Chapter 1

INTRODUCTION

Alex Tajirian

Introduction

1-2

1. ISSUES IN CHAPTER 1
! ! ! ! What are the different legal forms of for-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/or should happen to you?

2. CHAPTER OUTLINE
2.1 TYPES OF OWNERSHIP advantages & disadvantages 2.2 WHAT "SHOULD" THE OBJECTIVE OF A MANAGER BE? why, how, problems?

morevalue.com, 1997

Alex Tajirian

Introduction

1-3

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

morevalue.com, 1997

Alex Tajirian

Introduction

1-4

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.

morevalue.com, 1997

Alex Tajirian

Introduction

1-5

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, elect board of directors1. Board members are expected to oversee the proper running of the company. Board of directors appoints managers, generally different from owners, and is expected to ensure that managers act in the best interest of shareholders.

Advantages (
! ! ! ! unlimited life easy transfer of ownership; just call your broker limited liability; maximum loss is your investment in company Easier to raise capital; more info is publicly available on company

Disadvantages
! !

double taxation: corporate earnings & dividend received increase in Securities and Exchange Commission (SEC) regulation and reporting.
morevalue.com, 1997

Alex Tajirian

Introduction

1-6

CORPORATE ORGANIZATION
Shareholders Elect

BOARD OF DIRECTORS
Owners Managers
morevalue.com, 1997

Appoint

CEO
Alex Tajirian

Introduction

1-7

ORGANIZATIONAL FORMS
PROPORTIONS SALES DOLLAR

Proprietorship 71% 20% 9% Partnerships Corporations

Corporations 90% Proprietorship 6% 4%

Partnerships

morevalue.com, 1997

Alex Tajirian

Introduction

1-8

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

morevalue.com, 1997

Alex Tajirian

Introduction

1-9

4.2 Maximizing Market Value Comes From: # Making "best use" of existing operations/projects through reengineering 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

morevalue.com, 1997

Alex Tajirian

Introduction

1-10

4.3 MANAGERS WHO DO NOT MEET OBJECTIVE FACE DISCIPLINING FROM:

# Pressure From Within The Company ! threat of being fired by shareholders or board of directors R proxy fight ! compensation: foregone salary increases and bonus compensations

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

morevalue.com, 1997

Alex Tajirian

Introduction

1-11

Sources Outside The Company ! threat of firm being taken-over by another firm through: R hostile takeover by purchasing stock of the target company S on open market S tender offer

Illustration of the threat: Step 1: Suppose a manager is not maximizing the price of the company stock, say, producing inefficiently at a total cost = $30,000. Step 2: Now a new manager, also referred to as corporate raider, buys the company, reduces cost from $30,000 to $20,000. Y An extra value of $10,000 can be created, net of any costs associated with acquiring the company

firm can go bankrupt

In a Nutshell:
The above discussion of shareholder wealth maximization suggests that managers are actually meeting the objective, otherwise they would be out of the job. But are they actually doing it ?!

morevalue.com, 1997

Alex Tajirian

Introduction

1-12

5. PROBLEMS WITH "OUGHT TO" ANALYSIS Motivation:

There is evidence that managers are not maximizing value, yet they are still with the firm and making lots of money. An explanation for this and a solution to the problem is referred to as the 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 look for their own self-interest. Thus, if they are left alone, will not act in the best interest of shareholders Y they need to be monitored and given incentives.

Problem: Shareholders incur costs5 associated with monitoring management behavior. Solution: Principal needs to write a compensation contract6 that specifies the performance expected from the agents, and how it will be measured. One such contract is an executive stock option7.

morevalue.com, 1997

Alex Tajirian

Introduction

1-13

Why does management disciplining fail? ! Myopia is indirectly encouraged8 " management compensation has traditionally been based on short-term performance9 " " short-term job tenure Limited "patient capital"10 (few exceptions like Warren 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 with outsiders. Managers have better access to information about the company than outsiders, including shareholders. Thus, managers and shareholders have asymmetric information. Y Outsiders do not know that managers are not maximizing wealth Y Managers would not necessarily be fired.

morevalue.com, 1997

Alex Tajirian

Introduction

1-14

takeover threat fails " Mechanism itself does not work as supposed to! (Ch ?) Illustration: To takeover another company, raiders have had to pay on average 20% higher price than the preacquisition. Moreover, cost of outside legal and financial advice contribute an additional 2%. Thus, even if managers are maximizing only up to 78% of potential value, there would be no profitable takeover. Thus, bad managers have a cushion equal to about 23% of the maximum potential value of the firm. " Management has developed anti-takeover mechanism such as golden parachutes, poison pills, and greenmail to protect them.13

It is extremely hard to write 100% effective contracts as it requires predicting all possible future outcomes and scenarios.

morevalue.com, 1997

Alex Tajirian

Introduction

1-15

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 price performance rather than a fixed salary.

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

morevalue.com, 1997

Alex Tajirian

Introduction

1-16

6.

Conflict of Interest Between Creditors and Shareholders

it to themselves Y trouble for creditors.

Plausible source: Shareholders borrow $10,000 and distribute 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 to firm; for example, a contract prohibiting any future debt financing, even if debt is desirable!

Lesson: Creditors-shareholders need to design a contract that is

win-win.

