coordination among small shareholders can prove challenging. Larger block holders will likely attend, but they often don't want to "rock the boat" and/or burn bridges. We discussed an example with Coca-Cola and Warren Buffett. In 2014, Coca-Cola executives proposed a controversial compensation plan increase at a time when KO was relatively underperforming the market. This "excessive" pay proposal was widely criticized in the popular press, and many people looked toward Buffett to use his weight and vote the plan down (Berkshire owned over 400 million shares, or 9+% of KO). However, to the surprise of the media (not to me), Buffett abstained, and the compensation plan was approved with an 83% vote. Buffett was widely criticized and even called a "coward" by a *New York Times* columnist. Buffett later defended his decision saying, "I could never vote against Coca-Cola, but I couldn't vote for the plan either." He also said, "I don't think going to war is a very good idea in most cases." Oftentimes, these large block holders choose the more "political" route by not rocking the boat with a formal vote, but instead decide to shed some of their holdings. We also discussed the role of the Board of Directors and corporate governance in mitigating agency conflicts. You can generalize the board's role in three primary buckets: 1) Monitoring, 2) Disciplining, and 3) Providing complimentary strategic advice and opportunities. BOD's have a fiduciary duty to the shareholders, and the primary reason for their existence is to reduce the principal-agent problem. In theory, if a CEO misbehaves, the board can monitor and discipline on the shareholders' behalf. In practice, this mechanism doesn't necessarily work as well as theory suggests. Many board positions at top public firms are quite lucrative -- good compensation, little time commitment, lots of prestige, lots of material and non-public information, etc. They are awesome gigs! However, BOD's are often nominated or recommended by insiders (like CEO's), and there is strong research suggesting that "network effects" play a big role in directorships. If the CEO is a Yaley, it's more likely that he or she will nominate another Yaley. Further, many directors are "busy" with varying loyalties among other companies' boards and executive positions at other firms. Additionally, even "independent" (non "inside" directors, or directors not inside the firm, like CEOs, CFOs, COOs, etc.) are often not really that independent because they want to keep their prestigious job that pays well and has relatively little time demands. There is also a social dimension to being on the board. Talking about management and directors, Buffett has said, "They do not look for Dobermans. They look for Cocker Spaniels, and then they make sure that their tails are wagging." He has also noted that sometimes, voting against others on the board can result in a loss of influence among the board for future decisions. Buffett has said, "If you keep belching at the dinner table, you'll be eating in the kitchen." He's quite the wordsmith who understands how things play out in the "real world." Actually, there is a ton of research related to corporate governance -- it's an extremely popular topic in academia and in practice, and regulators (like the Securities and Exchange Commission) rely heavily on rigorous academic research in this area. I find this area of research quite interesting. Intuitively, you might think that "independent directors" might do a better job than inside directors. There is some evidence that they monitor and discipline better. However, there is evidence that more independent directors are associated with worse performance for smaller, tech firms, suggesting that the strategic and social dimensions of the role of the board matter. "Gray directors" are those that are not technically inside the company, but might have other personal or economic ties to the company (perhaps with a conflict of interest) like major customers in the industry, labor representatives, etc. There is evidence that firms with higher proportions of gray directors perform better. Generally, smaller boards tend to outperform larger boards, suggesting board communication and cohesion matters. My personal research has shown that the market looks at the network of boards and members' perceived effectiveness at monitoring public financial statement disclosures. For instance, if a firm restates their financial statements in a materially adverse way (they corrected previously disclosed financial statements in a materially downward fashion, which often results in a decline in stock prices), then other firms on which directors sit on the board also see abnormal declines in stock returns. The market seems to take directors' monitoring roles seriously. Board diversity and board composition are popular topics and generally yield mixed results in aggregate. Mixed corporate governance results should be no surprise, as "observables" like age, tenure, gender, ethnicity, education, inside / independent / gray, etc. captures only a small aspect of human behaviors and performances. I mean, labor economists have forever tried to explain variations in people's compensation, and the very best that they might achieve (after throwing in many intelligently crafted "observables") is about 27% of wages. This means that even the best models leave roughly 73% of the variation of wages unexplained (person-specific). Rigorous large-scale studies on human behavior is tough. Commonly publicized simple-stupid averages and summary statistics are