[Fin 411] Final Exam Flashcards
Your brother has heard the term “agency conflict” used in discussions of corporate management, and he asks you about it.
1a. What are agency costs? Who bears these costs?
2b. Discuss four mechanisms, besides direct monitoring, that encourage managers to act in the best interests of shareholders.
1a. Shareholders incur costs to ensure managers act in their best interests, with managers bearing these costs.
2b.
- Stock Options: Managers owning company stock act in shareholders’ interest as they benefit when the stock performs well.
- Performance-Based Incentives: Rewarding management for growing the company and aligning actions with shareholder interests.
- Threat of Firing: Managers risk losing their jobs if they don’t prioritize shareholder interests.
- Threat of Takeover: Underperforming management faces the risk of being replaced through a hostile takeover aimed at improving company performance.
Does an agency conflict exist between stockholders and bondholders? Explain.
Yes, an agency conflict exists between stockholders and bondholders because management-acting in the interests of stockholders- will likely pursue high-risk projects, whereas bondholders do not want the firm to take on high-risk projects due to the increased default potential.
Yes, an agency conflict exists between stockholders and bondholders because the bondholders have the first right to payment, often before any retained earnings or dividends are issued. It is the claiming of these funds that could present a major conflict. If a firm gets itself in trouble, the decision whether to pay dividends to retain investor relations, at the expense of debt default.
Your neighbor complains that he often does not trust statements made by corporate executives, even written statements in publications such as annual reports. Is your neighbor’s view related to the concept of asymmetric information? Explain, and define the term.
Yes, his perspective aligns with asymmetric information, where outsiders lack information compared to internal managers/sellers. Aklerlof introduced this concept, highlighting quality uncertainty when one party possesses more information than the other. For instance, a used car salesman holds more knowledge about the car’s true condition than the potential buyer.
Discuss one theory driven by asymmetric information.
Pecking order theory - Managers know more about the true value of the firm’s existing assets or new investment opportunities. Managers goal is to maximize shareholders wealth. Assume also that managers act in the interests of shareholders, meaning they attempt to maximize shareholder value and refuse, in general, to issue undervalued shares, start with debt, then use hybrid securities, then equity.
The pecking order theory is directly tied to the use of asymmetric information when deciding how to finance a company. The pecking order theory states that companies should use alternatives that do not rely on the public opinion of firm information such as internal cash, bank debt, or public debt before relying on shareholders to fund firms. This way, there is less risk to the firm and less potential for scrutiny from shareholders who may or may not be receptive to the information that managers possess. The more asymmetric information being withheld from the public eye, the more potential there is for investors to degrade firm value when depended on for financing operations. Thus, the Pecking Order Theory aims to minimize the market’s effects on firm health when there is asymmetric information in play.
Are all firms subject to the same degree of information asymmetry?
No, not all firms face identical degrees of information asymmetry. Factors such as industry norms, managerial transparency, company size, and the complexity of operations contribute to varying levels of information asymmetry among firms.
Discuss the importance of the cash conversion cycle in a firm’s capital structure from the perspective of one theory discussed in class.
It is important with the pecking order theory because if the managers effectively handle the working capital and cash there will be less need for external funding.
Explain how stock options provide incentive alignment between managers and shareholders and ways they fail to do so.
Stock options provide incentive between managers and shareholders align their interests by essentially making a manager a shareholder. If a manager owns stock, they will be more concerned with the performance of that stock because their net worth will be directly impacted.
Stock options do provide the incentive for managers to focus on short-term strategies to build riches instead of promoting long term wealth. There is possibility that the manager will get fired, so they do not care what happens to the company as long as they fill their pockets as much as they can while in charge. This also leaves the back door open for disaster to ensue as managers will become greedy in good times and sacrifice protective efforts for maximized earnings.
Briefly explain the “market for lemons” (Ackerlof) story. How does this story apply to financial markets?
The Market for Lemons is essentially a story explaining the old quote “you get what you pay for”. In this example, it is made clear that lower prices for a product will drive out higher quality goods from the market, leaving only overpriced- useless junk. It also demonstrates the lack of information available to the buyer, since they do not know the quality of cars being sold, they only know price. The decision - making process of the buyers only informed of price slowly drives the “peaches” from the market, which brings the entire industry farther from optimization.
The Ackerlof “market for lemons” asserts that when information asymmetry exists between two parties in an economic transaction, it may degrade the total quality of the basket of goods throughout the industry, which will either leave only “lemons” i.e. lesser goods available or eventually destroy the industry entirely. With application to financial markets, an investor may not know the true value of the company’s stock that he buys (information asymmetry). However, internal management of Company XYZ knows that it will miss its earnings report; they choose to “cook the books” to meet earnings expectations. The investor is left unaware of the firm’s underperformance and buys the “lemon” stock due to the lack of information.
Managers can “signal” good news by merely holding a press conference and making an announcement. Would such news be taken at face value by investors? How might (a) dividend actions and (b) capital structure actions be used as signaling devices?
