principles_of_corporate_finance_unit_i_lectures.pdf

Shareholders vs Managers MM Assumptions 1. Investment is held constant 2. No transaction costs 3. No taxes 4. No bankruptcy costs 5. Efficient capital markets 6. Managers maximise shareholders’ wealth Agency Conflict: Managers vs Shareholders • A key feature of large public corporations is the s...

Shareholders vs Managers MM Assumptions 1. Investment is held constant 2. No transaction costs 3. No taxes 4. No bankruptcy costs 5. Efficient capital markets 6. Managers maximise shareholders’ wealth Agency Conflict: Managers vs Shareholders • A key feature of large public corporations is the separation between ownership and control. • Managers have direct control over day-to-day operations but they do not have much equity. • Most outside equity holders do not run the firm. • This feature can create conflicts of interest between managers and other equity holders. • Agency problem: Managers may be self-interested and exploit equity investors. Agency Problem Example: Corporate Jets • Consider the use of a corporate jet. • Suppose the benefit of a corporate jet is $100K to you. • The jet’s purchase price is $15 million. • Would you buy the jet if you hold: • 0.25% of the company? • 100% of the company? Agency Problem Example: Corporate Jets (cont.) CEO’s Equity Stake NPV of Jet Purchase CEO’s Personal Valuation of Jet Cost to CEO Purchase Jet? Firm A .25% -$15 Million $100 K $37,500 Yes Firm B 100% -$15 Million $100 K $15 Million No Agency Problem: Intuition • Managers are self-interested. • They only bear a small cost (proportional to their ownership). • But they enjoy the full benefit. • One solution: align managers’ incentives with interests of shareholders. • Extreme case: let the manager(s) own the entire firm. • Use high-powered incentive contracts, eg, options. • This is not a silver bullet: short-termism, excessive risk-taking. • Another option? Debt! The End Agency Costs of Outside Equity Agency Costs of Outside Equity • Also known as the “effort problem” in Jensen and Meckling (1976) • Conflict of interest between inside and outside equity holders • Inside: Entrepreneur/managers (day-to-day control) • Outside: all other equity-holders (passive) • More outside equity reduces the incentive for managers to exert effort, reducing firm value • This misalignment in managerial incentives is less likely to occur when financing with debt A Simple Example • An entrepreneur-manager needs $120 of external financing for a new project today (t = 0). She owns 100% of the firm, which has no resources of its own. • The project’s cash flow (t = 2) will either be $180 or $80. • The likelihood of success depends on how much effort the manager chooses to exert (t = 1). The probability of success is 80% if the entrepreneur “works” (high effort), but only 20% if she “shirks” (low/no effort). • The manager incurs a private cost of high effort, κ = $25. • Assume risk-neutrality and a zero discount rate. Interpreting the Cost of Effort • The entrepreneur divides her time and energy between activities generating: • Financial returns shared by all investors in the firm • And private benefits for the entrepreneur only • κ is an opportunity cost • Effort is efficient ⇔ Private benefits are inefficient Example: Timeline Financing and investment t =0 Effort choice Outcome t =1 t =2 Investors cannot control or observe the manager’s choice of effort. Example Note that: • The project is positive NPV if the manager works, even if we include the cost of high effort. 25 = 15 (0.8 × 180 + 0.2 × 80) − 120 − |{z} | {z } 160 κ • The project is negative NPV if the manager shirks. (0.2 × 180 + 0.8 × 80) − 120 = −20 | {z 100 } • High effort is efficient: marginal benefit (60) > cost of effort (25). Example: Equity Financing • In exchange for providing 120, outside investors demand an equity stake α. • If outside investors believe the entrepreneur will choose to exert high effort, they break even if: α160 = 120 ⇒ α = 75% • Entrepreneur retains (1 − α) = 25%. • But will the entrepreneur choose to work hard under these terms? Example: Equity Financing (cont.) • The entrepreneur works hard if: (1 − α)160 − κ ≥ (1 − α)100 ⇔ (1 − α)(160 − 100) ≥ κ • To induce high effort, the stake retained by the entrepreneur would have to be at least: 25 κ = = 41.67% (1 − α) = 160 − 100 60 • Under the terms where outside investors break even (which assumes high effort), the entrepreneur prefers to shirk! • But if the entrepreneur shirks, outside investors will never break even (project is negative NPV). • Equity financing is impossible! Example: Debt Financing How about debt financing? • Assuming the entrepreneur works hard, debt holders will demand a minimum face value F , such that: 0.8 × F + 0.2 × 80 = 120 ⇒ F = 130 • When will the entrepreneur work hard? 0.8 × (180 − F ) − 25 ≥ 0.2 × (180 − F ) ⇒ F ≤ 138.33 • When F = 130, investors break even and the entrepreneur works hard. Debt financing is feasible! Intuition • To create value, managers must exert effort. • Managers bear the full cost of effort supply, but the benefits of these efforts are shared with outside equity-holders. • Increasing the