exp 482 corporate financial policy clifford w. smith, jr. winter 2007 presentation 3 * covers...
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EXP 482Corporate Financial Policy
Clifford W. Smith, Jr. Winter 2007 Presentation 3 * Covers readings on course outline through Brickley/Smith/Zimmerman, Chap 14 and 15
EXP 482 – Overhead 3
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Capital Structure Management
Trade Off Hypothesis
Pecking Order
Hypothesis
Market Timing
Hypothesis
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Pecking Order Hypothesis
There is an important information asymmetry between stockholders and managers
“What you don’t know CAN hurt you”.
If firm issues securities, those value depends on firm value investors price-protect themselves.
This cost is largest for equity, then risky debt; internally generated capital is least expensive.
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If there is an “optimal” capital structure, the firm spends a lot of time away from it.
Extreme Version: There is no optimal capital structure – observed capital structure is just the result of a sequence of myopic financing choices.
Pecking Order
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Regression results are strong and robust.
Look at tails of distribution.
Pecking Order
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Market Timing
Firm only issues equity when it’s overvalued
There is no optimal capital structure
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Determine the optimal capital structure for the economic balance sheet.
Look at the trajectory of capital structure.
Whenever the costs of deviating from target exceed the cost of adjustment - adjust.
Strategic Capital Structure Management
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Adjustment Costs
Leverage
Time
Target Leverag
e
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Adjustment Costs
Firm Value
LeverageTarget Leverag
e
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Differ by transaction─ Costs of share issues are higher than that for debt
─ Costs of share issues are higher than that of share repurchases
Exhibit fixed costs and scale economics─ Equity offers are rare while bank loans are common
─ Optimal adjustment frequently involves overshooting
─ Most companies spend considerable time away from their target
Adjustment Costs
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Strategic Capital Structure Management
But investment opportunities are not smooth – they are lumpy and episodic.
Suppose you have a large growth option – it will increase firm value by 50% and take three years to exercise.
How do you finance this project?
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Pecking Order Hypothesis
Market Timing Hypothesis
Tradeoff Hypothesis
Strategic Capital Structure Management
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Benchmark Compensation Plan
Suppose I offer a corporate manager a series of prespecified salary payments -- from the time he is hired until the time he retires -- with the only contingency that if the firm goes bankrupt, he will be fired, and his salary payments will be terminated.
What are the conflicts of interest that will likely arise between owners and managers under this benchmark compensation plan?
Executive Compensation
EXP 482 – Overhead 3
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Conflicts of Interest betweenOwners and Managers
Effort Problem
Horizon Problem
Differential Risk Exposure Problem
Over Retention Problem (Payout Policy)
Under Leverage Problem
EXP 482 – Overhead 3
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Choice of Organizational Structure
Potential "Solutions" to the Owner/Manager Conflicts
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Choice of Organizational Structure
Potential "Solutions" to the Owner/Manager Conflicts
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers
Internal and External Labor Markets
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The Market for Corporate Control
Incentive based compensation contracts
– explicit contracts– implicit contracts
Potential "Solutions" to the Owner/Manager Conflicts
EXP 482 – Overhead 3
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“Suffice it to say that one is the result of an extremely hostile takeover.”
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"Fixed" Compensation
Salary
Pension
Insurance
Perks
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Salary Typically largest component (but not always)
Within contracting period salary is fixed (close to our benchmark case)
Implicit contract to renegotiate salary in good faith based on performance
No one in the firm determines his/her own salary (compensation committee of board comprised of outside boardmembers)
EXP 482 – Overhead 3
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Pension Plans
Defined Benefits vs defined contribution plans
Vested vs nonvested plans (ERISA)
EXP 482 – Overhead 3
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Tax Deferral Effect of Pensions
Salary Pension
Raise 100.00 Contribution
100.00
Taxes 50.00 Interest 10.00
Interest 5.00 Taxes 55.00
Taxes 2.50
Total 52.50 Total 55.00
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Stock options granted to managers– Typically have approx. 5 years to expiration
– European options (cannot be exercised early)
– Restricted (cannot be sold before expiration)
– The option is actually a warrant (when exercised, the number of shares outstanding increases), but dilution effect is small.
Stock Option Plans
EXP 482 – Overhead 3
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Impact of option plan on:
– effort problem
– horizon problem
– risk exposure problem
– payout problem
Stock Option Plans
StockOption
S*X
EXP 482 – Overhead 3
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Stock Appreciation Rights (SARs)
Restricted Stock
Phantom Stock
Dividend Units
Base manager's pay on "abnormal" stock return
Other Stock-Based Compensation Plans
EXP 482 – Overhead 3
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Bonus(over 90% of medium to large size firms in US have some form of bonus plan)
Pool of Available Funds
Accounting-BasedPerformance Plans
Contributionsto Pool
EarningsEXP 482 – Overhead 3
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Bonus(over 90% of medium to large size firms in US have some form of bonus plan)
Pool of Available Funds
Accounting-BasedPerformance Plans
Contributionsto Pool
Earnings
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Bonus(over 90% of medium to large size firms in US have some form of bonus plan)
Pool of Available Funds
Accounting-BasedPerformance Plans
Contributionsto Pool
Earnings
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Bonus Plans
Impact of bonus plan on
– effort problem– risk exposure problem – payout problem– horizon problem
Long-term performance plans -- similar to bonus plans, but based on 3 to 7 year earnings performance
Performance units
EXP 482 – Overhead 3
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The use of accounting numbers vs stock prices for incentive compensation plans
– Accounting numbers allow disaggregation of performance measures
– Accounting numbers can provide perverse incentives
– Accounting numbers subject to manipulation
Top managers (who set accounting policy) typically compensated with stock-based plans. Lower level managers more likely to receive bonus.
Bonus Plans
EXP 482 – Overhead 3
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Choice of Organizational Structure
Potential "Solutions" to the Owner/Manager Conflicts
Board of Directors
CEO
CFO/COO
Middle Management
Production Workers
Internal and External Labor Markets
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What determines where a divisional manager's bonus payment falls along this spectrum?
Divisional Firm
Performance Performance
Bonus Plans
EXP 482 – Overhead 3
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Investment Opportunity Set
Leverage High Low
CompensationLevel of Pay Low High
Conditional onPerformance Low High
Assets inPlace
GrowthOpportuniti
es
EXP 482 – Overhead 3
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Click here to type pageFirm Characteristics
Level of Compen-
sation
Use of Stock
Options
Use of Bonus Plans
Growth Options (Merck) Higher Higher Lower
Credence Goods (Eastern) Higher Higher Higher
Product Warranties (Yugo) Higher Higher Higher
Future Product Support (Yugo/Wang)
Higher Higher Higher
Supplier Financing (Campeau)
--- --- ---
Closely Held Firm Higher Higher Higher
Size Higher Higher Higher
Regulation Lower Lower Lower
Tax Credits --- --- ---
Marginal Corporate Tax Rate --- Lower Lower
Marginal Personal Tax Rate --- Higher Higher
EXP 482 – Overhead 3
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Investment Opportunity Set
Assets inPlace
GrowthOpportuniti
es
Cost of Debt Low High
(Underinvestment)
Benefits of Debt High Low
(Free Cash Flow)
Predicted Leverage High Low
EXP 482 – Overhead 3