UNSW Business School School of Banking and Finance FINS5514: Capital Budgeting and Financial Decisions Lecture 1: Introduction to Corporate Finance and Agency Theory FINS 5514: Capital Budgeting and Financial Decisions Capital budgeting and financing decisions are primarily concerned with the major financial decisions faced by firms These decisions can be broadly categorized as the investment policy, the financing policy, the dividend/repurchase policy, and the restructuring policy. This course will examine the main theories and empirical evidence surrounding these decisions and to use this knowledge to help solve typical ‘real’ finance problems. 2 Business Organizations There are several different types of company and each type has certain advantages and disadvantages compared to the others. The most frequently seen types include: – Sole proprietorships / Partnerships – Corporations – Hybrid Organisations (some combination of the above) 11 Sole Proprietorships / Partnerships Sole proprietorships are owned and run by one person. Partnerships are two or more people. Advantages – These companies are simple to establish – Owners keep all the profits Disadvantages – Unlimited liability – Not quoted – Difficult to raise large sums of finance – The firm only lasts as long as the owners want it 12 Corporations A corporation is a legally registered company with distinct groups of owners and managers. Corporations are usually listed on a stock exchange. Advantages to a Corporation – Ownership can be transferred easily – Limited liability. Disadvantages to a Corporation – Corporate taxation – Complex legal formalities take time and money to complete 13 Financial Managers The financial managers of a firm makethree decisions in three primaryareas: – Investment – Finance raising – Dividends In theory these decisions are separate butin reality they areinterconnected. 14 Investment Decisions These decisions create profits and revenue, as well asthose that reduce costs andexpenses The primary objective is to increase firm value by deciding which long-term investments or projects the business should takeon Capital budgeting analysis is very important and includes analysis of: – The risk of cashflows – The timing of cashflows 15 Financing Decisions In order to invest, firms must raise funds. Debt: – Straight or convertible – Long or short term – Fixed or floating rate Equity – Ordinary or preference shares The choice depends upon many factors: – Taxation, external monitoring, risk, signalling,agency issues, capital structure and soon… 16 What are firms for What are the goals of afirm – Maximise profit – Minimise costs – Maximise market share – Maximise the value of the company’sstock – All of these There are two main answers to thisquestion 17 What are firms for (continued) Corporate wealth maximisation (CWM) – Satisfy all stakeholders in the firm including debt holders, employees and society as a whole – This approach is fairly rare but is seen in Germany and Japan – Shareholder wealth maximisation (SWM) – This is the most popular answer – Main objective of the firm is to increase share price – Ethical issues may arise as the shareholders expropriate wealth from other stakeholders 18 Agency Theory Under SWM, managers should only be thinking about shareholderwelfare. However, due to agency theory this does not always happen Agency theory says: – The principal hires the agent to represent his/her best interests. – In this case, the shareholders (principals) hire the managers (agents) to run their company 19 Agency Problems However, all stakeholders in the firm are primarily concerned with self-interest This leads to potential conflicts of interest. – These conflicts are the agency problem There are two main areas where it arises – Shareholders and managers – Shareholders and debt holders 20 Agency Problems For Managers and Shareholders In many countries, such as Australia, the UK and the US, the owners do not manage the firm on a day-to- day basis. – This is often called the separation of ownership and control. The owners and the managers may not have the same objectives and this can result in problems. – Managers prefer to increase their job security, power, status, or to generate perks for themselves – This may be at the expense of SWM 21 Agency Problems For Managers and Shareholders (continued) Agency costs arise as the shareholders attempt to control the managers Direct costs: – Managers act in their own interests, reducing value for the shareholders – Managers need to be monitored to ensure their actions are in the owners best interests. This generates monitoring costs – Setting up contracts also costs money Indirect costs: – Lost opportunities to create value for the shareholders 22 Possible solutions for Managersand Shareholders (continued) Internal mechanisms for solving this problem include: 1. The Board of Directors – Employing executive & non-executive directors on the Board. 2. Major shareholders, such as institutions, can exert considerable influence on the company. 