Corporate

Question 1

Modigliani and Miller, 1958

Answer 1

Describe a theory of the capital structure of the firm. Their main finding is that a firm’s value does not depend on its capital structure.

Question 2

Modigliani and Miller, 1958

Proposition 1 - No Taxes

Answer 2

Under the assumption that there is perfect information, no taxes, and no distress costs, the capital structure of the firm is irrelevant.

Question 3

Modigliani and Miller, 1958

Proposition 2 - No Taxes

Answer 3

As you increase the leverage of the firm (i.e. fund more of the capital with debt), the cost of equity will increase; this ensures that the cost of capital of the firm is the same.

Question 4

Modigliani and Miller, 1958

Propositions with Taxes

Answer 4

When there are taxes and no financial distress, the value of the firm increases as more debt is used and firms will end up holding 100 percent debt.

The cost of equity in this case is not easy clear and depends on the taxes.

Question 5

Myers and Majluf, 1984

Answer 5

This paper introduces pecking order theory. Firms will prefer internal funds to external funds and debt over equity.

The model also assumes that sometimes, when only equity is available, firms will pass up on good opportunities.

Question 6

Pecking Order Theory Proof

Answer 6

This comes from Myers and Majluf, 1984.

The idea is that there are information asymmetries between managers and investors. Managers learn the outcome of a project and investors do not and managers serve current shareholders. Because investors just have regular expectations, there are cases in which NPV positive projects harm current investors more than passing up on the project.

Question 7

Baker and Wurgler, 2002

Answer 7

The paper shows that today’s capital structure of a consequence of past attempts to market timing.

Specifically, they run a few regressions and show that past market-to-book can predict today’s capital structure.

Question 8

Baron, 1982

Answer 8

Paper theoretically derives the demand for investment banking, advising, and distribution services when investment banker is better informed about the issuance but
effort is unobserved. Most importantly, the model explains why some issues are underpriced.

Question 9

Baron, 1982

Basic Model Overview

Answer 9

The model assumes that investment banks have more information about an issue and both banks and issuers are risk neutral. Then, the issuer can decide to hire the bank to (1) set the price (2) advertise the issue.

Investment banks can exert unknown effort to increase demand for an issue. In general, the issuer will prefer to use the IB for sale over doing it themselves and when information are asymmetric will also use IB to set price. Because a contract must induce the IB to report truthfully, the banks and issuer share risk and the issuer loses some potential gains; the issue will be underpriced.

Question 10

Rock, 1986

Answer 10

There are informed and uninformed traders. If you want the uninformed traders to be part of the market, then some issues must be underpriced. Otherwise, the uninformed traders would only get the bad apples and quit.

Question 11

Benveniste and Spindt, 1989

Answer 11

They also propose a mechanism that yields to underpricing in the pre-selling and book building process in which investment banks attempt to get investors to reveal private information to the undewriter.

Question 12

Papers on Financing the Corporation

Answer 12

Modigliani and Miller, 1958; Myers and Majluf, 1984; Baker and Wurgler, 2002; Jensen and Meckling, 1976; Stulz, 1998

Question 13

Papers on New Issues

Answer 13

Baron, 1982; Rock, 1986; Benveniste and Spindt, 1989

Question 14

Jensen and Meckling, 1976

Answer 14

This is the paper on the theory of the firm and about how agency problems impact the structure of the firm. This paper defines a firm as a nexus of contracts.

An owner gets pecuniary and non-pecuniary benefits. The costs created from the agency conflict lead the owners to do more shirking when they have less ownership on the firm. This agency cost is completely borne by the manager owner.

In general, you can mitigate this through monitoring and bonding. The manager will agree to this if firm value in increased enough so that less fringe benefits equals marginal gain of wealth.

The reason that equity ownership is so diffused is limited liability. This and bankruptcy costs can make MM invalid.

With debt, there exists agency costs because you want to promise the safe project and then do the risky project.

Question 15

Fama and Jensen, 1983 (1 and 2)

Answer 15

These papers look at how different organizational structures deal with agency conflicts.

In open corporations, there can be agency conflicts between managers and shareholders. However, this is mitigated by board members and threats to takeovers.

