14 1 B40 2302 Class 11 BM6 chapters 12 3 33 34 12 3 and non BM6 material Agency problems solutions 33 Mergers takeovers 34 Corporate control financial architecture Based on slides created by Matthew Will Modified 11 28 2001 by Jeffrey Wurgler Irwin McGraw Hill The McGraw Hill Companies Inc 200 Principles of Corporate Finance Brealey and Myers Sixth Edition Making Sure Managers Maximize NPV Slides by Matthew Will Jeffrey Wurgler Irwin McGraw Hill Chapter 12 3 The McGraw Hill Companies Inc 200 14 3 Topics Covered The agency problem Evidence of its significance Solutions Incentives Other mechanisms some not in book Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 4 The Principal Agent Problem The problem Shareholders Owners Principals Managers Control Shareholders agents How do owners get managers to act in their interests i e to maximize NPV Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 5 The Principal Agent Problem How might manager s interests differ from shareholders interests Low effort slacking shirking Expensive perks corporate jets Empire building overinvestment Entrenching investment to keep job Avoiding risk so as not to lose job Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 6 Why does agency problem exist Agency problem exists because of the separation of ownership and control Managers do not bear the full costs of their decisions since they don t own 100 of firm Example Manager owns 10 of firm Can decide to buy corporate jet for 2 million which is worth 400 000 to him and 0 to shhs Will mgr buy it Yes since doesn t fully internalize costs of inefficient decisions Note if mgr owns 100 then no separation of ownership and control no agency problem wouldn t buy the jet Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 7 Why does agency problem exist Separation of ownership and control in modern corporation Benefits Limited liability professional management shareholder diversification allows firm to exist Costs Agency problems Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 8 Evidence on agency problems Hardly a competent worker can be found who does not devote a considerable amount of time to studying just how slowly he can work and still convince his employer that he is going at a good pace Frederick Taylor The Principles of Scientific Management New York Harper 1929 Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 9 Evidence on agency problems Much evidence on agency problems is from event studies If managers announce actions the event that investors don t like stock price falls Thus such actions must not maximize shhr value This inference is not justified if the action indirectly conveys some other bad news There are many types of managerial actions that investors don t like Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 10 Evidence on agency problems In the mid 1980s integrated oil producers spent roughly 20 per barrel to explore for new reserves Even though could buy proven oil reserves in marketplace for 6 per barrel Clearly NPV 0 but managers wanted to maintain their large oil exploration activities At every announcement of a new exploration project stock price dropped Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 11 Evidence on agency problems refer to appendix slide 1 Investors also do not like it when managers adopt poison pills Poison pills are devices to make takeovers extremely costly without target management s consent Suggests that managers resist takeovers to protect their private benefits of control rather than to serve shareholders Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 12 Evidence on agency problems 2 Study of stock market reactions to sudden executive deaths heart attack plane crash Shareholders often react positively to the news Especially shareholders of major conglomerates whose powerful founders built vast empires without returning much to investors Investors apparently believe the replacement manager will be better Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 13 Evidence on agency problems On average bidder returns on announcement of a takeover are negative This is especially true in firms whose managers hold little equity Or when the merger is diversifying Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 14 Evidence on agency problems There is a voting premium Consider two shares with equal cash flow rights but different voting rights The one with superior voting rights trades at a premium Indicates that control is valuable i e if you have enough shares you get other benefits of control private jet beyond just dividends In US voting premium is small but is 45 in Israel 6 5 in Sweden 20 in Switzerland 82 in Italy suggests managers in Italy have significant opportunities to divert profits to themselves not share them with nonvoting shhs Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 15 Evidence on agency problems Manufacturing firms in Russia at time of privatization were estimated to have market values of 1 of comparable Western firms Yes there is more regulation and taxation in Russia Poor management is also part of the story But equally important seems to be the ability of managers of Russian firms to divert profits and assets to themselves Stealing from shareholders is the ultimate agency problem Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 16 Potential solutions Incentives for managers Equity or stock options can give managers incentives to maximize shareholder value reduce agency problems Some believe that CEO incentives are not strong enough One study 3 CEO pay rises only 3 25 for every 1000 of shareholder value created Is this enough Even this amount could generate big swings in CEO wealth for a big firm Others believe that incentives are poorly designed Why aren t incentive contracts indexed to stock market Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 17 Potential solutions Monitor managers Shareholders delegate monitoring to the board of directors especially outside directors Auditors also perform monitoring on behalf of shhs Lenders also monitor to protect their collateral 4 poorly performing managers do get fired Monitoring may prevent the most obvious agency costs e g blatant perks manager not showing up for work But close monitoring is costly And manager has a lot of specialized knowledge There s no way to tell if it is being used just by watching Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 18 Potential