3. Compensation packages for the managers that give them an incentive to act in the best interests of the shareholders – The use of stock options / stock grants 23 Possible solutions for Managersand Shareholders (continued) 4. The market for corporate control (mergers and acquisitions) can help partially address the agency problem – Shareholders can threaten to sell their shares in a hostile takeover – If the takeover goes ahead, the firms managers are likely to be firedafterwards. – This is viewed as the “court of last resort” (Jensen 1988) 24 Agency Problems For Debtholders and Shareholders If a firm has debt, the debtholders have a claim on part of the earnings of the firm, or some of the assets if the firmgoesbankrupt. The interest rate on debt is based on the riskiness of current and future projects and the company’s current and expected future capitalstructure. – This is a risky investment for debt holders but they do not have any control over the company on a day-to- day basis. This is another form of agencyproblem 25 Types of AgencyProblems More formally, there are two types of agency problems 1. Moral Hazard (HiddenAction) – Although the principal and the agent have the same initial set of information, the principal cannot observe the action chosen by the agent 2. Adverse Selection (Hidden Information) – Both the principal and the agent know that the agent has information which is valuable to the principal but which the principal cannotsee. 26 An Example of Moral Hazard Consider car insurance. If my car is insured why should I drive carefully – The answer to this is the adoption of an incentive. – If I drive carefully my premiums will remain low. This form of coinsurance will ensure that I try to limit my exposure to a claim as I will have to pay part of the costs if I do not. 27 An Example of Moral Hazard (continued) In the case of firms, moral hazard arises in many different ways. – For example, imagine that both shareholders and managers know how much money a firm has (annual accounting figures). – But, the shareholders cannot see how the money is invested until after the investment ismade. – If the shareholders do not like the choice of investment strategy there is nothing they can do about it. 28 An Example of Adverse Selection Life insurance is a good example of hidden information. – A person insuring their life knows many things about the state of their health that is not known by the insurance company. – The population will be heterogeneous with respect to risk and some individuals will have a higher probability of dying young thanothers. – If everyone pays the same premium then high-risk individuals will take out more insurance and low-risk individuals will take out less. 29 An Example of AdverseSelection (continued) The solution here is to use market signalling where the person who has the superior information signals what he knows through his actions. – For example, an insurer may offer lower premiums if the person taking out the policy accepts very limited benefits in the first fewyears. – The presumption is that anyone who knows that their health is very poor and who may die within this period will not take out that insurance policy 30 Asymmetric Information One potential cause of agency problems is asymmetric information – This means that some people know a lot more than others. Managers have much more information than outsiders including shareholders and debtholders Without good information, markets will break down 31 Akerlof’s Market for Lemons Akerlof (1970) wrote an academic paper which illustrates the problems that arise from a lack of information He used the market for second hand cars as an example – Two types of second handcars – Lemons – poor quality cars which are worth $400 – Peaches – good quality cars which are worth $2,000 – Each type of car represents 50% of themarket 32 Akerlof’s Market for Lemons(cont) There are 3 scenarios to consider 1. Peaches and lemons can be accurately identified by everyone in themarket. – Here is there is no problem because everyone has all the necessary information. – Cars will be sold at their correct values and the market will continue to operate – A peach will be sold for $2000 and a lemon for $400. 33 Akerlof’s Market for Lemons(cont) 2. No-one knows whether any particular car is a peach or a lemon – So, all cars will sell at $1200 2 2 – Assuming risk neutrality, buyers will work out what they are prepared to pay: E(Value)= Proportion of lemons×(Valueof lemon) +Proportion of peaches×(Valueof peach) – In this example, this is: E(Value)= 1×($400)+ 1×($2000)=$1200 34 Akerlof’s Market for Lemons 3. Asymmetric information in which the sellers know the quality of the car but buyers do not. – Here the market will break-down – Sellers of good cars will only accept $2000 but buyers will not pay more than$1200 – Therefore, no good cars will be sold and the only cars on the market will belemons 35 Gresham’s Law The market for lemons is an example of Gresham’s Law which says that: “Bad money drives out good”. – In other words, if there are two items of different quality which have the same market value, only the lower quality item willbe traded – In this case, lemons and peaches are all worth $1200 to the buyers (due
