MBA/MFM 253 Enhancing Firm Value

1. MBA/MFM 253 Enhancing Firm Value

2. The Goal of Corporate Financial Management: Maximizing the Value of the Firm The Big Picture

3. Measuring Firm Value • The firm has many stakeholders – we will focus on four: Shareholders, bondholders, financial markets, and society. • Does an increase in stock price signal an increase in firm value?

4. What Determines Firm Value? Firm and Project Risk Input Costs Industry Economic Environment Financing mix (Debt vs Equity) Other? How do you calculate value?

5. Goal of Financial Management: Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firms projects and the financing mix used to fund the projects.

6. Firm Value and Stock Prices • Is maximizing the value of the firm the same as maximizing the stock price? • Only if maximizing stock price does not have a negative impact on other stakeholders in the firm.

7. The Classical Objective Function STOCKHOLDERS BONDHOLDERS Managers SOCIETY FINANCIAL MARKETS

8. Management and Stockholders • The Principal / Agent Problem • Whenever owners (principals) hire managers (agents) to operate the firm there is a potential conflict of interest. The managers have an incentive to act in their own best interest instead of the shareholders.

9. Management and StockholdersOther Problems • Lack of monitoring by shareholders • Individual shareholders often due not take the time monitor the firm • Lack of independence and expertise on the board. • Small ownership stake of directors • Take over defenses and acquisitions: • Greenmail, Golden Parachutes, and Poison Pills. Overvaluing synergy.

10. Reducing Agency Problems • One way to reduce agency problems is to make management think more like a stockholder. • Offer managers Options and Warrants • Problems – May increase incentive to mislead markets May increase incentive to take on extra risk

11. Reducing Agency Problems • More Effective Board of Directors • Boards have become smaller • Fewer insiders on the board • Increased compensation with options • Nominating committee instead of Chosen by CEO • Sarbanes Oxley and transparency • More active participation by large stockholders – institutional ownership

12. Empirical Evidence on Governance • Gompers, Ishii, and Metrick (2003)* • Developed corporate governance index based on best practices. • Buying stock in firms with high scores for governance and selling those with low scores resulted in large excess returns.

13. Disney Example • Reaction to decline in share price and captive board • Required executive sessions without CEO • New definition of director independence that must be met by a majority of the board • Reduction in committee size and rotation of committee chairs • New provisions for succession planning • Education and training for board members

14. Management and StockholdersBest Case Best Case Managers focus on stock price maximization and therefore the shareholders best interest. Shareholders are not powerless & do a good job of monitoring the firm. They make informed decisions about the board of directors and exercise their voting powers. The board acts independent of the CEO.

15. The Classical Objective Function STOCKHOLDERS Monitor the firm Hire & fire Managers / Board Maximize stockholder wealth BONDHOLDERS Managers SOCIETY FINANCIAL MARKETS

16. Conflicts Between Stockholders and Bondholders • Stock Price maximization may increase risk of default. • Risky projects that increase shareholder returns and increase chance of default • Funding projects with increased debt increasing chance of default. • Paying high dividend, decreasing cash available for interest payments

17. Bond Covenants and Other Solutions • Examples of Covenants • Restrictions on Investment policy • Restrictions on Dividend Policy • Restrictions on Additional Leverage • Problems • May force firm to pass up profitable projects • Bond Innovations – • Puttable bonds and convertible bonds

18. Conflicts Between Stockholders and Bondholders Best Case Lenders are protected via covenants in the debt contracts and management considers both bond and stockholders in decision making. Lenders supply capital to the firm and receive a return based on risk

19. The Classical Objective Function STOCKHOLDERS Monitor the firm Hire & fire Managers / Board Maximize stockholder wealth Bond Covenants BONDHOLDERS Managers SOCIETY Lend Money FINANCIAL MARKETS

20. Managers and Financial Markets • The Information Problem • Firms may intentionally mislead financial markets. Both Public and Private information impact firm value • The Market Problem • Even if information is correct, the markets may not react properly • Market overreaction • Insider influence • Are Markets too focused on the short term? • Markets and expectations

21. Improving Transparency • Increased information sharing by independent analysts • Market Efficiencies • Low transaction costs • Free and wide access to information • Complete markets (short selling, insider trading?)

22. Managers and Financial Markets Best Case Management does not intentionally mislead the Financial markets The markets interpret information correctly

23. The Classical Objective Function STOCKHOLDERS Monitor the firm Hire & fire Managers / Board Maximize stockholder wealth Bond Covenants Protect Lenders BONDHOLDERS Managers SOCIETY Lend Money Mangers do not use info to mislead markets Fin Markets interpret info correctly FINANCIAL MARKETS

24. Firms and Society • Management decisions often have social costs (intentional and non intentional) • pollution, Johns Manville and Asbestos… • A problem exists if the firm is not accountable for the spillover costs that results from its operations.

25. Firms and Society • What responsibility do firms have in respect to the communities in which they operate and the well being of their customers? • One definition – Sustainability : meeting the needs of the present without compromising the ability of future generations to meet their own needs • Others?

26. Corporate Social Responsibility • Firms respond to financial incentives • Part of social responsibility depends on shareholders responding to poor decisions relating to social responsibility. (US Universities divesting in tobacco firms, customer boycotts etc.) • Should the firm pursue “socially responsible” actions if it decreases shareholder returns (decreases the value of the firm)??

