MANAGEMENT AND SHAREHOLDER OBJECTIVES
WHY DO WE NEED AN OBJECTIVE FUNCTION IN CORPORATE FINANCE?
- A manager cannot make decisions without an objective function.
- Choosing the wrong objective function can be disastrous.
- The objective function matters since it determines the optimal decision making model.
Eg. Maximizing earnings vs Maximizing stock price
- A firm has to have one objective function that dominates all others.
Eg. The problems of decision making in public sector firms where managers are asked to deal with multiple objectives are well documented.
THE CLASSICAL VIEWPOINT
Van Horne: "In this book, we assume that the objective of the firm is to maximize its value to its stockholders"
Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value."
Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders."
Brigham and Gapenski: Throughout this book we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.
1. All other stakeholders have the same objective as the stockholders. (Management and labor also want to maximize firm value.)
- Managers' only objective is to maximize stockholder wealth. They are disciplined by the prospect of having to answer to stockholders and the board of directors.
- Stockholders do not enrich themselves at the expense of bondholders.
2. Financial markets are efficient
i.e. the market price is an unbiased estimate of the true value of the firm
3. Social costs can be privatized
i.e. any social costs created by the firm can be traced to it
A BUM RAP ...
* Maximizing firm value or stock prices does not mean that you do not focus on customer satisfaction. Usually, the firms that focus customer satisfaction are the ones that maximize stock prices (Example : Walmart, The Gap..) and the firms that do not end up losing in financial markets as well (KMart, Sears (before the change in management). However, maximizing customer satisfaction cannot be the ultimate objective of a firm. It has to be an intermediate objective.
* Maximizing firm value or stock prices also does not mean that employee satisfaction and welfare is ignored. Again, the firms that do best in financial markets often are firms where employees are happiest (Microsoft, Rubber Maid ...) . Conversely, a firm that ignores its financial health to take better care of its employees will ultimately find itself unable to do so because it lacks the resources. The first and most important service that a firm can render its workers is to be financially healthy.
* Maximizing firm value or stock prices also does not imply that the firm has to be a social outlaw. Again, there is a healthy payoff to being viewed as socially responsible (Levi Strauss) and a large cost to being viewed as socially irresponsible (Exxon, after the Valdez spill, and Union Carbide, after the Bhopal Gas Leak.) Ultimately, however, even the most socially responsible firm has to pay its bills.
THE REAL WORLD INTRUDES .....
I. Stockholders Interests versus Management Interests
Theory: The stockholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors.
Practice: Neither mechanism is as effective in disciplining management as theory posits.
The Annual Meeting as a disciplinary venue
The 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 managent starts off with a clear advantage when it comes to the exercising of proxies.
* For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.
Board of Directors as a discipliniary mechanism
Directors, for the most part, are well compensated and underworked
The CEO hand-picks most directors:
1. A survey by Korn/Ferry revealed that 74% of companies relied on recommendations from the CEO to come up with new directors; Only 16% used an outside search firm.
2. Directors seldom hold more than token stakes in their companies. The Korn/Ferry survey found that 5% of all directors in 1992 owned less than five shares in their firms.
3. Many directors are themselves CEOs of other firms.
Directors lack the expertise to ask the necessary tough questions:
* CEO sets the agenda, chairs the meeting and controls the information.
* The search for consensus overwhelms any attempts at confrontation.
Time Inc.: Board rejects offer of $200/share (Stock was trading at $125) from Paramount and offers to buy Warner for $14 billion. Stock drops almost 50% in the following year.
An aside: The chairman of Xerox and retired CEO of IBM sat on the Time board, while the CEO of Time served on their board.
A further aside: Time's directors were the second-best paid in the United States with $60,000 a year. (Pepsico was the highest)
Allegheny Corp.: Directors voted themselves six months of severance pay after creditors forced them to turn over control of their bankrupt concern to a shareholder group that owned more than 50% of the stock. (In the mid-eighties Allegheny took on hundreds of millions of dollars of debt to finance among other things , its then chairman's wine cellar, a fleet of jets and a mansion.)