Other private organizations have many different mechanisms to deal with agency problems.

Sometimes, it is efficient to make control and ownership in the same person in non-complex organizations.

However, in complex structures it is better to have people with expertise in different areas do different roles. That’s when you want to have some people do management and others control the managers. (these last two cases could be law firm vs. big corporation)

They come up with two parts of the decision process: decision management (e.g. implement and initialize) and decision control (i.e. ratify and monitor). These two parts of the process are often separate. Whenever these two decision components are separate, the residual claims must also be separate. If these components are in the same people, then residual claims also reside in those people.

Restricting decision management and control in the same people can save on agency costs, but it comes at the loss of having the availability of winning from risk sharing as in open corporations. However, family members and other close relationships can also benefit and reduce agency costs.

Question 16

Main Papers on Agency Theory

Answer 16

Fama and Jensen, 1983; Jensen and Meckling, 1976

Question 17

Main Papers on Ownership Structure

Answer 17

Harris and Raviv, 1988; Stulz, 1988

Question 18

Harris and Raviv, 1988

Answer 18

What should be the assignment of voting rights to stock and what kind of rule should determine voting outcome? First, the simple majority voting rule is the best outcome because the better management team is always elected. To maximize the aggregate value of the securities listed, it would be optimal to issue two separate classes of shares: those with rights to future cash flows and those with voting rights

Why simple majority: because it treats the rival and incumbent equally (nobody has an advantage)

Why two separate share classes: because investors can extract their private benefits of control to the most extent. However, this is not socially optimal (a one share one vote would be socially optimal because you cannot buy your votes in those cases)

Question 19

Stulz, 1998

Answer 19

This paper analyzes how managerial control of voting rights affects firm value. They find that the value of the firm is positively related to alpha (the share of ownership of the manager) for low levels of alpha and negative for high values of alpha. The idea is that a higher alpha decreases the probability of a takeover attempt and thus decreases the value of the firm. However, it also increases the premium paid and hence there is a point at which is lowers and at which it increases firm value.

Another finding in this paper is that changes in the capital structure can change the value of the firm through alpha.

Question 20

Main Papers on Corporate Control

Answer 20

Grossman and Hart, 1980; Shleifer and Vishny, 2003

Question 21

Shleifer and Vishny, 2003

Answer 21

Stock market acquisitions are driven by the relative valuation of the merging firms. The only reason to do cash acquisitions is that the target is undervalued.

Question 22

Grossman and Hart, 1980

Answer 22

This paper covers the free-rider problem. Let’s say that a company is made up of small shareholders. If a raider wants to then take over the company, no shareholder would be willing to sell their shares at the discount and the raid could not take place. The solution to this problem is dilution, selling assets cheaply, or only giving managers voting power who can then sell their shares.

Question 23

Big Views on Executive Compensation

Answer 23

There are three views on executive compensation. The first is the view on shareholder maximization. Second, there is a view of rent extraction. Third, there is a view that laws and regulation shape the compensation structures

Question 24

Some general points on executive compensation

Answer 24

We don’t know what can be the best model to explain the data. But we have seen that shareholder maximization theories can explain many factors and that there are many agency conflicts involved in this literature.

It is also clear that executive compensation has increased a lot (but so have firm sizes)

Question 25

Important Papers on CEO Compensation

Answer 25

Gabaix and Landier, 2008; Yermack, 2006; Jensen and Murphy, 1990

Question 26

Top Areas To Know

Answer 26

Mergers and Acquisition, Corporate Governance: Executive Compensation, internal and external methods, Common and Family Ownership, Econometrics, Capital Structure, Capital Raising (IPOs seasoned offerings etc.)

Question 27

Gabaix and Landier, 2008

Answer 27

Between 1980 and 2003, CEO compensation has increased dramatically.

The paper cites two reasons. First, there has been an increase in incentive pay and thus higher pay. CEOs are risk averse and expected compensation must increase if wanting to keep expected utility at the same level.

In addition, the size of firms has increased recently and this should lead to a rise in CEO compensation. Most importantly, the paper is unable to find evidence that CEOs have become better at extracting rents.

