Maximize Firm Value

1. Maximize Firm Value • The objective of maximizing firm value is often restated as maximizing the stock price (particularly for public companies). • Why?

2. Focus on Stock Price Maximization • Stock prices are easily observable and are constantly updated • Stock prices, in a rational market, attempt to reflect the long-term effects of decisions made by the firm. • The objective of stock price maximization provides some very elegant theory on: • How to pick projects • How to finance them • How much to pay in dividends

3. Threats to Objective Function • Managerial objectives may deviate from stockholder wealth maximization • Stockholders may expropriate wealth from bondholders and other creditors • Information produced by management may be misleading and noisy, and market responses may be out of proportion to the information • Firms may create significant social costs (externalities) which are not deducted in determining earnings

4. Agency Costs of Separation of Ownership from Control • Satisfice rather than maximize (Herbert Simon) • Consumption of excess compensation and perquisites • Rapid escalation in top management pay, particularly CEO compensation • Repricing of employee stock options • Empire building (e.g., overpaying on takeovers) • Maintain your position • Greenmail • Golden parachutes • Poison pills • Shark repellants (Anti-takeover amendments)

5. Empire Building • The stock price of the acquiring firm typically declines at the announcement of a takeover (merger). • Acquisitions often fail, for example: • Kodak bought Sterling Drug for $5.2 billion and sold it for $4.5 billion 5 years later. • Quaker Oats bought Snapple for $1.7 billion and sold it for $400 million 5 years later. • AT&T bought NCR for $7 billion and sold it for $4 billion 4 years later.

6. Greenmail • The target of a hostile takeover buys out the potential acquirer’s existing stake, generally at a price much greater than the price paid by the raider, in return for the signing of a ‘standstill’ agreement. • Negative consequences for existing stockholders: • Cash payment by the managers makes the firm poorer • Payment of greenmail reduces the likelihood of a takeover, which would have raised the firm’s stock price • Accounting treatment? • FTB 85-6

7. Golden Parachutes and Exit Packages • Golden parachutes are provisions in employment contracts that provide for the payment of a lump-sum, or cash flows over future periods, if the managers covered by these contracts lose their jobs in a takeover. • A large number of Fortune 500 firms have incorporated golden parachutes into top management compensation contracts. • Excessive exit packages (Michael Ovitz and Disney)

8. Poison Pills • A security, the rights or cash flows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill.

9. Shark Repellants • Anti-takeover amendments have the same objective as greenmail and poison pills – dissuading hostile takeovers. • However, unlike greenmail and poison pills, shark repellants require stockholder approval. • Examples of anti-takeover amendments: • Super majority voting requirements • Fair-price amendments • Staggered election to the board of directors

10. Theoretical Means of Reducing Agency Costs of Equity • Annual meeting of stockholders • Voice displeasure with incumbent management and remove them if necessary • Election of individuals to the board of directors • Fiduciary duty is to ensure that managers serve the stockholders

11. Practical Difficulties – Annual Meeting • Power of stockholders to act at annual meetings is diluted by three factors: • Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings. • Incumbent management starts off with a clear advantage when it comes to the exercising of proxies. • Large stockholders often prefer to vote “with their feet”

12. Practical Difficulties – Board of Directors • Most individuals who serve as directors cannot spend much time on their fiduciary duties • Directors often suffer from a lack of expertise on many issues • Directors, even outsiders, are often not independent • Interlocking directorships (CEO lodge) • Most directors own only a small number of shares • CEO sets the agenda, chairs the meeting, and controls the information flow • Search for consensus dominates any attempts at confrontation

13. More on Reducing Agency Costs of Equity • Provide managers with an equity stake in the firm • Increases risk of expropriating wealth from bondholders • Increases risk of misleading financial information being conveyed to the markets • Provide stockholders with better and more updated information • Have a large stockholder become part of incumbent management • Have more “activist” institutional stockholders • Make boards of directors more responsive to stockholders

14. Agency Costs of Debt • Stockholders may maximize their wealth at the expense of bondholders and other creditors. For example: • Increase leverage dramatically • Increase dividends significantly • Taking riskier projects than those agreed to

15. Reducing the Agency Costs of Debt • Use covenants to: • Restrictions on what or where the firm can invest in • Restrict dividends to a certain percentage of earnings • Require the consent of existing bondholders before issuing new secured debt • Make existing bonds “puttable” • Issue “rating sensitive” bonds • Require that certain financial ratios are maintained

16. Informational Problems • There is evidence that managers: • Suppress information, generally negative information • Delay releasing bad news (the Friday after 4 effect; EBBS – everything but bad stuff) • They sometimes reveal fraudulent information

17. Externalities • Negative: • Pollution • Increased traffic • Increased crime • Positive: • Access to goods or services where previously absent • Development in inner cities