27. Social Welfare • Assuming that all shareholders are protected: Does firm value maximization benefit society? The owners of the firms stock are society Stock price maximization promotes efficiency in the allocation of resources Promotes economic growth and employment

28. Firms and Society Best Case Management decisions have little or no social costs. Management acts in the best interest of society, and attempts to be a good “corporate citizen”. Any social costs can be traced back to the firm.

29. The Classical Objective Function STOCKHOLDERS Monitor the firm Hire & fire Managers / Board Maximize stockholder wealth Bond Covenants Protect Lenders Costs are traced to the firm BONDHOLDERS Managers SOCIETY Lend Money No Social Costs Mangers do not use info to mislead markets Fin Markets interpret info correctly FINANCIAL MARKETS

30. Sustainability • Brundtland Commission (United Nations 1987) • Sustainable Development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs

31. Everything Constrained by Environment? a ^ Scott Cato, M. (2009). Green Economics. London: Earthscan, pp. 36–37. ISBN 9781844075713.

32. People, Places, and Profit Adams, W.M. (2006). "The Future of Sustainability: Re-thinking Environment and Development in the Twenty-first Century." Report of the IUCN Renowned Thinkers Meeting, 29–31 January 2006. Retrieved on: 2011-06-30

33. Triple Bottom Line • Social • Environmental • Financial • The current value of any financial action should reflect future costs • Capacity to raise capital and repay providers of capital • “Profit” incorporates social and environmental costs

34. Our Assumption • In class we will assume that management attempts to act in the best interest of all stakeholders. • Therefore, stock price maximization and firm value maximization are basically the same thing. • However, we know that in the “real world” there cases where stakeholders incur costs associated with share price maximization.

35. Other Systems • Germany and Japan • Industrial groups where businesses invest in each other, and make decisions in the best interest of the group. • Potential Problems? • Less risk taking? • Contagion effects within the group • Conflicts of interest

36. Other Objectives? • Should firm value / stock maximization be replaced by other objectives? • Maximize Market Share • Observable – does not require efficient markets • Based on assumption that market share increases pricing power – and earnings (increasing firm value) • Profit Maximization • Consistent with Firm Value Max, creates problems with Accounting • Empire Building

37. Quick Outline of Class • Part 1 Review of basic tools and concepts • Time Value of Money • Measuring Risk and Return • Part 2 Applying and extending the basic tools to financial decision making

38. Financial Decision Making • The Investment Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate • The Financial Decision Find the right kind of debt for your firm and the right mix of debt and equity • The Dividend Decision If you cannot find investments that make your minimum acceptable rate, return cash to owners of your business

39. Quick Outline of Class - Part 2 • Investment Decision • Estimating Hurdle Rate Chapter 3, 4 • Returns on projects Chapter 5 • Financial Decision (Capital Structure) • Does an optimal mix exist? Chapters 6, 7, 8 • Matching financing and projects Chapter 9 • Dividend Decision • How much cash is available? Chapter 10 • How do you return the cash? Chapter 11 • Introduction to Valuation Chapter 12

40. Goal of Financial Management: Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskinessof the firms projects and the financing mix used to fund the projects.

41. A Simple Example You deposit $100 today in an account that earns 5% interest annually for one year. How much will you have in one year? Value in one year = Current value + interest earned = $100 + 100(.05) = $100(1+.05) = $105 The $105 next year has a present value of $100 or The $100 today has a future value of $105

42. Calculations 105 = 100(1.05) or FV = PV(1+r) Rearranging PV = FV/(1+r)

43. Present Value and Returns • The $105 is discounted to its current value using the present value interest factor 1/(1+r) • The interest rate represents the return you receive from waiting for one period to receive the $105. • The return also represents an amount of risk that is associated with the certainty of receiving $105 in the future.

44. Risk and Return • Assume that you have $100 to invest and there are two options • You can invest it in a savings account that pays 5% interest (the future return is known with certainty) • You can loan it to a friend starting a new business, if the business fails you get nothing, if the business succeeds you get $105 Which option would you choose?

45. Risk and Return • Consider two other options • You can invest it in a savings account that pays 5% interest (the future return is known with certainty) • You can loan it to a friend starting a new business, if the business fails you get nothing, if the business succeeds you get $110 Which option would you choose?

46. Rules of Thumb • Generally, accepting extra risk is compensated with a higher expected return. • Most individuals (and financial managers) are risk averse: They avoid risk, choosing the least risky of two alternatives with an equal return. However they may be willing to accept extra risk if compensated by extra return.

47. Cost of Capital • The return represents the return the investor expects to earn in return for giving up the $100 today. • The investor is choosing to forego other investments • For the firm, this represents a cost, the cost of borrowing the $100 today and repaying an amount in the future.

48. Goal of Financial Management: Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firms projects and the financing mix used to fund the projects.

49. Outline of Class - Part 2Applications of the Tools The Investment Decision: Allocating scarce resources among possible projects under certainty and uncertainty. (estimating future cash flows and discounting them) The Financing Decision: What mix of Debt and Equity should be used? (the financing mix) The Dividend Decision: How much, if anyshould be returned to the shareholders?

50. The Investment Decision • The total value of the firm is an aggregate of the value of its individual projects. • Choosing which projects to undertake will be based upon the concepts of present value.