to information asymmetry), despite the fact that they are of different quality. Therefore the only cars in the market will be lemons. 36 Solutions to Asymmetric Information The market for lemons is an example of problems that arise from asymmetricinformation There are some solutions: 1. Buyers can gain the skills to improve their knowledge but this can be expensive 2. Sellers can signal the quality of their product with guarantees and trial periods – However, effective signals must be unambiguous and credible. This can be costly. – Just saying something is good is not enough 38 Solutions to Asymmetric Information (continued) In the context of a corporation, managers try to signal to investors that the firm is a good one through corporate This can be done announcements suchas: – Dividends – Capital structure – Takeover plans – Initial public offerings 39 Corporate Governance Corporate governance is the name for any measures that can be used to close the incentive gap between managers and shareholders and reduce agency problems. Some firm level solutions are on the previous slides To illustrate why this is important, consider a situation where governance failed: – The collapse of Enron 40 Some Background to the EnronCase – Consumers received a 10% price cut and guarantees that there would be no price Background: – During the 1990’s demand for electricity in California grew 12%.Supply grew by 1%. California’s energy industry was deregulated in 1996 increases until 2002 – The utilities issued US$7 billion in bonds and were allowed (eventually) to pass this cost on to consumers. 41 Deregulation in the CalifornianEnergy Industry Deregulation relied on competition to keep the electricity companiesefficient. – The share prices of the involved companies nearly all went upconsiderably. – Many of the companies sold off their plants for vastly inflated prices. 42 Deregulation in the CalifornianEnergy Industry (continued) Throughout 2000, the electricity supply in California failed to meet demand and there were blackouts – The State spent US$40 million a day to buy extra power. – There was some evidence that the power companies colluded to push up their profits by limiting supply at certain times. 43 Enron Corporation Enron was formed in July 1985 as a result of the merger of Houston Natural Gas and InterNorth of Omaha,Nebraska. – Enron specialized in energy trading and distribution and, at one time, was the 7th largest company in the US(16th in the World), – Enron was valued at approximately $90 billion but it had very few hardassets. 44 The Collapse of Enron mark-to-market century for use on In 1991, Enron adopted accounting. – This was devised in the 19th highly liquid futures markets. A trader uses estimates of their profitability to determine how much money to leave on the exchange (the margin) to protect theExchangeagainst loss. Each day the present market value of the contract is evaluated and the margin alteredaccordingly. This technique allows you to book value before completing the transaction. 45 The Collapse of Enron (continued) Enron used mark-to-market accounting on long-term contracts and made someerrors: – Enron only considered the best possible outcome. – Enron booked the entire profit on the day the contract was signed – Enron ignored the time value of money and interest rate risk – Enron never updated the numbers – Enron used fake hedges to hide any losses 46 The Collapse of Enron (continued) Enron hid its losses by creating Special Purpose Entities (SPEs) – The SPEs were paid (in Enron stock) to guarantee Enron’s losses – This sort of guarantee is only viable if the guarantor is totally independent. – Guarantors should be firms that operate in entirely different markets, subject to different conditions and likely to be making money when you are not. – Enron’s SPEs did nothing. 47 The Collapse of Enron (continued) Forexample, Year 1. Enron invests Estimated outcome in 10years Estimated profits $100m $250m $150mProfits on the books today $ Year 3. Actual profits Loss($150m-$15m) $15m $135m The SPE is paid $150m (in Enron stock) to guarantee the $150m profit – But if share price drops, the stock is no longer worth $150m. If the investment looses money, how can the SPE pay Enron the $150m it guaranteed 48 The Collapse of Enron (continued) After deregulation Enron grew rapidly and made a lot of dubious business decisions. It also failed to pay any taxes for 4 years at the end of the 1990’s. By using many different and interconnected SPE’s, Enron hid over US$1 billion in debt. – In October 2001, the hidden debt was revealed 49 The Collapse of Enron (continued) Enron’s accountants (Andersen) concealed the extend of the problem, saying the company was solvent – Both Enron and Andersen shredded documents concerning the auditing process. – Enron voluntarily went into Chapter 11 (bankruptcy protection) in December2001 50 The Collapse of Enron (continued) 100 90 80 70 60 50 40 30 20 10 0 Ju ly -8 5 Ju ly -8 7 Ju ly -8 9 Ju ly -9 1 Ju ly -9 3 Ju ly -9 5 Ju ly -9 7 Ju ly -9 9 Ju ly -0 1 Ju ly -0 3 Sh ar e Pr ic e Californian deregulation Californian energy crisis Chapter 11 51 The Collapse of Enron (continued) How much did it cost – Shareholders