Conflicts of interest and Corporate Governance Flashcards
(45 cards)
1
Q
Principal-Agent Model (Separation of ownership and control)
A
- shareholders (principal) are identical with the management of the firm (agent)
- shareholders are usually a large number of dispersed individuals / institutions: It is impossible to act in concert and exert
control on a daily basis - shareholders limit their role to providing equity to their firm and the managers run the firm on a day-to-day basis
- managers run the firm on behalf of the shareholders
- organizational form of large public corporations matches individuals who own capital (principals) with individuals who know
best what to do with it (agents)
2
Q
Importance of Principal Agent Model
A
- most important models in financial economics
- strongly influenced by the efficiency of the economy’s capital investment
- Being the managers of other people’s money…it cannot well be expected that they should watch over it with the same anxious
vigilance = Adam Smith
3
Q
Principal Agent Model: Different interests
A
- interest of the two groups may not necessarily (always!) coincide
- shareholders of a firm simply want the value of their shares to be as high as possible, i.e., they want to be compensated for providing risk capital to the enterprise
- managers, while certainly not inherently adverse to a high share price, may have other interests
4
Q
Agents’ interests
A
- Managerial shirking (e.g playing gold instead of working)
- Managerial consumption of perquisites (e.g plush offices, corporate jets)
= expenses / investments hurt (or benefit) shareholders is often difficult to assess
5
Q
Agents interest : conflicts of interest between managers and shareholders
A
- Manager’s desire to stay in power
- Managerial risk aversion
- Free cash flow and empire building
6
Q
Manager’s desire to stay in power
A
- Top managers do not like to lose their jobs
- If the right management team is not the one that is currently in power, a serious conflict of
interest between managers and shareholders may result
7
Q
Managerial risk aversion
A
- Managers usually have all of their human capital tied up in the firm and also the majority of financial wealth
- Managers may be overly risk-averse and
unwilling to take on projects that are worthwhile from the shareholders’ point of view
8
Q
Free cash flow and empire building
A
- Free cash flow is the cash flow generated by a firm in excess of the amount required to fund all available positive NPV projects
- FCF presents serious potential
conflicts of interest.
9
Q
Separation of ownership and control: solving the problem
A
- Bond managers contractually to behave in shareholders’ best interest
- Monitoring of managers
- Alignment of incentives between managers and shareholders
10
Q
Bond managers contractually to behave in shareholders’ best interest
A
- only a partial solution, at best, as it would require to spell out every possible eventuality and specify what action a manager should
take in that situation. Moreover, often it is even ex-post difficult to assess what would have been the value-maximizing decision at the
time. - Contracts may provide crude guidelines for manager behavior and help to ensure that managers will not take certain actions which harm the principal or that the principal will be compensated if he does take such
actions
11
Q
Monitoring of managers
A
- Monitoring requires effective monitors who present credible threats to management
- The obvious monitor would be the shareholders. But: most shareholders lack the necessary expertise and the incentive to
monitor! - A more effective monitor could be for example the board of directors
12
Q
Alignment of incentives between managers and shareholders
A
By providing performance dependent, and in particular stock-based, compensation, managers become shareholders and the interests between principal and agents are (better) aligned
13
Q
Corporate governance: definition
A
- corporate governance can be seen as the set of institutions, practices and rules developed to prevent expropriation of outside investors by “insiders
- Corporate governance deals with the ways in which suppliers of finance to
corporations - set of institutional and market mechanisms that induce self-interested managers (controllers) to maximize the value of the residual cash flows of the firm on behalf of its shareholders
14
Q
Corporate governance: Potential valuation benefits for shareholders –> 2 channels
A
- Good corporate governance may lead to high stock price multiples as investors anticipate that less cash flows will be diverted and a
higher fraction of the firm’s profits will come back to them as interest or dividends. - Good corporate governance may reduce the expected return on equity to the extent that it reduces shareholders’ monitoring and
auditing costs, leading to lower costs of capital
15
Q
Corporate governance: Mechanisms
A
- Compensation structure
- Threat of firing by the board
- Monitoring by a large stakeholder
- Threat of takeover
- Payout
- High debt levels
- Legal protection
- Transparency
- Product market competition
16
Q
Compensation structure
A
Stocks, stock options and, in general, greater pay-for-performance may align interests with shareholders
17
Q
Threat of firing by the board
A
An effective and independent board can monitor and discipline the managers
18
Q
Monitoring by a large stakeholder
A
Large stakes can mitigate free-riding. Also manager- owners can reduce conflicts of interest
19
Q
Threat of takeover
A
A more active market for corporate control disciplines managers
20
Q
Payout
A
By giving back free cash flows to shareholders by paying dividends or doing share repurchases, managerial slack is reduced
21
Q
High debt levels
A
Forces managers to work hard and/or sell
unproductive assets to meet interest obligations
22
Q
Legal protection
A
Legal restrictions on managerial self-dealing.
