FIN 562

1. FIN 562 Intermediate Financial Management (catalog name) “Real” Name: Topics in Corporate Finance Prof. Daniel A. Rogers, PhD

2. Key Points of Syllabus • Objective • Format • Materials • Workload

3. Course Objective • Provide more breadth and depth to your understanding of corporate finance • Enable you to become a “user” of research in financial economics by developing your ability to “think about conceptual issues.”

4. Course Format • Seminar • Discussion of research • Focus on “practical” issues • View from senior financial executive perspective • Prepare you for “big picture” issues to be faced as career progresses • Preparation is crucial

5. Course Materials • Background and reference: FIN 551/561 textbook. • Almost all articles available through PSU library electronic resources. • Notes/Supplements available on my website. • Suggested: student subscription to Journal of Applied Corporate Finance (JACF).

6. Course Workload • A lot of reading (and some writing)! • Class participation (35%) • Exec summaries of selected research papers (3) – (30%) • Research project (35%)

7. Course Overview • What are the consequences for analyzing corporate finance decisions in an environment characterized by “imperfect” markets? • Topics considered: • Agency Problems • Capital structure • Payout policy

8. Course Overview – Topics (cont’d) • Basics of option valuation • Executive & employee compensation • Managerial incentives • Corporate governance • Ownership structure and its effect on firm performance • Hedging/risk management • M&A and the diversification discount • Discussion of how the current financial situation is related to many of the issues discussed during the course!

9. Fundamental Question of Corporate Finance • How do corporate financing decisions affect firm value? • Already know that proper investment decisions (i.e., positive NPV) have first-order effect. • Corporate financing decisions = capital structure, payout, risk mgt, compensation & exec ownership policy, etc. • Is there a framework for analyzing?

10. Birth of Modern Corporate Finance (Miller and Modigliani) • Perfect Capital Market Assumptions • No taxes or transaction costs (frictionless markets) • Information symmetry (homogeneous expectations) • No “big” market participants (atomistic) • Investment plans of firms are fixed and known • Capital structures of firms are fixed

11. The Primary Lesson of M&M • In an environment of perfect capital markets, corporate financial policies (i.e., capital structure decisions, payout policy, compensation decisions, hedging decisions, etc.) have NO effect on firm value. • THEN, why do senior finance execs spend so much time & effort worrying about these issues?

12. Because Capital Markets Are Not Perfect • “Real-world” violations of perfect capital market assumptions: • Frictionless markets • Existence of corporate and personal taxes. • Variation of tax rates across investors (and firms). • Existence of transactions costs. • Differences in transaction costs across investors (and firms). • Homogeneous expectations • Competing interests with claims on firm’s assets (shareholders, managers, lower-level employees, debtholders, government, etc.)  Information asymmetry  creates environment for existence of agency costs. • Atomistic market participants • Dominant investor (including the firm) may influence market value.

13. Real-world violations of PCM assumptions • Fixed investment programs • Protection of “strategic” information from competition precludes firm’s managers from sharing information regarding future investment. • If firm has risky debt, shareholders may choose to deviate from “optimal” amount of investment (underinvestment/overinvestment). • Fixed financing programs • Shareholders have incentives to increase equity value  includes altering capital structure to make themselves better off at the expense of creditors. • Obviously, many “problems” are created by separation of firm into differing “agency” classes (shareholders, managers, creditors). There must be benefits, RIGHT?!

14. Benefits of Separation of Ownership & Control • Allows manager to diversify holdings. • Lowers manager’s risk. • Allows for secondary market for ownership claims on the firm. • Increased liquidity of firm’s shares translates to higher market value.

15. Firm as a “Nexus of Contracts” • In environment of perfect markets, objective is “maximize firm value.” • Jensen and Meckling (1976) highlight a broader notion of “ownership structure” with various stakeholder groups: insider owners, outside shareholders, creditors, government. • Example: insider owner gains utility from consuming assets of the firm for personal utility gain (to the detriment of outside shareholders). • Creates need for contracting: incentive-based compensation contract. Goal: provide incentives for insider owner to maximize equity value.

16. Agency Costs • Costs borne because contracting parties act in own self-interest to the detriment of overall firm value. • Agency costs are the sum of: • Monitoring costs • Bonding costs • Residual loss • These reflect the trade-off between maximizing the objectives of contracting parties. • The practical nature of most contracting problems in corporate finance is to design solutions that minimize the agency costs.

17. A Simple Example • Suppose I own a building (owner = principal) • I hire you to manage my building (i.e., find tenants, collect rent, maintain structure, etc.) (manager = agent) • As manager, you have incentives to take actions that may not be in my best interest (i.e., use “prime” rental space for your office, etc.) • I must expend time and effort to ensure that you do not do things that make me worse off. • Because of such monitoring costs, the value I receive from my ownership of the building may be lower than if I managed it myself. • I have to view this economic loss against benefits obtained by freeing up most of my time!

18. Some Examples Highlighting Agency Costs of Managerial Discretion • Perquisite consumption • Manipulation of financial statements • Empire building • Excess diversification • Lack of long-term focus • Underutilization of debt • Managerial entrenchment & board appointments • Basic point: execs like more compensation and/or lower firm-specific risk.

19. Agency costs of debt • Given agency costs associated with separation of ownership and control, why don’t we observe firms owned by a manager with the remainder of capital supplied by fixed claimants? • Incentive effects associated with debt • Monitoring costs created by manager’s incentives • Bankruptcy costs

20. Manager’s incentives • Equity = call option when firm is levered. • Call option’s value increases at higher levels of volatility. • Thus, manager’s incentives are to invest in projects with more risk (NOTE: not unlimited…why not?). • This incentive would hurt bondholders  negatively affects how much they will pay for bonds. • This value reduction is one source of agency costs of debt.

21. Monitoring, bonding, and bankruptcy costs • Monitoring • Financial covenants • Bonding • Audited financial statements • Bankruptcy costs

22. Jensen and Meckling’s Theory of Ownership Structure • When deciding how much outside equity and debt, owner-manager trades off agency costs of outside equity vs. debt. • When deciding how much outside capital to issue, owner-manager takes into account additional agency costs borne by issuing additional outside capital relative to her need for additional financing.

23. Another agency cost of debt – Underinvestment • According to Jensen and Meckling, issuing outside capital to fixed claimants may cause investors to invest in overly risky projects. This is commonly called the “overinvestment” problem. • Myers (1977) illustrates that shareholders requiring debt financing to fund a positive NPV project may reject it because too much of the project’s value is captured by the creditors.

24. So, what’s the point? • We can use “agency” cost arguments as a major point in analyzing many corporate financing decisions. Examples include: • Capital structure (week 2). • Payout policy (week 3). • Executive compensation (week 4). • Managerial ownership and firm performance (week 6). • Risk management (weeks 7 & 8). • M&A / corporate diversification (week 9).

25. Some important questions – background from Jensen (2001) • Does shareholder value maximization mean “taking advantage” of other stakeholders? • Are stockholders and stakeholders “opponents?” • Should value maximization be the “goal” of corporations? • Question 1: Why are we in business? • Follow-up question: How do we determine success? • Does maximizing corporate value maximize social welfare? • Externalities • Role of governments • Do managers REALLY prefer stakeholder theory? • What does “long-term” market value mean?