So what next? When the cat is idle, the mice will play ....
If managers view stockholders as impotent, they will choose to protect their interests at the expense of stockholders. The following are examples of such -
1) Greenmail (Targeted Repurchases)
* Greenmail refers to the scenario where a 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, where a legally binding promise not to buy shares for a specified period is extracted from the raider. Greenmail is like blackmail, with two differences. Unlike blackmail, it is legal in many states of the union, and the money that managers raise to pay greenmail is not their own, but belongs to their stockholders.
* There are at least two negative consequences for existing stockholders. First, the cash payment by the managers makes the firm poorer. Second, the payment of greenmail reduces the likelihood of a takeover, which would have raised the stock price of the firm. Thus it is not surprising that the payment of greenmail makes stockholders in the firm paying it worse off, as illustrated in the following table --
(2) Golden Parachutes
* Golden parachutes refers to provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if the managers covered by these contracts lose their jobs in a takeover.
* By the mid-eighties, almost 25% of the firms in the Fortune 500 had incorporated golden parachutes into top management compensation contracts. (Examples of excesses: The payment of $23.5 million to six officers at Beatrice in connection with the leveraged buyout in 1985, and $35 million to the CEO of Revlon, can be considered to be examples of these excesses.)
(3) Poison Pills
* A security, the rights or cashflows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill. The objective is to make it difficult and costly to acquire control. ( For instance, in a flip-over rights plan, shareholders receive rights to acquire shares in their firm at an exercise price well above the current price. In the event of a takeover, the rights 'flip over' to allow shareholders to buy the acquirers' stock at an exercise price well below the market price.)
* Poison pills are generally adopted by the board of directors and do not require stockholder approval.
(4) Shark Repellents (Anti-takeover Amendments)
* Anti-takeover amendments have the same objective as greenmail and poison pills, i.e., dissuading hostile takeovers, but differ on one very important count. They require the assent of stockholders to be instituted.
* There are several types of anti-takeover amendments, all designed with the objective of reducing the likelihood of a hostile takeover. Among them are
- super majority requirements (where the acquirer has to acquire more than a bare majority to acquire the firm)
- fair-price amendments (where the offer price has to exceed a price specified relative to earnings)
- staggered elections to boards of directors (which prevent acquirers from getting control for several years) and authorizations to create new classes of securities with special voting rights to dilute the acquirers' holdings.
(5) Compensation that does not match performance
(6) Overpaying on takeovers
* The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover, since the amounts paid on takeovers tend to dwarf those involved in the other decisions listed above.
* The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms for mergers and acquisitions that their managers have, since the stock prices of bidding firms decline on the takeover announcements a significant proportion of the time.
* Many mergers do not work, as evidenced by a number of measures. The profitability of merged firms relative to their peer groups, does not increase significantly after mergers, which seems to suggest that the promised synergy seldom materializes. An even more damning indictment is that a large number of mergers are reversed within a few years, which is a clear admission that the acquisitions did not work.
What does overpaying on a takeover do? It transfers wealth from the stockholders of the acquiring firm to those of the acquired firm, and the amounts involved can be staggering in some cases. Consider, for instance, the takeover of Sterling Drugs by Eastman Kodak in 1988. After a hotly contested battle with Hoffman La Roche, Eastman Kodak won the bidding war and acquired Sterling Drugs on January 22, 1988, at $90.90 per share (which worked out to $5.1 billion for the equity in the firm). The market value of equity for Sterling Drugs had been $3.0 billion, thirty days prior to acquisition. On the announcement of the takeover on January 22, the stock price of Eastman Kodak dropped 15%, a decline in the market value of equity of approximately $2.2 billion. While it is dangerous to draw strong conclusions from stock price reactions alone, the drop in Kodak's value is strikingly close to the market premium paid by it of $2.1 billion. The following graphs chart out the divergent paths of stockholders' wealth in Sterling Drugs and Eastman Kodak around the acquisition.