I think that there are some cases in which a press conference can signal good news, but with the unpredictability of the market recently, there is no way to be sure. There is also speculation that managers will use press conferences and the announcement of good news to attempt to sweep the issuance of bad news under the rug.
a. Dividends are arguably one of the most important indicators of the health of a company. They are also a great incentive to current and future investors. The increase of a dividend, in theory, suggests the health of a company is improving. Contrarily, the suspending of a dividend would indicate deteriorating financial performance of a firm, and would possibly fail to appease speculative investors. The active Dividend rate should always be considered sustainable because investors can get really pissed off if the dividend fluctuates negatively.
b. Any action taken to alter the capital structure of a firm could be a signal to investors, much like dividends. If a company were to issue more debt or stock, this could be an indicator that sales are underperforming and capital is being used inefficiently. This, in turn, would be a negative sign to investors. On the other hand, the same announcement could be used to indicate the expansion of the firm and entice investors.
Briefly discuss why LBOs (Leveraged Buyouts) may provide a stronger managerial incentive alignment (align the manager’s preferences with those of the stockholders) than stock options.
EF-With a LBO, especially a MBO, managers become the sole stockholders, so their motives are fully aligned. With stock options, there is not as much skin in the game, because there the majority of issued stock is outstanding.
LM-From a managers perspective, leveraged buyouts are more attractive in terms of tax advantages with debt financing due to tax shield, the ability for founders to take advantage of a liquidity event without giving up operational influence or discontinuing day to day involvement, there is no scrutiny unlike public company or a captive division of a larger parent, and the opportunity for managers to become owners of a significant percentage of a firms equity. Therefore, the managers interests are aligned to the stockholders and the well being of stockholders unlike stock options. Employee stock options offer employees or managers the right to purchase a set number of shares at a specified price for a fixed period of time, however the stock options do not align the interests of managers with the stockholders. Therefore the LBO gives a stronger incentive of alignment between managers and stockholders rather than stock options.
Discuss three reasons for LBOs. Which do you think is more likely and why?
Three potential reasons for LBOs include the control hypothesis, wealth transfer hypothesis, an increased tax shield, and managerial incentive alignment. The control hypothesis states that the more concentrated the ownership of a company is, the more management will monitor the firm’s activity. Similarly, the reasoning of managerial incentive alignment suggests that an LBO- by placing managers as stockholders- forces managers to act in the best interests of stockholders, rather than their own individual interests; this is an attempt to solve the principal-agent problem. The wealth transfer hypothesis states that the wealth of the company is transferred during an LBO from stockholders in the market to the buyer bondholders, and thus any dividends and profits from riskier projects. Lastly, an increased tax shield through increased debt holdings creates savings for the firm. The wealth transfer hypothesis is the most likely reason in my opinion, specifically with internal LBOs (MBOs) because of the information asymmetry and inside knowledge internal managers have of the firm’s worth and future prospects. For example….
EF-BARBARIANS AT THE GATE- How the buyer couldn’t even imagine the payout he would receive, at the expense of issuing an ungodly amount of debt. The board of Directors would also be well compensated for deciding to agree to the LBO.
Explain the relationship between a golden parachute and an LBO.
A golden parachute is a compensation arrangement that offers significant financial benefits to top executives if they lose their jobs due to a change in ownership, like during a merger or acquisition. In contrast, a leveraged buyout (LBO) involves acquiring a company primarily using borrowed funds secured by the assets of the acquired company, often resulting in a change in management or restructuring.
The relationship between a golden parachute and an LBO lies in the potential activation of golden parachutes when an LBO occurs. In some cases, existing management may negotiate golden parachute clauses in their contracts to protect themselves in the event of an LBO, ensuring they receive substantial compensation if they lose their positions due to the buyout and subsequent management changes. These agreements can impact the financial dynamics and negotiations during an LBO.
Explain why an underwriter may be willing to “leave money on the table” (underpricing) in an IPO.
An underwriter may be willing to underprice in an IPO due to several of the following reasons. The underwriter is invested in the success of the IPO, as it will impact the reputation of the underwriter and attract more business in the future. The underwriter also receives business through friends and existing clients, so it is important that the underwriter has a good reputation and relationship with current clients. Lastly, the underwriter leaves money on the table to be collected by the market in order to avoid litigation from angry investors if the IPO were to be unsuccessful and unprofitable due to and overpriced IPO.
Explain why an issuing company may be willing to “leave money on the table” (spread) in an IPO
A firm may be willing to leave money on the table during an IPO in order to promote positive relations with investors and incentivise growth in the price of the stock throughout the issue day and after. It it better to leave money on the table to attract positive investment rather than risk overpricing of an IPO, which would be devastating for the company not only through the IPO, but for months to follow.
Your neighbor plans to issue an IPO. His strategy is to use the underwriter that promises the highest issue price. Do you agree with this strategy? Why or why not.
I do not agree with this strategy. With using the underwriter that promises the highest price, there is greater potential to price your shares out of the market. That underwriter may be attempting to fill their pockets with as much cash as possible, while leaving your IPO to suffer. There are more things to consider such as experience, customer base, and brand reputation in addition to the promised IPO price when determining who to use for an IPO.