easy, but this isn't good research and can be grossly misleading! Critical thinkers don't trust inferences based on summary stats. I say all of this because as intelligent students, you should know that while the theory of the existence of the Board of Directors is relatively straight-forward, the reality is much more complex. Sometimes BOD's are effective, but there are many instances where boards fail to properly fulfill their roles, one of which is to mitigate agency conflicts. If the two primary "Utopian view" mechanisms of annual meetings and Board of Directors do not properly alleviate the principal-agent problem, then management can behave selfishly in ways contrary to shareholders' interests. Sometimes, we use the term "entrenchment," where managers already have, or attempt to create, barriers to monitoring and disciplining. In this case, another mechanism to effectuate change in managements' misbehaviors is the "market for corporate control," which you can think of as hostile takeovers or acquisitions. Keep in mind that the mere threat of a hostile takeover can make entrenched managers behave properly. In these instances, an investor or a group of investors (sometimes called a "corporate raider") gobbles up shares, often to purge management, inefficient processes and redundancies. Oftentimes, corporate raiders attempt to "cut out the fat" (sometimes disruptively), transform the company into a more efficient version of its old self and then sell their ownership at a sizable profit. So, if management is entrenched, the market for corporate control can help solve some of the agency conflicts. To ward off hostile takeovers that could effectuate change, management might institute corporate governance provisions such as poison pills, shark repellants and others. We briefly discussed a specific example of Papa Johns and the poison pill implemented by the BOD to deter Papa (John Schnatter) from taking more voting control. Poison pills are primarily aimed to thwart a hostile takeover. In the PZZA example, if anyone (loosely defined as an investor or investor group) amasses more than 15% of stock without the board's approval, then the event triggers a provision granting additional shares (or rights) to existing shareholders. So, if I purchased 15% of PZZA without board approval, then it triggers every other shareholder receiving one-for-one additional shares in PZZA, and therefore my ownership dilutes significantly. Essentially, poison pills make hostile takeovers difficult, if not impossible. PZZA stock price immediately dropped after the announcement of the poison pill, which is not uncommon. This limits shareholder rights. Keep in mind that poison pills come in many forms, and each are tailored for the specific purposes of management and the board (like most all corporate governance provisions). We discussed some of the more common governance provisions, but there are several others. There are other ways that the market helps alleviate agency problems. We didn't discuss them, but fierce competition is one way. Intense product market interactions can punish inefficient firms, and to the extent that many agency issues are inefficient, then these firms might perform poorly, be targets of hostile takeovers or go bankrupt. Additionally, some research suggests that debt can be a monitor. This concept basically says that firms with enough debt must pay their debts when they become due, and therefore, management has less ability to behave poorly due to the risks of default (and potential of bankruptcy). There are other ways that market forces can help with agency problems, but I've hit on many of them. Outside of market forces, governmental regulation can help with these issues, but often we encounter unintended consequences (like Sarbanes-Oxley). Shareholder lawsuits (or the threat) can also help, but they are also costly (attorneys and consultants like them though!). One popular method for shareholders to more directly manage agency conflicts is to properly structure managerial compensation contracts. Typically, this involves including an equity-like component (tied to shareholder value). The intuitive concept is something like this -- if we want managers to behave in the way that we want, then let's try to turn them into someone who is more like us. So, these compensation contracts often compliment the fixed (presumably lower) salary component with stock and/or call options. Of course, we must be careful when trying to "fix" a problem such that we do not induce unintended consequences. We must be careful to consider the timing (vesting) of such equity grants. We discussed potential problems with stock option grants. Remember, call options give the person the right, but not the obligation to purchase (call away from someone) a security for a specific price by a certain time (the options expire at some point). Like any option in life, the option holder can exercise their right (like attending class), or not (skipping class) -- it's their choice. So, if the stock price is "in-the-money" (stock price is higher than the strike price), the option holder will exercise. If not, then he or she will walk away (not exercise the right). Deeply "out-of-the-money" options can be problematic in that they might not incentivize managers to take on good projects, and they certainly won't "punish" managers (pocketbook-wise) for taking on bad projects. "At-the-money" options can incentivize managers to take on excessive risks for risk sake. Remember, risk is neither bad nor good -- it's a fact of life. But, shareholders do