Question 28

Yermack, 2006

Answer 28

Shareholders react negatively when CEOs first get a personal aircraft. This paper is trying to show that there is CEO skimming, but it honestly does a trash job at it.

Question 29

Jensen and Murphy, 1990

Answer 29

This paper tests empirically the incentives provided to CEOs in their compensation packages. It finds that last year’s performance can predict this year’s compensation change. However, the incentives from options are much larger than those from cash. For 1,000 dollar increase in shareholder wealth, CEOs get about 2.2 cents in cash and 16 cents in options in the following year.

One reason these effects are not bigger is because CEOs cannot commit to pay if firm does well and shareholders cannot commit to give up large parts of the firm to the CEO if the firm does really well.

Overall, the paper thus finds that there is not as strong of a performance pay relationship as it had predicted

Question 30

Big Theories of Capital Structure

Answer 30

Pecking Order Theory, static trade-off theory, MM where nothing matters lol

There is also a free cash flow theory that mostly applies to large firms and says that very high debt is value maximizing even though there are potential distress costs.

Question 31

Corporate Governance Definitions and Parts

Answer 31

Overall, corporate governance is difficult to define (could be rules set in place for the firm or could be ways in which investors ensure they get a return).

However, it usually has two parts: internal and external.

The internal part are managers and boards of directors and all those relations and rules. External are shareholders, bondholders, but also employees etc. which are all part of the firm (as a nexus of contracts). Even outside of that, there are laws and society etc. that also share governance (eg. though activism)

Question 32

What are the two important private property rights in corporate governance with regard to blockholders.

Answer 32

The first is collocation: the owner and decision maker are the same person. The second is alienability: the right to transfer the ownership to others.

This gives rise to the two main channels of corporate governance of blockholders: voice and exit. The blockholders can influence management directory or threaten to sell their shares.

Question 33

In terms of atomistic shareholders and ownership; state the free rider problems that shareholders have.

Answer 33

When no one shareholder has a large stake in a company, no shareholder may find it necessary to monitor the management of the company.

The free rider problem is that all shareholders share the benefits of monitoring, but only the shareholder doing it has to pay for it. All shareholders prefer that somebody else does the monitoring .

However, the data shows that most firms do have a blockholder and there is also often the option of activists coming in and out of firms and trying to convince the passive blockholders (e.g. pension funds) to vote for changes.

Question 34

Main issue with family firms.

Answer 34

The main issue when studying governance of family firms are agency conflicts. There are four main agency problems: (1) shareholder vs manager (2) majority vs minority shareholder (3) shareholder vs bondholders and (4) inside family vs outside family.

(1) This problem is closest to Jensen and Meckling (1976) and Fama and Jensen (1983). Families are likely to have high ownership and incentives to use the voice channel of corporate governance. Downside may be though that family members get jobs that they do not deserve

(2) The conflict between large family owners and small owners increases compared to the case when the large owner is a government or bank. Family firms have higher private benefits of control. An example of this is the entrenchment of family managers as discussed in part (1)

(3) Debt can be beneficial because it can force management to increase effort and includes covenants. But there are two issues with debt: asset substitution and underinvestment. The asset substitution problem occurs when management engages in more risky projects after receiving debt.

(4) The issues here could be inter-generational: who gets to inherit what and who will run the firm in the future.

Question 35

Governance Mechanisms in Family Firms

Answer 35

Outside blockholders can largely reduce agency problem (1).

Family firms in specific can reduce the debt vs. shareholder and manager vs. shareholder problems at the expense of family vs. other shareholders and intra family conflict.

Boards of directors are a mechanism that can help with the small vs. large shareholders. Many countries give rights to minority shareholders to have board representation.

Specific to family firms are family governance systems such as trusts and other contracts within a family to determine how a family runs a business.

Question 36

Main papers on Mergers and Acquisitions

Answer 36

Grossman and Hart, 1980; Shleifer and Vishny, 2003

Question 37

What are some of the main reasons to engage in M&A

Answer 37

The first main reason is simply profitable investments (i.e. maximize shareholder value). If a firm is underpriced or you have good synergies with a firm, then it makes sense to acquire or merge with that firm.

