Part 1:An overview of corporate finance and govarnance

Question 1

How does the financial contracting situation look like?

Answer 1

• Investors provide funding to the firm in return for certain claims, which specificy the conditions under which the investors are entitles to a monetary return on their investment and how large this return should be, as well as what right the investor has to exert influence over the firm’s decisions.

Once the firm has recieved the funding, it decises what to do with it, according to some preferences, but under some degree of influence exerted by the investors.

Investors:
Type of claims
- Cash flow rights
- Control rights

Firms:
“Who” is the firm?
- Preferences/decisions
- Goverance/Control

Question 2

What are the two sources of corporate financing?

Answer 2

Cash-flow rights and Control Rights

Question 3

What are the two simplest and most basic types of financial claims?

Answer 3

Debt and equity

Question 4

How is debt defined in terms of cash-flow rights?

Answer 4

Debt is a claim to a predetermined level of firm income.

(Lender gets a fixed payment, like interest, regardless how the company is performing)

Question 5

What is equity’s relationship to firm income in terms of cash-flow rights?

Answer 5

Equity is a residual claim to all income beyond the predetermined level.

(You own a piece of the company. If it does well, you get part of it)

Question 6

If you were to graph the cash-flow rights of debtholders, how would it look like?

Answer 6

Debt is a concave claim
- As long as firms income is lower than the level of debt, then the debtholders have the right to recieve all firm income.
- On the other hand, when the firms income is higher than the level of debt, that does not mean tht the debtholders are entitled to anything more.

Question 7

If you were to graph the cash-flow rights of Equity holders, how would it look like?

Answer 7

Equity is a convex claim
- Since debtholders are entiled to everything until the level of debt is reached the equity holders get nothing.
- Once the debt has been repaid, equity holders have a residual claim to everything the firm earns

Question 8

Are debt or equity holders more risk prone?

Answer 8

Suppose the expected level of income is just above the level of debt.

Debt holders would want to reduce the variability of income so that they run with as low risk as possible to make a loss. They want to see a probability distribution around the expected level of income that is “quite tight”.

For equity holder, if that expected level of income is reasched, they will get something but not that much. Therefore, equity holders will be interested in widening the range of possible outcomes around the expected income. Then there is some possible probability that they will get a lot higher payout than the expected income. On the other hand, they don’t care if the income is just below or a lot below the level of debt as they will get no payout either way.

Equity holders are more risk prone.

Question 9

Simple debt-equity dichotomy may not be sufficent to characterize the claims. Give an example and explain it using graphs.

Answer 9

The cash-flow rights of a debt claim on a highly leveraged firm are then very similar to the cash-flow rights of an equity claim on a firm with low leverage

(Figure 3)

Question 10

Additional reasons why the simple debt-equity dichotomy is insufficent:

Answer 10

• So far we have looked into one period. Investors typically hold onto a claim for a longer period of time and there are multilpe periods of payouts. More complex stream of cash-flows
• Imperfect income measurement and verificantion may be imperfect
• Who holds the claim matters. Is this a small or large investor? does the investor have a lot of information about the firm or no information at all? Are the claims concentradet or dispersed, i.e. are they held by a few investors or by a large number of smaller investors?
• Debt can be ordinary or secured. and can have different levels of seniority.
• The debt-equity classification does not account for a wide range of intermediary claims (e.g. prefered stock, convertible debt., etc.)

Question 11

How does the prioity of different types of claims in liquidation look like?

Answer 11

Highest priority to lowest:
- Direct bankruptcy costs
- Unpaid taxes and pension liabilities
- Wage claims (to a limit)
- Secured debt
- Ordinary (senior) debt
- Subordinated (junior) debt
- Preferred stock
- Common Stock

Figure 4

Question 12

What are control rights?

Answer 12

Control Rights specify the rights of investors to intervene in the firm’s decisions. Mirror cash-flow rights and their priority structure.

• Debt-holders have the right to intervene and take control if their cash flow tights are not paid out (contingent control to force the firm into bankruptcy)
• Equity-holders have full residual control of ownership of the firm as long as the cash-flow rights of all higher-priority claims are paid out

Question 13

In practice, the theory of control rights is too simplified. Why?

Answer 13

• Debt contracts may specify intervention rights based on performance bench marks or prevent certain actions by the firms that they are not allowed to make.
• The firm has some sort of Legal Bankruptcy Protection. Firms cannot immidately be forced into liquidation simply for failing to service the debt
• Limited possibility to legally enforce control rights (too costly or too risky to take the case to court, transaction cost)
• By far, the most important reason that formal control rights don’t tell the whole story is that residual control rights are difficult to exerice for reasons other than absence of legal enforceability (check out the firms perspective)

Question 14

What could be the objective fuctions of a firm?