not want managers to take on negative NPV risks. Essentially, "at-the-money" options allow the option holder to win on the upside, and not lose on the downside. It's the classic, "heads I win, tails I don't lose" situation. Consequently, "in-the-money" options are popular fixes to the agency conflict. The reason is simple, but often overlooked. A primary problem with "out-of-the-money" and "at-the-money" options is that the manager doesn't get hit in the pocketbook if they destroy value by acting in their own self-interest. With "in-the-money" options, managers also destroy their own wealth when the stock price declines, which is often the point of such grants. Hopefully these notes help provide you with a better understanding of agency conflicts, how they manifest in the business world and some potential "fixes." The NPV Rule assumes that managerial incentives are aligned with increasing firm (or shareholder) value. I encourage you to recognize that principal-agent problems exist -- we can't bury our heads in the sand. But, there are (theoretical and empirical) mechanisms that can help mitigate these concerns and allow us to more comfortably use the NPV Rule to help guide our decision calculus. ***Shareholder-Bondholder Conflicts*:** We discussed the fundamental difference between bondholders and shareholders. Bondholders (or, debtholders) care more about protecting the "downside" of firm value. If the firm value falls below the par (book) value of debt, then debtholders participate in that value loss. However, if the book value of debt is safely below the value of the firm (so, the firm is financially healthy), then an increase in firm value does not necessarily reflect additional value to the debtholders -- their value remains relatively constant. In a sense, bondholders' upside is limited, but their downside is real. Shareholders (equity holders) have limited liability on firm value. This means that if the firm's value falls low enough, equity holders are not on the hook to fund the value loss. In a sense, equity prices do not fall below zero. In terms of firm value, equity holders are the residual claimants (meaning that they get what is left over after paying vendors, employees, other costs and bondholders). So, shareholders care more about the "upside" of firm value rather than absolute downside. If bondholders are properly protected, such that increasing shareholder value does not decrease bondholder value, then "increasing firm value" is the same as "increasing shareholder value" (previously mentioned). Another important distinction between shareholders and bondholders is that shareholders typically have operating control of the firm, while debtholders have little to no operating control. So, the bondholders can be at the shareholders' mercy. Because shareholders and bondholders have both a different payoff structure and a different level of control, conflicts can obviously arise! We discussed how these differences can create some problems. Because shareholders have operating control, they may be able to "rip off" unprotected bondholders. Keep in mind that there are two fundamental ways to rip someone off, and we've discussed them in this class. How can value decrease? Well, lower cash flows and/or changes in the discount rate. So, shareholders can either strip away bondholders' cash and/or push more risk onto the bondholders. The first way (taking someone's cash) is the typical way that people think of "ripping someone off," but we must recognize that risk transfer is a very common way of extracting value from another party. In terms of bonds, if the yield to maturity (YTM, which reflects both a risk-free rate and a default spread) goes from 5% to 8%, then the price (value) of the bond is lower. So, if the riskiness of the debt increases, the value of bond declines. Other examples of bondholder-shareholder conflicts include dividend and share buyback surges. Here, shareholders decide to distribute cash to themselves, putting the company at a higher risk of default (the primary risk that debtholders bear). Additionally, shareholders might borrow more on the same assets. Let's say that a lender provides an \$800k loan secured on a \$1m machine. If the lender is not protected, the firm may decide to get another collateralized loan secured (perhaps at a higher priority) on the same machine. In terms of risk-shifting behaviors, I have seen bondholders get completely fleeced. I worked on a case where Verizon spun off their "yellow pages" division into a public entity called Idearc. VZ unloaded some of its debt onto the new company (Idearc), and Idearc filed for bankruptcy (termed BK in industry) in two years. So, think about a lender who provided capital to VZ only to have that debt held by a completely different company focusing on yellow pages. Yeah, they were not thrilled, and they sued VZ. Sometimes a simple numerical example can provide students with decent intuition. Let's say that a firm is currently worth \$1,000, and it has \$800 in debt (therefore \$200 in equity). Let's say that there is a project that costs \$500 today, and with 50% probability will be worth \$900 tomorrow, and 50% probability will be worthless tomorrow. The NPV of this project is clearly negative. NPV = (50%)\*(+\$400) + (50%)\*(-\$500) = -\$50, so it should be rejected. However, shareholders will rationally choose to accept this project. From equity's perspective, if they take the project and the "good state of the world" happens, then the firm value = \$1,000 - \$500 + \$900 = \$1,400. With \$800 of debt, the equity