lost $74 billion – Approximately 22,000 employees lost their pensions and their jobs – Other investors (including several major financial institutions) also lost their investments – At the time of the Chapter 11 filing, Enron’s liabilities were estimated to be around $23 billion 52 The Collapse of Enron (continued) What went wrong 1. The auditors (Arthur Andersen) failed to pick up on the true financial situation in the firm. – Did Andersen deliberately conceal the true situation 2. The Board of Directors should have been working in the shareholders best interests – Share options made Enron’s Directors interested in short term price movements rather than the long-term. 53 The Collapse of Enron (continued) 3. Investment banks are supposed to impartial advice to investors and provide provide banking services to firms – Enron’s investment banks helped design Enron’s partnerships, and also invested in them. The banks issued “buy ratings“ to help keep the share price up. 4. Credit rating agencies set ratings that are used to determine the interest rates at which the issuer pays its debt – Enron’s credit ratings were maintained until 5 days before it went bankrupt. 54 The Collapse of Enron (continued) 5. Lawyers are hired to provide firms with legal advice. The lawyers are obliged to act in the company’s best interest. – Enron’s lawyers helped the firm set up its partnership structures. This was a highly unusual and the lawyers should have been a critical of theprocess. 55 The Collapse of Enron (continued) January 2006 – Company founder and Chairman Ken Lay and former CEO/ COO Jeffrey Skilling faced court in America. – The charges included: Conspiracy to commit fraud Security fraud and wire fraud Making false statements to auditors Insider trading Major witnesses for the prosecution include other Enron management who agreed to testify in return for reducedpenalties. 56 The Collapse of Enron (continued) The trial ended in May2006 Ken Lay was found guilty of 10 charges of securities fraud and related offenses. – Experts expected Lay to spend 20 to 30 years in prison but Lay died in July 2006 before sentencing so his convictions were vacated (declared void) Jeffrey Skilling was found guilty of 28 charges of fraud and conspiracy. Sentenced to 24 years and 4 months and fined $45 million – This was later reduced on appeal 57 The Collapse of Enron (continued) Andersen employees faced charges of obstruction of justice during a federal investigation Andersen surrendered its license in 2002 and sacked all its employees. – The conviction was overturned in 2005 but the few employees still left spend their time dealing with law suits 58 Some Other Major Bankruptciessince Enron Year Corporation Value Business 2002 WorldCom $103.9 billion Telecom 2008 Lehman Brothers $691 billion Finance 2008 Washington Mutual $327.9 billion Finance 2009 General Motors $91 billion Automobiles 2009 CIT $71 billion Finance 2014 Chrysler $39.9 billion Automobiles 2014 Energy Futures Holdings $40.9 billion Utilities 59 Country Level Corporate Governance Corporate governance also exists at a country (macro) level. These regulations try to encourage / force firms to act in the best interests of their shareholders However, it is difficult to get the balance correct between enforcing good governance and still allowing firms to evolve and react to changing situations. 60 ASX Corporate Governance Principles & Recommendations P1: Lay solid foundations for management and oversight P2: Structure the board toadd value P3: Promote ethical and reasonable decisionmaking P4: Safeguard integrity in financial reporting P5: Make timely and balanceddisclosures P6: Respect shareholder rights P7: Recognise and manage risk P8: Remunerate fairly andhonestly 61 Sarbanes-Oxley Act (2002) KeyProvisions: 1. Public Company Accounting Oversight Board (PCAOB). The PCAOB provides independent oversight of public accounting firms providing audit services. It registers auditors, defines procedures for compliance audits, enforces conduct, quality control, and compliance. 3. Corporate Responsibility. Senior executives must take individual responsibility for the accuracy ofcorporate financial reports. 4. Enhanced Financial Disclosures. Details reporting requirements for financial transactions. Requires firms to have adequate internal controls for assuring the accuracy of financial reports and disclosures. 62 Sarbanes-Oxley Act (continued) 5. Analyst Conflicts of Interest. It defines the codes of conduct for securities analysts and requires disclosure of conflicts of interest. 8. Corporate and Criminal Fraud Accountability. Details criminal penalties for manipulation, destruction or alteration of financial records. Provides protections for whistle-blowers. 9. White Collar Crime Penalty Enhancement. Increases penalties for white collar crime and adds failure to certify financial reports as a criminal offense. 10. Corporate TaxReturns. The CEO must sign the company tax return. 11. Corporate Fraud Accountability. Identifies corporate fraud and records tampering as criminal offenses and details increased penalties. Lets the SEC freeze unusual transactions or payments 63