; Do Questions: 1-13 (

morevalue.com, 1997

Alex Tajirian

Introduction

1-17

SUMMARY
T

FORMS OF ORGANIZATION
! ! ! Sole Proprietorship Partnership Corporation G Double Taxation G Limited liability G Easier access To Financial Markets

Objective of firm/manager should be to :

Maximize shareholders' wealth ] Maximize price of stock

T T

Objective of manager might be: high pay, prestige, leisure, and high dislike for risk Theoretical justification of should be is:
threat of hostile takeover, bankruptcy, & firing Y manager would lose her job if does not meet objective.

Agency problem has to do with monitoring of management & design of incentives to induce managers to act in the best interest of shareholder. Y ownership does matter

Problems in practice with should be:

G managers have more information about the health and the expected performance of the firm than outsiders do. Managers need not have an incentive to share "bad" information. Anti-takeover techniques: poison pills, greenmail, and golden parachute No core investor to monitor and discipline management Corporate structure has built in biases that encourage short-term management behavior (myopia). Limited patient capital

G G G G

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 best interest of shareholders. This is called the agency issue.
morevalue.com, 1997

Alex Tajirian

Introduction

1-18

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

VOCABULARY sole proprietorship, partnership, corporation, limited liability, raiders, proxy fight, hostile takeover, poison pill, golden parachute, principal-agent.

morevalue.com, 1997

Alex Tajirian

Introduction

1-19

ADDITIONAL SUGGESTED READING

Porter, M. "Capital Disadvantage: America's Failing Capital Investment System," Harvard Business Review. 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.

morevalue.com, 1997

Alex Tajirian

Introduction

1-20

Endnotes
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 Increase profit Limitations 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 longterm; ignores risk; and can be legally manipulated by, say, amortizing advertising expenditure over several years as opposed to expensing them. A practice, though legal, was used by America Online (AOL). Maximizing market share Having a large market share does not necessarily mean that the firm is actually profitable. For instance, a company can capture most of a particular market if it sells the product below cost.

Thus, the objective of a manager is to maximize the wealth of shareholders. But since a shareholders 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 of shareholders. 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 than expected. 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 of failure were outside the control of the manager, can have dire consequences on the managers compensation, and thus, her livelihood.
morevalue.com, 1997

Alex Tajirian

Introduction

1-21

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 an accurate value on this cost! 6. Note that the course is not about designing contract but about why we need to write contracts that 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 comparisons see 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 million shares 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 the profitability of IBM by $1, you would have gotten back only .000168 cents. Therefore, only investors 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.

morevalue.com, 1997

Alex Tajirian

Introduction

1-22

GUIDELINES TO AGREE/DISAGREE-EXPLAIN QUESTIONS Agree 1. From xyz theory 2. From definition of ... 3. from empirical evidence 4. from relationship between variables 5. A combination of above Disagree 1. contradicts ( or no support) xyz theory 2. contradicts definition 3. contradicts empirical evidence 4. wrong causal direction: If x causes y, then y does not necessarily cause x 5. counter example Suppose: if x increases then z increases, and if y increases, then z increases too. However, if z increases does not necessarily mean than x has increased. It could be that y has increased! Note. XYZ does not refer to a specific theory.

morevalue.com, 1997

Alex Tajirian

Introduction

1-23

7. QUESTIONS
Agree/Disagree-Explain ! ! ! 1. 2. 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.

There are no advantages to being incorporated, since a company would be double taxed. We do not see a large number of takeovers, because firms are maximizing shareholders' wealth. Management (CEO) compensation has been effective in disciplining management behavior. The second-hand car market provides a good example of "asymmetric information." The agency problem is a cost to the firm. There can be no conflict of interest between management and shareholders. Raiders are anti-takeover repellents. Maximizing EPS is a sound objective of a firm. Maximizing market share is a sound objective of a firm. Stock price maximization is equivalent to shareholders' wealth maximization. Sole proprietorships have hard time raising capital because they are risky. The purpose of a poison pill is to make a company prohibitively expensive to takeover. Greenmail is blackmail that involves green $.

3. 4. 5. 6. 7. 8. 9. 10. 11.H 12. 13.

morevalue.com, 1997

Alex Tajirian

Introduction

1-24

10. ANSWERS TO QUESTIONS

1. Disagree. The advantages include: easy transferability, limited liability, and easier access to capital markets. Disagree. A takeover is not easy to analyze. Moreover, existence of asymmetric information between managers and outsiders, anti-takeover repellents adopted by management, diminish the frequency of takeovers and managers are not maximizing shareholders' wealth. Disagree. There is evidence that U.S. CEOs are paid too much based on their talent and effort, 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. Agree. There is asymmetric information in such a market. The seller/owner knows more about the car than a potential buyer does. 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. Disagree. Agency problem, which is ....., see p. 12. Disagree. Corporate raiders try to buy companies that seem undervalued. It usually is done through a hostile takeover. 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 is created. Actually a cost is incurred. 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
morevalue.com, 1997

2.

3.

4.

5.

6.

7.

8.

9.

Alex Tajirian

Introduction 10.

1-25

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. Disagree. Even if they are risky, there is an appropriate reward/return for whoever is doing the 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 small companies/investors. Thus, is would be hard for these companies/investors to borrow at a "fair" rate. Agree. This is the purpose of poison pills. Disagree. See definition of greenmail.

11.

12. 13.

morevalue.com, 1997

Alex Tajirian