is worth \$600, so there is a 50% chance of shareholders gaining \$400. If the "bad state of the world" happens, then firm value = \$1,000 - \$500 + \$0 = \$500. Since there is \$800 in debt, the equity is "underwater" and worth zero. In this case, the equity lost \$200. Consequently, equity will look at their own NPV, which would be (50%)\*(+\$400) + (50%)\*(-\$200) = +\$100, and they will accept. This is a classic, "heads equity wins, tails debt loses" scenario. Equity gets the upside, but debt bears part of the losses if the project goes poorly. In this simple example, we see a value destroying project (negative NPV) that is rationally accepted because the debtholders are not protected. There is strong evidence that part of the financial crisis followed this pattern of "heads equity wins, tails debt loses." Too-big-to-fail banks had a lot of financial leverage. The example above was 80% debt / 20% equity. TBTF banks were capitalized more like 97% / 3% (or worse). Smaller regional banks were more like 80% / 20%. It's almost as if the TBTF banks (and their lenders) "knew" that there would be a government (taxpayer funded) bail out if things went awry, and guess what? It happened. These TBTF banks took on substantial risks where the upside would go to shareholders, but the debt (backstopped by the taxpayers) would bear the burden of the downside. The smaller regional banks (and their lenders) likely knew that they would not be bailed out, and the market didn't feel comfortable with these banks having such high financial leverage. We discussed the most prevalent method of resolving the shareholder-bondholder conflict -- contracts! You may have seen debt contracts before -- they are thick. Oftentimes, these contracts include items called covenants. Positive covenants typically refer to clauses that require a company to take specific actions, like provide audited financials, supply monthly maintenance reports, keep insurance, etc. Negative (restrictive) covenants place limits or thresholds on the company's operations. For instance, a firm must keep their EBITDA / Interest expense above a certain ratio, LTD / Assets below a certain value, cannot spend over \$X on capex initiatives, cannot payout more than \$Y in dividends, etc. There may be some clauses that require a firm to keep certain key employees (or have life insurance on them). Most contracts include a "change in control" clause, where if there is a material change in the control of the firm, then a covenant is "tripped" ("breached" or "violated" are also common terms in industry). There are many types of covenants, many of which are industry-specific, that can help bondholders protect themselves. But, keep in mind that contractual protections are only as strong as the legal environment. If contracts are not enforceable, then we often see less lending in general, because it's more difficult for bondholders to protect their interests. Why do bondholders demand these contracts (with covenants)? Remember, they have no operating control and they worry about the downside. They prefer to know *beforehand* if a firm is at risk of default. If a firm "trips" a covenant, then the bondholders typically get a "seat at the table," meaning that they receive some more operational involvement. These are called "technical defaults," which differ from actual defaults in that the firm is typically still paying their debts when they become due. Like I said, the bondholders want to get a seat at the table before the firm actually defaults. At FTI, I worked on a few projects that went like this: A firm hit some financial trouble and violated a debt covenant. The bank had the right to demand all of its capital back, but the company didn't have that much cash on hand (they used the capital). The bank doesn't really want to throw the company into BK (it's very costly, and the company is continuing to pay interest payments), so they hire experts (FTI) to dig into the operational aspects of the company. FTI would advise our client (the bank) as to whether they should work with the company or not. So, when I would work with these firms, I was always working directly with the CEO's and CFO's, as these were stressful times for the company. Talk about learning through a firehose -- this was my life at FTI, and it was fun! Going back to the simple example above, if the debtholders had a Debt / Value covenant limiting the company to be below a certain percentage, then the negative NPV project would not have been undertaken. If the debtholders had a capex-type covenant limiting the amount of investment into a risky project, then the negative NPV project would not have been undertaken. If the firm was in technical default, then the bondholders would typically have veto power on the shareholders taking the project (and would exercise that veto power). Sometimes students ask if debtholders always stop a firm from doing something that's within their rights, like spending large capital expenditures. Of course not. Covenants give the lenders a seat at the table, so if the large capex is beneficial to overall value and does not put the lenders in a worse position, then they often greenlight the spend. I believe that classrooms underemphasize the role of debt in the capital structure. Many of you will witness debtholder-firm interactions and how firm behavior changes due to lenders. Hopefully these brief notes give you a little more understanding of debt in general, and also the potential conflicts and the market "fixes" with contracts. ***Inefficient Capital Markets*:** We discussed how