Shareholders can sue if management misbehaves
23
Q
Transparency
A
Only with detailed and reliable data, investors can assess and monitor managers’ actions
24
Q
Product market competition
A
Similar to takeover threats, competition exerts
pressure on managers to work hard and efficiently
25
An executive compensation program: 3 objectives
1) Attract the right individuals
2) Retain these individuals
3) Motivate these individuals to achieve outcomes that are consistent with the objectives of the firm and its shareholders
26
Executive compensation debate on 4 areas
1) The overall level of executive compensation and the role of share options
2) The suitability of performance measures linking executive remuneration with performance
3) The role played by the remuneration committee
4) The influence that shareholders are able to exercise on directors’ remuneration (e.g., say-on-pay)
27
Are CEOs overpaid? 2 opposite view
Yes : CEOs are overpaid as for example visible by the growing disparity between
total pay granted to CEOs vs. average workers
No: CEOs are paid the going fair-market rate and high compensation simply
represents high demands for the position (time, skills, attention, risk) and or
limited supply of able individuals
28
What does research say? CE0 paid
- market value of the companies increased sixfold as well: “the rise in CEO compensation is a simple mirror of the rise in the value of large
U.S. companies since the 1980s
- Growth rate of CEO pay 1994-2005 is comparable
to that of hedge fund & PE managers, venture capitalists, lawyers, and
professional athletes.
29
Debt and incentives : Investment distortions, What are the implications for investment / financing policy if shareholders
are in power?
- Risk Shifting / over-investment
- Debt overhang problem or under-investment
- Bait and switch
30
Risk Shifting / over-investment
- The value of equity increases in risk because
of the option-like payoff: downside risk is limited but you benefit from upside
risk
- equity holders may want to take negative NPV projects if they are sufficiently risky
31
Debt overhang problem or under investment
if the value of the firm is low, equity holders will
have no incentive to contribute cash to take on a positive NPV project because all the gains will
go to the debt holders.
32
Bait and switch
Equity holders have an incentive to issue additional debt and “dilute” the value of existing debt holders
33
Debt and incentives: risk shiftingm, which project is better to choose?
- page 35 - 36
--> Shareholders might prefer projects with lower NPV but that have more volatile payoffs
--> If debtholders are informed / sophisticated, they anticipate that and take precautions
34
Debt and incentives: Reluctance to liquidate --> Decision rule of liquidation from the perspective of debt holders
Liquidation value > Going concern = liquidation is efficient
35
Debt and incentives: Reluctance to liquidate --> Decision rule of liquidation from the perspective of shareholders
Shareholders would not agree to liquidate the firm and gamble for resurrection
see example page 37
36
Debt overhang problem, what is the problem?
Firms with existing senior debt obligations may not be able to finance positive NPV investments because the payoff from the investments goes completely to
the existing bondholders due to the seniority
37
Debt free rider problem, what happen if only one debt holder help to finance the project?
If there is only one debt holder, it is rational for this debt holder to finance the project with new debt
--> payoff with no investment
--> payoff with investment
= voir page 40
38
Debt free rider problem, Suppose there are four lenders, but only one considers to participate, and the new
debt is subordinated (debt is ranked lower in priority). Would she do it?
A single debtholder will not invest
= voir page 41
39
Debt and incentives: Bait and switch
Assumption:
- Risk neutrality
- Zero interest rate
What are the values of debt and equity?
- calculate the value of debt and the value of equity
--> The bond is safe because creditors will receive full repayment in either state.
40
Bait and switch – Example of LBO by RJR Nabisco
- Triple its debt
- Idea of LBO
- Market reaction
- External investor
--> voir page 44
41
Credit covenants to protect debt holders : examples of restrictions imposed in bond indenture
- Restrictions on subsequent financing
- Restriction on dividends
- Restriction on merger activity
--> Having too many covenants may also be costly since it can severely restrict the
flexibility of firms
42
bond indenture
a legal contract between a bond issuer and bondholders that outlines the terms and conditions of the bond
43
Restrictions on subsequent financing
Issuance of new debt prohibited unless certain ratios are met, like tangible assets to long term debt, earnings coverage ratio, or leverage ratio
44
Restriction on dividends
Allow payments of dividends only if sufficient payable funds exist where payable funds are a function of earnings, assets, leverage, and past dividends paid.
45
Restriction on merger activity
Bondholder has the right to sell the bond back to company at some given price if some specific event (such as a takeover) occurs.
