Maximize Firm Value

• The objective of maximizing firm value is often restated as maximizing the stock price (particularly for public companies).

• Why?

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

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

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)

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.

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

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)

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.

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

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

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”

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

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

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

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

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

Externalities

• Negative:– Pollution– Increased traffic– Increased crime

• Positive:– Access to goods or services where previously

absent– Development in inner cities