Traditional Corporate Finance theories typically assume that markets are efficient. In this class (and in general), you can think of an efficient market as being one in which prices reflect true value. Remember, we often don't know the true value of an asset. Prices are merely a signal of value, and we take the price signal and then infer the asset's true value. If markets are efficient, then prices are good signals. If markets are inefficient, then prices provide noisy signals. The concept of market efficiency is two-pronged as it relates to traditional corporate finance assumptions. First, we assume that managers disclose relevant and material information truthfully and timely. Second, we assume that the market is not irrational in the sense that if firm value increases (decreases), then the market appropriately adjusts prices to reflect the value increase (decrease). Students seem to quickly understand the need for managers to be truthful and release information quickly. Students seem to have not been previously introduced to the concept that managers also desire a rational market for prices, such that they can make better future decisions. We know that markets can be inefficient. Managers might provide misleading information (or "spin") to cover for bad news. There is evidence that managers tend to disclose more bad news on Fridays than on other days of the week. I doubt that bad news knows what day of the week it is, so this implies that some managers delay information until right before the weekend. We have also seen instances of outright fraud (Enron, Theranos, Worldcom, Tyco, etc.). What are the "fixes" that help keep management from being bad actors here? Well, the market tends to punish firms' stocks harshly. When prices decline heavily, it attracts potential buyers (market for corporate control), might attract enough scrutiny to fire management, might affect managers' pocketbooks if they have equity-based compensation and/or could spark investor lawsuits (among others). Jail time, loss of reputation, loss of business relationships (customers, employees, vendors, etc. don't want to work with bad actors) and other ramifications can prove costly. These don't solve all of the misinformation issues, but the threat of them can curtail some bad behaviors. Now, let's discuss some problems for the managers if the market is "irrational," meaning that the market might over or under react to news. In this case, the market is not efficient, as prices do not necessarily reflect true value. Remember, prices are merely signals, and we rely on the collective knowledge of the market to provide a strong signal. If the markets are efficient, then if management makes a value-destroying (value-enhancing) decision, then the stock price should decline (increase). What happens when a market is inefficient? Well, sometimes, a good decision can result in a stock price decrease, and a bad decision can result in a stock price increase -- prices are noisy signals. This can mislead managers who rely on market reactions to help guide future decisions. For instance, let's say a manager makes a bad (value-destroying) decision, but the stock price goes up. The manager might be encouraged to continue making bad decisions, which will ultimately destroy value in the long run. On the flipside, if a manager makes a good choice, but the stock price declines, then the manager might be encouraged to stop making similar decisions. Both of these can be bad. How might managers be able to "fix" a noisy stock price signal when using it to help guide future decisions? Well, just like anything else when trying to find a more precise estimate, we need to gather more (good) data. One way is to look "out the window" and identify similar decisions made by other public firms and view their stock price reactions. Let's say that out of ten similar decisions, eight of them resulted in positive stock returns, while two did not. Perhaps the manager can see that as a "good decision," and feel more comfortable moving forward. We can also "look in the mirror" and look at our own similar decisions. If we see that three times a similar choice resulted in higher stock returns, and nine times the stock price declined, then we might want to reconsider (or perform additional analyses) the decision. Another way that we can gather more information is by looking at accounting or other data. Instead of looking at equity prices, we can look at an intermediary objective function, like maximizing revenue, maximizing market share, maximizing customer satisfaction, etc. These alternate objective functions are fine if they *correlate with firm value*. This is extremely important! I've worked with people who pitch an investment to improve "click throughs" or something else. When I asked how that translates to increasing value, they sometimes mumble something that is partly incoherent, or wave their hands, or talk really loudly to seem authoritative (yes, I'm talking from experience here). What I'm saying is that without a decent mapping to increasing value, these intermediary objective functions can be dangerous. As an example, American Airlines decided that their objective function was to maximize domestic market share in the 1980's. They won -- they achieved the largest U.S. market share. But, they were also forced into bankruptcy. Clearly, their alternative objective function did not increase value. I hope that this brief description of inefficient markets and their effects on traditional corporate finance is a bit different than what you have already learned. When