Answer 14

• Shsreholder value maximization
• Profit maximization
• Maximization of the manager’s utility
• Maximization of all stakeholders’ utility (debt-equity holders, employees, customers and supliers, surrounding community)
• Etc

Question 15

What is the Neoclassical view of the firm (Arrow-Debreu)?

3 main points

Answer 15

• “The firm” is simply a bundle of real investment opportunities, owned by one or more shareholders, who may or may not take on debt to finance the investments
• Claims on the firm are completely defined from cash-flow rights, since control rights are always strictly and costlessly enforced.
• There is no meaningful difference between the firm and its shareholders:shareholder value maximization becomes equivalent to optimizing shareholder consumption over time; firms’ financing policies are irrelevant for achieving this objective (standard MM results)

Question 16

What is the Contractual view of the firm?

3 main points

Answer 16

• In practice, the manager/entrepreneur actually running the firm is much better informed about the firm itself, its investment opportunities, prospects and risk than the investors providing the funds, and has direct executive power
• => seperation of ownership/financing and control/management: investors are (more or less uninformed) “outsiders” and mangers are (informed) “insiders”
• The insider-outsider problem is exacerbated by dispersion among investors, given rise to:
  1. Reduced ability and incentives for aquiring information and exercisiong control rights for individual investors (free-riding problem)
  2. Coordination problems and possible conflics of interest between investor groups (majority vs. minority owners, owners vs. creditors etc.)

“The firm” has no preferences (but managers, owners, creditors etc) do, and the firm’s decisions depend not just on the distribution of formal contol rights, but on the distribution of information and de facto control

Question 17

The separation of financing and management (the asymmetry in general) results in two main types of contracting problems. Explain.

Answer 17

Adverse selection:
- Information asymmetries: “Good” and “Bad” firms may be indistinguishable to outside investors
- Both good and band firms will seek to obtain financing, but to protect themselves, investors will have to offer financing on terms that cover for the possibility that they are funding a bad firm
- Disadvantageous to good firms (subsidize bad firms) => good firms self-select out of the market for outside financing
- Realizing that good firms have an incentive to withdraw, investors will find themselves with a worse pool of firms to invest in and may - in the limit - be unwilling to provide any funding at all (i.e. the market for outside financing dries up)

Moral hazard:
- Once financing has been provided, insiders (management)should act on behalf of the investors who hold the formal control rights (Principal-agent problem)
- However, due to outsiders’ information disadvantages, limited monitoring capabilites, coordination and free-riding problems etc., most of the residual control rights will effectively end up in the hands of the insiders.
- Self-interested insiders do not necessarily act in the best interest of investors, and their substantial discretion over the firm’s decisions can be abused for private benefit

Question 18

Consequences of control problems

4 points

Answer 18

1. Insufficent effort
   - avoid difficult decisions
   - inadequate internal control e.g. market research
   - overcommitment to competing activities e.g. playing golf or working with another company as well
2. Overinvestment/non-value increasing investment
   - empire building e.g. excessive acquisitions of other companies
   - pet projects e.g. spending money on product development on projects that are not going anywhere
   - diversifying investments e.g. investing into businesses that are unrelated to the companies core activites
3. Entrenchment strategies
   – Invest in increased complexity to make themselves indispensable i.e. basically strategies to avoid negative incentives
   – Performance-measure manipulation to mask poor performance
   – Excessive conservatism in good times (“quiet life”) or excessive risk-taking in near-distress situations (“gambling for resurrection”)
4. Expropriation of investors’ funds, self-dealing (legal or illegal)
   - Perk consumption
   – Excessive salaries
   – Nepotism in hiring, supplier selection, etc.
   – Below-market-price asset sales
   – Insider trading or information leakage for private gain

Question 19

Exemplifying with actual instances of (large-scale) managerial misbehavior will severely understate the significance of agency problems. Explain two reasons why.

Answer 19

First, Media/Court cases are a tiny fraction of the total

Second, in reality, much of corporate law, institutional structures, financing arrangements and practices, etc., that are often taken for granted, have been instituted to address exactly these
types of problems.

More generally, size and structure of financial system, ownership patterns, etc. reflects responses to contracting/control problems that have evolved over long periods of time

Question 20

There are two overall effects of imperfectly dealing with control problems. Which ones?