A second reason is empire building. CEOs get more compensation when they manage large firms and that can lead them to want to make acquisitions. However, the labor market and markets for takeovers and limit the incentives to do so.

Finally, there are some legal reasons to engage in these transactions such as to get rid of certain employees or to get certain tax breaks.

There is also important room for behavioral biases in mergers and acquisitions.

Question 38

Let’s say you want to investigate the impact of a merger on a firm. What are some techniques to do this?

Answer 38

The first would be to do an event study around the merger. You can estimate the exposure to some factors using prior data and then see whether there were any abnormal reactions to the activity on that day. For robustness, you can also test whether those abnormalities were specific to the firm (e.g. use a matched sample of similar firms).

Alternatively, you can look at how the merger changes some accounting data of the firm or any other publicly available information. Then, you can compare those to the accounting ratios over other firms in the same industry or matched on company characteristics.

Question 39

What are the stock price effects of mergers and acquisitions

Answer 39

The evidence overall is not very clear.

Overall, target companies have gained significant abnormal returns. The premiums paid for target firms tend to be 20-30 percent (high). These returns are higher for cash and tender offers than for negotiated and stock deals.

However, when it comes to acquirers, the returns are small and it is not sure whether or not they earn abnormal significant returns.

Question 40

Are mergers on average successful?

Answer 40

On average, the value of the combined firm tends to increase by like one or two percent. But there is some evidence that these stock returns are poor predictors of actual combined value.

Overall, the evidence here is pretty week and indicates that results depend on the type of merger and some other factors, but that the gains are slightly positive is believed today (contrary to early evidence).

There is some evidence that the gains DO NOT come from market power (thus it could be tax benefits or synergies or efficiency improvements).

Tender Offers tend to complete faster and with higher premiums. A tender offer is an offer with which you bypass the board and go directly to the shareholders.

One other thing that could explain this finding is common ownership. Mutual funds that own part of the target and the acquirer are more likely to vote for mergers where the acquirer loses because they gain on the target.

Question 41

What are the two conditions for an instrumental variable to be valid and what can you do to test them?

Answer 41

Relevance: First, the instrumental variable must be correlated to the variable that it should proxy. Specifically, this can be done by just running a regression of the X variable on the IV. The variable should be significant although here the requirement is just to have a linear projection relation and not to have identification.

Exclusion: The instrumental variable must not be causally related to the dependent variable of interest or to any of the other explanatory variables! This second part is often forgotten. Thus, Cov(z,u) = 0. Thus, the instrument ONLY impacts z through its correlation with x (hopefully it is only correlated with the good part of x).

Important is to check the F-Stat and the R2 in the first stage and to think carefully about using an instrument. Weak instruments can make the coefficients look implausibly large.

Question 42

What are some robustness tests you can run to make sure that your DiD design is valid?

Answer 42

First, you can check whether other covariates are significant in the regression (this should not be the case if treatment assignment is random). Then, you can also do falsification tests (e.g. change the treatment timing for all those who were treated)

You could also check for treatment reversals (e.g. does something change after the treatment is reversed?)

Finally, you can compare the treatment and control groups and test whether there are any systematic differences between them.

Question 43

What are the identification assumptions of a regression discontinuity design (both fuzzy and sharp) and how can you estimate it?

Answer 43

For a sharp RDD design, the assumptions are that the treatment depends on a known cutoff value and that the potential outcomes are continuous at that cutoff value and that you cannot choose on which side of the cutoff value you are. Then, we can run a regression below and above the cutoff value and compare the intercepts.

For a fuzzy RDD design, the first assumption changes. Now, the probability of being treated depends on the x variable still, but does not go from zero to one. Instead, there is a jump in the probability at the cutoff point. To estimate a fuzzy RDD, we first calculate the probability of being treated using an intercept, a dummy for being above or below the cutoff and some general function of the x variable. Then, we put that dummy into a second regression and estimate the beta as always, again controlling for the distance from the cutoff point and some other variables.

Question 44

What are the main theories to explain the IPO underpricing?

Answer 44

Again, remember that the main papers are the Baron (1982), Rock (1986), and Benveniste and Spindt (1989) papers.