I entered the "real world," I did not think of prices as signals of true value. We never really know what the true value of an asset is, but we gather data (often prices) to give us a better sense of value. When markets are inefficient, the price signal is noisy. Therefore, people don't trust prices as much, which can have a profound effect on decision making. If we think about the market method of valuation, it relies on a relatively efficient market, as we are using pricing data from other assets to "infer" a value of our asset. Further, most fundamental concepts of corporate finance assume rational market participants. If you think about it, if you assume people are irrational, you can pretty much "prove" anything that you want. I assume that people are irrational, so I "prove" that the world is flat -- give me the Nobel Prize please... Likewise, most (if not all) risk-return models assume rational market participants. So, any sort of discount rate estimate largely stems from models that rely on market efficiency. ***Firm-Society Conflicts*:** Personally, I find that firm-society issues are quite interesting. There is no way to incorporate all important concepts in these short notes, but I'll try to include some that relate to the NPV Rule and traditional corporate finance. Students typically understand that firms can exploit public goods for the firm's benefit, and society's loss. For instance, if a firm can cut costs by polluting, then this can enhance firm value by lowering expenses and thus increasing cash flows. However, society bears the costs. We hear about these complaints all of the time. However, we must also be mindful that firms often create positive externalities. For instance, they may revitalize beaten-down areas of town. They create employment and wealth, and most obviously, they can create a "consumer surplus" where consumers are happier with their products and services in excess of the prices that they paid. In theory, all of these "bads" and "goods" can be traced back to the firm. So, if a firm pollutes or creates a lot of unwanted noise, then society can "charge that back" to the firm in some way. Alternatively, if a firm creates a lot of extra benefits (like revitalizing a part of town), then in theory, the firm would see some of those benefits. We know that properly tracing these "bads" and "goods" is difficult, if not impossible. Fundamentally, these societal costs (for brevity, I will term them "costs," but we can always think of benefits -- like negative costs, as well) can be extremely difficult to quantify. They often affect people differently. Additional noise might not bother me, but it might aggravate someone else. Increased traffic might annoy me if I drive during rush hour, but not if I travel during different times. I think that you get the point, but different decision-makers will value these costs differently, and therefore assign varying values in their analyses. Additionally, you can't know the unknown -- a firm may think that it is providing a product that enhances society, but then, perhaps decades later, discovers that the product has substantial societal costs. I mentioned asbestos in the slide deck. This was a phenomenal product when developed, but we now know that serious health problems can arise from its use. There are countless examples of products having good intentions only to later find out that they caused harm. Unfortunately, without a crystal ball, if we carry these concerns to their extremes, then managers might suffer from "paralysis by analysis." The uncertainty of possible future costs can stifle innovation and strip society of potentially great products and solutions. I mean, what if in thirty years, we find out that staring at computer screens while on Zoom correlates (or "causes") retinal detachments? Should Apple, Dell and Microsoft have tested rats for decades before introducing laptops? Think about the negative effects on productivity and consumer happiness that would have happened if they did. Ultimately, it's a tough trade-off, and firms must do their best with imperfect information. Recently, the firm-society conflict was highlighted in Amazon's proposed HQ2 in Long Island City, NY. Most people didn't frame it this way (of course, it turned political), but it's the correct way to think about it. The controversy stemmed from the sizable tax subsidy, with many people opposing such incentives to a highly profitable firm. Others supported the move, as the headquarters would provide high paying jobs, new opportunities and increased income tax revenue. Opponents also contended that increased rent prices and strains on public transit would be "bads." Supporters said that the additional commerce would boost the local restaurants, "Mom & Pop" shops and revitalize the area. There was a lot of back and forth. Some people tried to quantify the costs and benefits of Amazon moving into the area, which is a good exercise, but again, the costs and benefits are in the eyes of the beholders. When you see something like this (perhaps a similar controversy), I hope that our brief discussion comes to mind. Can we trace some of the costs and benefits back to the firm? If so, then perhaps we can include them in our calculus. I like to ask the class a question related to firms and society. Assume that you work for a large, profitable company and that you have an opportunity to open a store in an inner-city neighborhood. The store is expected to lose about \$1 million per year forever, but it will create much-needed employment and may help revitalize the