Answer 20

• Reduction in investros’ willingness to supply financing ex ante
• Reduction in the efficency of resource alllocation ex post

Question 21

There are four main government mechanisms to solve control problems. Which ones?

Answer 21

1. Legal Protection
2. Incentive alignment
   - Direct incentives
   - Indirect incentives
3. Delegated Monitoring
   -Boards
   - Large investors and Debt holders
   - Investor activism
4. The Market for corporate control
   - Takeovers
   - LBOs

Question 22

Explain the legal obligation and the diffeerent types of laws

Answer 22

Legal protection: legal obligations of firms/managers to investor

Company law:
- managers’ fiduciary duty (holds a legal or ethical relationship of trust with one or more other parties) to shareholders, mandatory board influence on major decisions

Bankruptcy law:
- Creditors’ rights to force liquidation, seize collateralized assets, vote in reorganization

Securities law:
- insider trading laws, protection of shareholders’ voting rights

Takeover law:
- restrictions on takeover defenses

In addition: the general quality of law enforcement in a country

Question 23

What are the implications of a strong legal investor protection?

Answer 23

• Better availability of exteral financing and better financing terms for firms
• It should reduce ownership concentration as weak and dispersed investors are more willing to supply funding in countries with high protection of minority investors

Countries with legal systems originating in English common law traditionally have stronger investor protection than civil-law countries and also deeper finacial markets

Question 24

Limitations of legal protection and legal enforcement

Answer 24

• Residual control rights vague and typically not directlly legally enforceble
• Courts don’t make business judgements
• Legal sanctioning of misallocation of resources only in extreme cases

Legal protection necessary but not sufficent

Question 25

What are the two types of incentive alignments?

Answer 25

• Direct (positive) incentives (carrots)
• Indirect (negative) incentives (sticks)

Question 26

Explain direct (positive) invcentives

Answer 26

Monetary rewards to managers/insiders for pursuing outside investors’ interests (i.e. pay for performance)

Performace measure should be highly correlated with managers’ actions and verifiable

In practice, this means performance based pay. A typical executive compensation package consists of:
- Fixed part (salary)
- Variable part (bonus)

Question 27

Positive incentives are imperfect for several reasons

Answer 27

• Additional opportunities for self-dealing (timing, earnings manipulation, etc.)
• Both earnings and stock prices are influenced by exogenous factors ⇒ insiders are rewarded for “luck”; these rewards are typically asymmetric
• To avoid paying managers for factors outside of their control, compen sation should be: (i) immunized against the effects of exchange rates, interest rates,
  commodity prices, etc. (ii) based on relative rather than absolute performance
• Bonuses and equity-/option-based compensation are complements rather than substitutes, because the former is short-term and favors focus
  on current profits, the latter is long-term and forward- looking; balance between both is required
• Pools of CEOs and directors are often too small and/or compensation committees of boards are in other ways not independent from CEOs ⇒ compensation contracts are not designed solely to benefit outsiders
• The performance sensitivity of executive pay is in practice quite low (a marginal 0.003 per 1 unit increase in net earnings according to one early estimate); the only way to perfectly incentivize all managers,
  workers, directors, etc., is a one-to-one relation between compensation and earnings (unrealistic, leaves nothing for shareholders) ⇒ incentive
  pay is necessarily imperfect
• Anecdotal evidence suggests direct incentive pay is quite crude and possibly ineffective: during 1982-2000, equity-based pay increased from 20 to 50% in the US; in the same period, average CEO pay increased
  from 42 to 531 times the average worker’s pay

Question 28

Give examples of Indirect (negative) incentives

Answer 28

• Potential job loss (CEO turnover rate correlates negatively with per formance)
• The threat of bankruptcy or reorganization (including reputational damage for CEO of running a firm into bankruptcy)
• The potential for redistribution of control rights (more independent directors on the board, concerted action by investors or greater investor
  influence achieved by other means, etc.)

Much of the indirect
incentives insiders face are achieved via product-market competition

Question 29

“Sticks” have their limits too, however, and may also give rise to adverse incentives

Answer 29

• Excessive risk-taking/gambling (particularly if the firm is close to distress)
• Excessive attention of executives to relative (rather than absolute) per-
  formance
• Herding behavior; executives make similar decisions as competitors for fear of standing out (better to be wrong together…)

Question 30

Delegated monitoring can be divided into active and passive. Explain it

Answer 30

• Active monitoring is forward-looking, focused on shareholder value, and based on the exercise of control rights (active monitors have the means and intention to intervene in corporate decision-making)
• Passive monitoring is (partly) backward-looking, focused on portfolio returns, and passive monitors do not necessarily have control rights or
  the intention to intervene in decision-making (exit over voice). Examples: institutional investors, analysts, rating agencies, media

Question 31

Who are the active monitors

Answer 31

• Boards of investors
• Large Investors
• Active (minority investors)

Question 32

The very purpose of boards of directors is to monitor corporate management on shareholders’ behalf. In practice, however, monitoring by boards is also imperfect. What are the reasons?