proportion of equity held by outsiders means fewer benefits accrue to managers, thereby reducing their incentive to exert effort and increasing their incentive to divert funds and receive perquisites. • More outside equity results in a lower firm value. • The fraction of the return from effort that accrues to managers is larger with debt financing than equity. Hence, debt maximises the incentive to exert effort. • Implication: a leveraged recapitalisation can be value-enhancing even in the absence of taxes. The End Debt and the Free Cash Flow Problem Source of the Problem • What kind of companies are more likely to suffer from the agency problem? • Free cash flow: cash flow in excess of amount needed to fund all positive NPV projects. • FCF should be paid out to investors. • FCF can potentially be wasted by managers on personal perks or vanity projects. • This agency problem is also referred to as the “agency cost of free cash flow”. Solution to the Problem • Dividends and repurchases could work but are imperfect • Debt is a legal commitment to pay out cash flow • A company carrying debt will have less free cash flow to waste. • If the company goes bankrupt, the manager will often be fired; therefore, debt obligations can act as a disciplining mechanism • Managers work harder and often smarter in companies with large debt since they need to generate cash for debt service, eg, LBO/private equity. • Implications for capital structure • Optimal debt levels would leave just enough cash in the bank, after debt service, to finance all positive-NPV projects. The End Financing and Information Asymmetry MM Assumptions 1. Investment is held constant 2. No transaction costs 3. No taxes 4. No bankruptcy costs 5. Efficient capital markets 6. Managers maximise shareholders’ wealth Signalling • Asymmetric information: one party to a transaction has more/better information than the other • Managers know more about their companies’ prospects, risks, and values than do outside investors. • The actions of the better informed party can help the uninformed party infer the informed party’s private information → ‘signalling’ • The actions of managers can act as signals, causing the market (ie, investors) to react • Remember, stock prices tend to rise on the announcement of an increase in the regular dividend as investors interpret this as a credible sign of management’s confidence in future earnings. • Capital structure decisions can be a signal too The End Adverse Selection in Financing Signalling Implications: Theory Outline: Myers and Majluf (1984) • Benchmark case: managerial decisions under symmetric information • Asymmetric case: managers have relevant information before other investors and prior to making investment and financing decisions Myers and Majluf (1984) Example: Set-up A firm with some assets in place is considering a positive NPV project. This project will require an investment of 100 cash. Assumptions • The firm does not have this cash and can only issue equity. • There are no taxes, transactions costs or other market imperfections. • Managers maximise the wealth of the old (ie, current) shareholders. • Old shareholders do not purchase the new stock issue. Example: Deterministic Benchmark Case Benchmark case (deterministic, symmetric) As a warm-up, assume no uncertainty and everyone is equally informed. The firm’s assets in place are worth 150 and the project has NPV = 20. How much equity, as fraction of the new company, does the firm need to sell? • Firm value after issue: Vfirm = 150 (Existing assets) + 100 (New equity) + 20 (NPV) = 270 • Need to raise 100, so sell (100/270) ≈ 37% of new firm’s equity • Ownership after issuance: new shareholders – 37%; old – 63% • Pay-offs: • New: 37% × 270 = 100 (they break even, ie, fair value) • Old: 63% × 270 = 170 = 150 + 20 (old shareholders capture the project NPV) Example: Uncertain Benchmark Case Benchmark case (uncertain, symmetric) Now assume that asset values and NPV are uncertain (ie, random) but everyone is still equally informed (or uninformed). There are two possibilities, both equally likely. Assets in place Investment opportunity (NPV) Value of firm post-issue State 1 (good) State 2 (bad) E (value) 150 50 100 20 10 15 (= 120 − 100) (= 110 − 100) (115 − 100) 270 160 215 Since the expected NPV is positive, the investment should be taken in both states. Example: Uncertain Benchmark Case (cont.) How much equity should be issued? • Since no one knows the true state, valuation is based on expected values • Expected value of the firm after issuance is 215 • To raise 100, sell (100/215) ≈ 46.5% of new firm’s equity • Old shareholders retain 53.5% • Pay-offs: • New: 46.5% × 215 = 100 (fair value) • Old: 53.5% × 215 = 115 = 100 + 15 (ie, old shareholders capture the expected value of the existing assets and NPV) • Even with uncertainty, positive NPV projects are implemented and financial markets are efficient (securities purchases are zero NPV) Example: Asymmetric Information Case, Part I Asymmetric case (uncertain, asymmetric) Now introduce asymmetric information. • Managers know the true state before the investing and financing decision is taken. • Outside