Where is the synergy?
II. Stockholders' objectives vs. Bondholders' objectives
In theory: there is no conflict of interests between stockholders and bondholders.
In practice: Stockholders may maximize their wealth at the expense of bondholders.
1. Increasing leverage dramatically and making existing bonds less valuable
* If a firm increases leverage significantly, and existing bondholders are not protected, they will lose wealth. (Bond prices will go down.)
2. Increasing dividends significantly
3. Taking projects which are significantly riskier than those the bondholder assumed that you were going to take.
* Bondholders base the interest rate they charge on the perceived risk of the firm's projects. If the firm takes on riskier projects, they will lose.
III. Firms and Financial Markets
In theory: Financial markets are efficient. Managers convey information honestly and truthfully to financial markets, and financial markets make reasoned judgments of 'true value'. As a consequence-
(a) A company that takes on good long term projects will be rewarded.
(b) Short term accounting gimmicks will not lead to increases in market value.
(c) Stock price performance is a good measure of management performance.
In practice: There are some holes in the 'Efficient Markets' assumption.
1. The information revealed by companies about themselves is usually
( ) honest and truthful
( ) biased
( ) fraudulent
1. Managers control the release of information to the general public.
There is evidence that
- they suppress information, generallly negative information.
- they delay the releasing of bad news (Eg. till weekends)
- they try to hide bad news, sometimes fraudlently
2. Even when information is revealed to financial markets, the market value that is set by demand and supply may contain errors.
2. Focusing on market prices will lead companies towards short term decisions at the expense of long term value.
( )I agree with the statement
( ) I do not agree with this statement
3. Allowing managers to make decisions without having to worry about the effect on market prices will lead to better long term decisions.
( ) I agree with this statement
( ) I do not agree with this statement
4. There is conclusive evidence that markets focus on short term results (especially quarterly earnings) at the expense of long term value.
( ) I agree with this statement
( ) I do not agree with this statement
There are those who argue that
- prices are much more volatile than justified by the underlying fundamentals (Eg. Did the true value of equities really decline by 20% on October 19, 1987?)
- financial markets overreact to news, both good and bad
- financial markets are short-sighted, and do not consider the long-term implications of actions taken by the firm (Eg. the focus on next quarter's earnings)
- financial markets are manipulated by insiders; Prices do not have any relationship to value.
Are Markets Short Sighted?
While the argument is that markets are short sighted and managers are long term, there is little empirical evidence for this statement.
* There are hundreds of firms, especially small and start-up firms, which do not have any current earnings and cashflows, do not expect to have any in the near future, but which are still able to raise substantial amounts of money on the basis of expectations of success in the future. If markets were in fact as short term as the critics suggest, these firms should be unable to raise funds in the first place.
* If the evidence suggests anything, it is that markets do not value current earnings and cashflows enough and value future earnings and cashflows too much. Studies indicate that stocks with low price-earnings ratios, i.e., high current earnings, have generally been underpriced relative to stocks with high price-earnings ratios.
* The market response to research and development and investment expenditure is not uniformly negative, as the 'short term' critics would lead you to believe. Instead, the response is tempered, with stock prices, on average, rising on the announcement of R&D and capital expenditures.
On average, these announcement evoke positive responses, though the magnitude of the response varies from firm to firm, as it should.
IV. Firms and Society
In theory: There are no costs associated with the firm that cannot be traced to the firm and charged to it.
In practice: Financial decisions can create social costs and benefits.
* A social cost or benefit is a cost or benefit that accrues to society as a whole and NOT to the firm making the decision.
* Examples of social costs include:
- environmental costs (pollution, health costs, etc.)
- 'Quality of Life' costs (traffic, housing, safety, etc.)