Answer 32

• Lack of independence (insiders on the board)
• Conflict avoidance
• Insufficient attention/overcommitment (sitting on multiple companies boards)
• Insufficient incentives
  Positive incentives: there is usually a weak link between firm performance and directors’ compensation
  Negative incentives: the litigation threat for failing to act on shareholders’ behalf is weak for directors (shareholders can sue boards only in extreme cases)

there is also a silver lining to most of them

Question 33

There are two major routes toward improving the functioning of boards. Which ones?

Answer 33

1. Legislation/centralized regulation
2. Self-regulation and codes of conduct

Question 34

Explain “Large investors: concentrated ownership” as a governance mechanism

Answer 34

• (residual) control rights in a few hands => coordination becomes easier
• The ability to exert influence through board representation, voting and other means, combined with the size of the stakes, give large owners incentives to get informed expend resources to monitor management. => free-riding problems eliminated
• category of large owners vary (banks, institutional investors, families
• ownership concentration is more common where legal protection is weaker

Question 35

Concentrated ownership of control rights does not necessarily correspond to
an equal concentration of cash-flow rights

Answer 35

• Dual-class shares
• Proxy votes
• Pyramids
• Cross-holdings and business groups

Question 36

There are a number of costs and drawbacks of relying on concentrated owners as monitors

Answer 36

• Concentrated owners that are not well-diversified bear excessive idiosyncratic risk, which may make them too conservative (giving rise to
  potential conflicts of interest with diversified minority owners)
• Private benefits of control (particularly if voting rights substantially exceed cash-flow rights)
• Expropriation of minority investors (special dividends, greenmail/targeted stock repurchases, transfer pricing, etc.)

Question 37

There are essentially two dimensions to debt as a governance mechanism

Answer 37

1. Large debt holder (e.g. main bank) : similar role as concentraded owners
2. High amounts of debt (concentraded or dispersed): discipline management by sharpening negative incentives

Question 38

The powers and incentives of large debt-holders (primarily banks) to exert monitoring reside in

Answer 38

• Their substantial cash-flow claims on the firm
• Their contingent control rights in case of default or covenant breaches
• The necessity for firms to regularly roll over debt
• Sometimes proxy voting rights of other equity-holders

Question 39

Drawbacks of large debt-holders as monitors

Answer 39

• Potential conflicts of interest between large debt-holders and dispersed minority shareholders
• Relationship banks extract rents from shareholders by exploiting information monopolies (“holdup” problem)
• Even large debt-holders may in practice have little incentive to expend monitoring costs and discipline management as long as the firm is far from default

Question 40

The discipline of debt (in general, not just debt held by large creditors):

Answer 40

• Debt-holders, through the contingent control right and priority of their claim, can force the firm into bankruptcy, leading to job loss for management (as well as the reputation loss of bankrupting the firm); creates
  a powerful incentive to enhance performance
• Covenants can substantially expand the states of nature in which control rights are transferred to creditors
• Even if the firm is nowhere near default, debt servicing takes cash out of the firm, preventing management from wasting it (Jensen’s agency
  costs of free cash-flow hypothesis)
• Debt (particularly short-term) forces management to ensure the possibility of future debt issuance/loan renewals, or face illiquidity (same roll-over argument as above)

Question 41

Limits to debt as a governance mechanism

Answer 41

• Crude and indirect way of solving agency problems (“nuclear option”:
  the firm is completely destroyed, i.e. bankrupted, if management misbehaves)
• Debt overhang: with excessive debt, the firm may reject positive-NPV projects because if successful, the payoffs of the investment will only benefit debt-holders and not shareholders, resulting in deadweight (opportunity) costs of underinvestment
• Covenants may similarly lead to underinvestment by preventing the firm from raising additional debt
• Exacerbates owner-creditor conflict (increases risk-shifting incentives)
• Debt increases expected illiquidity costs (refinancing risk, risk of credit rationing), as well as expected costs of financial distress (or, in the extreme, bankruptcy
• Small” breaches of debt-holders’ cash-flow rights may lead to inefficient liquidation of the firm, particularly if debt is dispersed (coordination failures, transaction costs, etc., lead to a “grab for assets”)
• Debt-holders may be unwilling to exercise their contingent control right:

Indirect distress costs (e.g. loss of business) may be quite detri-
mental to the firm and therefore counterproductive for debt-claimants

Bankruptcy codes with extensive reorganization possibilities (whose purpose is precisely to prevent inefficient liquidation) may be quite lenient on management, leave the call option value of continued operations with shareholders, and leave debt-holders to carry most of the cost (automatic-stay provisions, forced write-downs, granting new claims seniority over existing ones, etc.)