area. Would you open the store? If yes, would you tell your stockholders and let them vote on the issue? If no, how would you respond to a stockholder query on why you were not living up to your social responsibilities? I like these questions, because there are no "right answers," and I like hearing the class discussion. In my experience, some students (less than 25% - remember, they are in a finance class) say that they would open the store. When I ask them why, they generally say something related to the "positive press" generated from the decision. So, many of them tend to think of this cost as a marketing type spend, or perhaps a culture boost expense or something. They are thinking of the perpetual million-dollar losses as an investment. This is fine, but what if these benefits were already baked into the NPV analysis? I mostly get shrugs after that question. Some students just say that they would open the store because it's a "good thing to do." That's cool. Would you tell shareholders and let them vote? Most say yes. I've only had one student (out of over 1,000) say that he wouldn't tell shareholders. I asked why, and he said that he would just open the store on his authority. I asked if that was because it would make him feel good, even at the expense of shareholders, and he said yeah, probably (classic agency conflict). Most students say that they would not open the store, but they have difficulty communicating how they would respond to questions related to them not living up to their "social responsibilities." A decent response to this would be that if the cost is truly like a "charity" (not a positive NPV investment), then why should a firm decide on the charity with the shareholders' money? The shareholders can give to charity on their own and choose the charity that they like. Why should the firm decide unilaterally for them? Students typically understand what I'm getting at when asking these questions, but we can go further. What if the firm has special competencies that would allow it to "stretch a dollar" in ways that shareholders cannot? For instance, if a company can exploit efficiencies and turn \$1 into the equivalent of \$2 of charitable donations (perhaps with superior distribution, brand cache, customer lists, etc.), then it might make sense that the firm moves forward with the "charity" (while still asking for a shareholder vote). I have found that this is a good way to communicate "social responsibilities" like the example above (not all social responsibilities). If the firm is more efficient at social giving than the sum of individuals, then there might be a good argument for it. On the other hand, if the firm is merely "writing checks" and not providing additional value compared to the sum of the individuals, then it might not make much sense (unless shareholders approve). You might notice that if the social benefits of the "charity" in this case (revitalizing the inner-city neighborhood) were properly traced back to the firm (perhaps with tax breaks), then the store might be NPV positive for the firm (and therefore opened), and this whole discussion would have been moot. We've discussed several problems, but what about the "market's" solutions? Typically, we think about government and regulations helping with negative externalities. We know that regulations, while sometimes necessary, often have unintended consequences. Of course, the legal system can help with lawsuits aimed at holding the firm accountable, which can be quite expensive. There are several other possible "fixes." If we think of other stakeholders in the company, we might think that investors, employees, customers and vendors don't want to work with social outlaws. This can put a strain on the company. Many investors steer clear from "socially irresponsible" firms -- there are funds with specific restrictions on gambling, alcohol, tobacco and other investments (I'm not saying that these are necessarily "socially irresponsible" industries, but some investors believe so). Additionally, in times when stories are increasingly able to go "viral," firms may fear stakeholder backlash and the associated value destruction. So, even if firms can find ways to skirt laws and regulations, they might find it more difficult to defend against the dissemination of negative information of them being bad actors. While none of these resolutions are necessarily perfect, they can create barriers for firms contemplating taking good projects for them, but bad projects for society at large. I hope that these quickly written notes help round out your understanding of some of these topics. As future managers, you will come into direct contact with many of these issues. It will be your responsibility to identify, address and hopefully resolve (as much as you can) these conflicts before working through the investment decision / valuation. If these problems persist, you might find some positive NPV projects being rejected and/or negative NPV projects undertaken. Many peculiar accept / reject decisions can be mapped back to the fundamental assumptions in any NPV analysis, and unfortunately, I find that textbooks and many classrooms do not emphasize the importance of these conflicts in this setting. Importantly, you should know a) what is assumed in a traditional NPV analysis, b) what can go wrong, and c) how can the issues get mitigated or fixed? To the extent that you understand these items well, you will shine relative to your colleagues and potentially create a lot of value (or warn others about potential value destruction) in your company.