* Examples of social benefits include:
- creating employment in areas with high unemployment
- supporting development in inner cities
- creating access to goods in areas where such access does not exist
* Social costs and benefits are generally difficult to factor into decisions because:
- they might not be known at the time of the decision (Example: Manville and asbestos)
- they are 'person-specific' (different decision makers weight them differently)
- they can be paralyzing if carried to extremes
When traditional corporate financial theory breaks down, the solution is:
* To choose a different objective function:
- There are a large number of alternative objective functions
(1) Choose an intermediate objective function, which is correlated with the firm's long term health and value and maximize this function. Examples would include
- maximize market share
- maximize 'customer focus'
- maximize growth
The danger here is that the linkage between this intermediate objective and the final objective may change (and even break) over time, leaving the firm floundering.
(2) Profit maximization function: Maximize current profits or profits over a period of time.
(3) Size/Revenue function: This is the equivalent of empire building.
(4) Social Welfare objective functions: Here, the objective of the firm is to maximize some broader social welfare goal. (An example would be maximizing employment.)
* To maximize stock price, but reduce the potential for conflict and breakdown:
- Making managers (decision makers) and employees into stockholders
- By providing information honestly and promptly to financial markets
- By considering social costs/benefits in financial decisions
A Partial Solution
I. Stockholders Interests and Management Interests
* Make managers think like stockholders: Managers should derive a portion of their compensation from stock price performance. They can be given stock or warrants in the firm.
* Increase the power of stockholders:
(1) Improve the information that is available to stockholders about the firm's decisions and financial performance.
(2) Have a large stockholder become part of the incumbent mangement.
(3) Institutional investors need to become more activist in challenging management, where they feel that management interests are conflicting with stockholder interests. Some of the ways in which institutional investors can use their muscle include -
(a) Proxy fights, where institutional investors contest incumbent management for proxies.
(b) Speaking up when their interests are under siege. (Eg. Takeover restrictions) The following table summarizes some of the changes that institutional investors have been able to make as a consequence of pressure that they have brought to bear on incumbent management.
INSTITUTIONAL INVESTORS VS. MANAGERS
Company Agreement Investors' Groups
K Mart Phase out poison pill provision Wisconsin Inv. Board
Avon Meet regularly with stockholders Calpers
Boise Cascade Count only submitted proxy ballots Calpers
Boise Cascade Require vote on golden parachutes United Shareholders Assn
Baxter International Make all proxy votes confidential United Shareholders Assn
Consolidated Freight Phase out golden parachutes United Shareholders Assn
General Motors Require a majority of outside directors Calpers
General Signal Make all proxy votes confidential United Shareholders Assn
W.R. Grace Seat outside directors on pay committee Calpers
Unisys Make all proxy votes confidential United Shareholders Assn
Weyerhauser Make all proxy votes confidential United Shareholders Assn
* Allow hostile takeovers. The threat of a takeover is often the
best weapon that stockholders have against incumbent management
that is not doing its job. The typical target firm in a takeover
is a badly run, badly managed firm.
II. Stockholder and Bondholder Interests
* Put in restrictive covenants into bond agreements, restricting
- investment policy; taking on risky investments is made more difficult.
- dividend policy; there are restrictions on how much can be paid out in dividends.
- financing policy; future borrowing is restricted
* Put in protective puts into bonds, allowing bondholders to 'put' their bonds back to the firm at face value or a premium, if it takes any action that affects bondholders adversely.
* Bondholders also take an equity stake in the firm.
III. Firms and Financial Markets
* Have an active private information market, i.e. private analysts following the firm.
* Punish misleading/fraudelent information revelation by managers severely.
* Have low transactions costs/barriers to trading on financial securities.
* Hope for the best.
IV. Firms and Society
* Society can always pass laws and regulations, forcing firms to be good citizens.
* Better yet, create an environment where it is in the best interests of firms to be good social citizens.
APPROPRIATE OBJECTIVE FUNCTION FOR DIFFERENT CIRCUMSTANCES
APPROPRIATE OBJECTIVES NECESSARY CONDITIONS
1. Unrestrained Value Max. (a) Managers have large 'equity' position in the firm (b) Market prices are 'good' estimates of long term value