investors do not know the true state, but know that managers know. Remember: Managers act optimally to maximise the wealth of old shareholders (outside investors know this too). Example: Asymmetric Information Case, Part II Suppose managers issue stock and undertake the project regardless of the true state. • New investors cannot learn anything from this strategy, so will price by expectation (same as previous case) • Expected firm value: 215 • Ownership structure: new – 46.5%; old – 53.5% • What is the payoff to old shareholders under this strategy? • State 1 (good): 53.5% × 270 ≈ 144 • State 2 (bad): 53.5% × 160 ≈ 86 Example: Asymmetric Information Case, Part III • Compare these pay-offs to the alternative where managers do nothing (ie, do not raise equity to invest in the project). Issue equity Do nothing State 1 (good) State 2 (bad) 144 150 86 50 • Managers acting optimally will not issue and invest in State 1! Old shareholders’ wealth is maximised by issuing stock and investing only in State 2. • So, if the firm announces a share issue, outside investors learn that it must be State 2! • Outside investors will revise their post-issue valuation of the company down to 160 (State 2 value) and demand a (100/160) = 62.5% stake in the company’s equity. Example: Asymmetric Information Case, Part IV • We still need to check if managers have the incentive to issue stock once investors figure out it is State 2 • Old shareholders: 37.5% × 160 = 60 > 50 (do nothing) → Yes! • Also need to check that managers would not issue in State 1 under these terms • Old shareholders: 37.5% × 270 = 101.25 < 150 → Don’t issue! Equilibrium outcome • If State 1: no issuance • Old shareholders worth 150 • If State 2: sell 62.5% of company priced at 160 • Old shareholders worth 60 • Expected wealth of old shareholders: (150 + 60)/2 = 105 < 115 (symmetric case with uncertainty) • Loss = 10 = 20 × 0.5, ie, the NPV = 20 project in State 1 that is foregone (50% probability) Example: Conclusions • Under symmetric information, regardless of risk • All positive NPV projects can be implemented. • When uncertainty is realised, old shareholders may win or lose, but there is no efficiency loss. They get the full NPV in expectation. • Under asymmetric information • Investors cannot tell the quality of the firm. • Pooling together with bad firms gives a low price for good firms. • This can create an adverse selection problem: when quality is unobserved, only poor quality goods are sold. In this example, only bad firms issue equity. • Efficiency loss: Good firms with positive NPV projects cannot be financed. Potential Solutions: Retained Earnings or Debt • Cash on hand: Retained earnings are cheaper than external financing because then the firm is not forced to forego positive NPV projects. • Risk-free debt: Suppose the company borrowed 100 risk-free to fund the project (zero discount rate). • • • • • Borrow 100, pay back 100 State 1 shareholder pay-off: 270 − 100 = 170 > 150 State 2 shareholder pay-off: 160 − 100 = 60 > 50 In both states, the firm has the incentive to borrow and invest in the project Intuition: the value of debt is less sensitive to private information than equity The End Signalling: Empirical Evidence Evidence: Equity Issues Asquith and Mullins (1986) performed an event study on the announcement of both primary and secondary issues (ie, sale) of stock. • A primary offering is when a firm issues stock. • The number of shares, the total value of equity, and the total value of the firm increases. • A secondary offering is when a shareholder sells a large block of stock to another shareholder. • The firm is not involved in this transaction, so there is no change in the number of shares. Empirical Evidence: Results All Issues Primary Secondary Day before announcement -1.8% -2.3% -1.0% Announcement Day -0.9% -0.7% -1.0% Two day return -2.7% -3.0% -2.0% T-statistic 14.8 12.5 9.1 N observations 266 128 85 Empirical Evidence: Conclusions • Problem: Is the −3% primary issue price fall due to the revelation of negative information or other effects related to changes in capital structure? • Solution: Look at secondary issues, which do not impact the capital structure. • The −2% drop in price is most likely due to the negative information conveyed by the transaction. • Conclusion: At most 1% of the primary issue price change is attributable to capital structure changes. The rest must be due to signalling. • Signalling: A large sell order tells the market that the seller has some negative private information about the company. The End Pecking Order Theory Pecking Order Theory • Pecking order theory: when financing projects, firms prefer to use the least information-sensitive securities first • Logic: if the value of a security depends a lot on your private information, it suffers from adverse selection problems; the issue of securities is a signal that those securities are overpriced • Pecking order 1. Least sensitive: retained earnings (cash), risk-free debt 2. Median: risky debt 3. Most sensitive: equity Pecking Order Theory (cont.) Aggregate sources of funding for CAPEX, US corporations 1 1 Berk and DeMarzo The End