(check ppt)

Question 42

What are activist investors?

Answer 42

significant minority owner exercising influence via reputation, visability, and threat of proxy rights

Investor activism can be viewed as a “middle-ground” between active monitoring by large shareholders and the discipline instilled by full-blown takeover threats

The role of activist investor is typically taken on by specialized hedge funds, (private) equity investment companies, and some institutional investors

Question 43

Limitations of investor activism as a governance mechanism

Answer 43

• The interests of investors large enough to be an active monitor may not coincide with those of other (minority) investors, possibly resulting in undermonitoring, collusion with insiders, self-dealing, etc.
• Possible time inconsistency: active monitoring to achieve long-term value improvement may be too costly compared to exit if the stock is sufficiently liquid (i.e., active monitoring may only pay off for illiquid stocks)
• Active investors themselves typically act on behalf of beneficiaries; monitoring may be impaired by agency problems related to delegated and institutional investing
• “Overmonitoring” may lead to adverse incentives for management (e.g.,
  make them excessively preoccupied with short-term earnings)
• Legal and regulatory obstacles

Question 44

The market for corporate control: there are two main types. Which ones?

Answer 44

Hostile takeover
Potential aquirer bypasses the firm’s board and management and makes a tender offer directly to minority shareholders (bid is contested by the firm’s insiders)

Buyout
full takeover of a public firm by a group of investors, where the firm is taken private, usually financed by taking on large amounts of debt (LBO)

Question 45

There are two related main reasons why mismanaged firms are more likely to be takeover targets

Answer 45

(i) Stock in firms in which there is substantial expropriation of outsiders by insiders will command a lower price in the market, making them relatively “cheap” to acquire

(ii) disgruntled minority investors
in mismanaged firms will be more likely to accept a bid from a potential acquirer, even if the bid is contested by the firm’s board and management

Question 46

What are the incentives of takeovers/buyouts?

Answer 46

• Takeovers and buyouts are also often followed by substantial reorganization of the firm, its capital structure, and investor influence.
• Managers likely to be replaced in a hostile takeover
• Discipline of debt for LBOs
• Management’s ownership stake aligns incentives with investors for MBOs

Question 47

Drawbacks of takeovers as a governance mechanism

Answer 47

1. Takeovers are very expensive
2. Free-riding problems: the expected value of the firm increases with the takeover ⇒ existing shareholders have an incentive not to tender unless the bid premium is large enough; therefore, the bidder may have to surrender most of the gains from taking control in order for the bid
   to succeed

3.The threat of takeovers may give rise to incentives for management to underinvest in unobservable long-term investments

4. Takeovers may increase agency costs (if they are part of empire building); takeovers are also subject to political pressures (not least international takeovers), and competition/market power concerns (horizontal
   acquisitions)

Question 48

What is an LBO?

Answer 48

An LBO effectively works like a large-scale stock repurchase, financed by
issuance of debt. The deal is usually initiated by a group of investors and
sponsored by an LBO specialist firm, whose stake in the deal is typically around 20%. Sometimes the group of investors is headed by the current management of the firm, in which case the deal is referred to as a management buyout (MBO). A typical sharing rule is then that management
acquires 10-30% of the equity, and other investors the remainder. The actual
leverage varies substantially over time and across deals, with debt/equity ratios ranging from 50 to 2000%

Question 49

Advantages of LBOs as a governance mechanism

Answer 49

• Active monitoring: LBO partners have the means and incentives for
  intervention
• High leverage means effective disciplining (cf. subsection 4.3.2 above)
  -The fact that management takes a substantial ownership stake in the firm (in MBOs) or is replaced from within the group of LBO partners aligns their incentives with those of investors

Question 50

Limitations of LBOs as a governance mechanism

Answer 50

• The LBO is a transitory form of organization (given that partners will want to cash out within, say, 10 years)
• The reliance on high leverage means that LBOs are generally successful only in mature industries with sufficiently high and steady cash-flows
  to service the debt
• Even for such firms, the financing structure may be too tough, and stifle investment in the long term (debt overhang)