One class of reasons is asymmetric information. An example is the winner’s curse problem in Rock 1986, that states that uninformed investors would be crowded out if these issues were not on average underpcied. The data does seem to back this idea up to some extent.

Since we now have bookbuilding, more and more theories focus on getting bidders to reveal their true intentions (benveniste and spindt 1989).

Third, we have the theories of agency relationships as in Baron (1982). Here, companies must compensate the investment bank to reveal private information or to exert efforts etc.

There are also institutional explanations such as avoidance of lawsuits (you’d rather sell an underpriced IPO than get sued). Price stabilization and tax advantages could also be reasons.

Finally, there are incentives to keep prices low for ownership and control. When companies can be bought cheaply, the outside threats are higher and governance increases. Going public may also just make the stock more liquid, provide better governance etc.

Question 45

Signaling

Answer 45

The main paper on Signaling is the Akerlof market for lemon paper of 1973. The main idea is that you have an incentive to lie about the quality of the product you sell. However, bidders will know that and only bid the expected value. Thus, if your product is high quality, then you will not sell and the market will completely break down (or only a market for lemons will persist).

There are a few things to fix this. One is credibility of signaling and the design of incentive contracts (e.g. pay is contingent on performance). Others could be warranties, credible signals based on tests or testimony etc.

Another important aspect of this is adverse selection. This process can also take place in mergers or when raising capital and is the same as the market for lemons.

A related but different problem would be moral hazard, which is when people have incentives to do something against your best interest (e.g. CEOs who want to engage in empire building)

Question 46

Summarize some of the main literature on behavioral corporate finance.

Answer 46

Behavior takes into account odd utility functions (e.g. lottery preferences), irrational belief formation, and cognitive limitations. Not all of behavioral finance must hence be irrational (although that could be part of it)

There are three main agents that could have behavioral biases: investors, managers, and other agents outside the firm.

Overall, this can be applied to almost any research area and is thus always important to consider.

Most the papers have looked at what happens when X is rational but Y is not… but in reality, we should also look at the interplay: what happens when both are irrational at the same time.

Question 47

Summarize the biggest topics regarding law and corporate governance.

Answer 47

One of the most important legal points about corporate governance is that incorporated companies have limited liability. This is crucial.

Another interesting question concerning the legal environment is that so much power lies in the states. States compete for businesses and can provide a vastly different legal environment (e.g. anti-takeover provisions).

Question 48

What are legal governance differences between private and public firms.

Answer 48

While many of the issues are similar, there are some specific differences between private and public company governance.

First, the public companies also subject to exchange and federal listing laws in addition to the state laws.

Second, the number of shareholders and important players is much larger in public firms. Therefore, private contracting is not a useful governance tools (not all key players will have the same opinion on some given topic.

Another difference is that public companies tend to be much larger and more complex. Hence, it makes sense to separate decision management and decision control to people with comparative advantages in these areas. This will create agency conflicts and force the residual claims to be held by a different class.

Public companies also run into the issue of which shareholders to serve since they can change almost continuously, while for private companies the existence of shareholders if often known and fairly stagnant. Since shareholders have very little say in public companies, hostile takeovers and tender offers (bypass the board) were often used to bring change to a public company.

One final thing to note is that recently the horizonal governance issues have increased (i.e. shareholder vs. shareholder or shareholder vs. bondholder)

Question 49

Blockholders are important to overcome free-rider problems, but they are also potentially problematic when it comes to cross-ownership. Describe the problems in this literature.

Answer 49

There are a few things that I think people don’t take into account. First, the question of whether to maximize shareholder value or firm value is complex. (see law review)

The idea is that when shareholders are diversified, then it may make sense for firms to not maximize firm value and reduce competition.

Important definitions include:
(1) Common Ownership: Incidence or frequency of shareholder overlap between firms
(2) Common-Ownership Concentration: The extent to which influential shareholders in one firm also hold ownership in another firm.

With all the issues, most empirics support the idea that common ownership is bas for competition. However, there are many measurement issues such as how to define industries, how to measure voting rights, aggregating at the fund level, etc.

Question 50

Risk shifting

Answer 50

Risk shifting is the idea of raising capital under the disguise of a safe project and then investing the money in that project at a higher rate.