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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
Making Sure Managers Maximize NPV
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 12.3
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Topics Covered
The agency problem Evidence of its significance Solutions:
Incentives Other mechanisms (some not in book)
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The Principal-Agent Problem
Shareholders = Owners = “Principals”
Managers = Control = Shareholders’ “agents”
The problem:
How do owners get managers to act in their interests?
(i.e. to maximize NPV)
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The Principal-Agent Problem
Low effort (slacking/shirking) Expensive perks (corporate jets) Empire building (overinvestment) Entrenching investment (to keep job) Avoiding risk (so as not to lose job) …
How might manager’s interests differ from shareholders’ interests?
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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
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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
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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 TaylorThe Principles of Scientific Management (New York: Harper, 1929)
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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…
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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 …
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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
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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
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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”
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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
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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!
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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?
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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
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Potential solutions
Finance with debt
Managers can’t waste money if there is constant pressure to meet interest payments
This commits managers to paying out free cash flow• If they don’t, default occurs, managers lose control• Dividends, in contrast, are less of a commitment: they can be cut
whenever management wants
Thus, agency problems are (like taxes) another reason to favor debt
• Especially in “cash cow” firms that generate cash but don’t have good investment opportunities
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Potential solutions
Others:
Takeover pressure• If don’t maximize share value, outsider may take over
firm, fire management, run firm better, create value Managerial outside labor market
• If don’t maximize share value, and subsequently get fired, hard to find a new CEO job, or get lucrative outside directorships
Proxy fights• Shareholders organize themselves to fight
management
Mergers
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 33
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Topics Covered
Sensible Motives for Mergers Some Dubious Reasons for Mergers Estimating Merger Gains and Costs Takeovers: Unsolicited/hostile mergers
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1997 and 1998 Mergers
Selling Company Acquiring Company Payment, billions of dollars
NYNEX Bell Atlantic 21.0McDonnell Douglas Boeing 13.4Digital Equipment Compaq Computer 9.1Schweizerischer Union Bank of Swiz. 23.0Energy Group PCC Texas Utilities 11.0Amoco Corp. British Petroleum 48.2Sun America American Intl. 18.0BankAmerica Corp. Nationsbank Corp. 61.6Chrysler Daimler-Benz 38.3Bankers Trust Corp. Deutsche Bank AG 9.7Netscape America Online 4.2Citicorp Travelers Group Inc. 83.0
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Merger waves in US history
1893-1904: horizontal mergers to create monopoly Mergers of companies in same line of business
1915-1929: vertical mergers Mergers upstream (toward raw material) or downstream (to consumer)
1940s-1950s: “friendly” acquisitions of small, privately-held companies
1935: Roosevelt passed “soak-the-rich” tax laws with high estate taxes; so private firms put up for sale to avoid taxes
1960s-1970s: conglomerate mergers Mergers across unrelated lines of business
1980s-1990s: still unnamed Seem to be more underlying logic than conglomerate wave Deals are much larger, often done in cash, often hostile (especially in
1980s), premia have increased
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Sensible Reasons for Mergers
Economies of Scale A larger firm may be able to reduce its per-unit cost by using
excess capacity or spreading fixed costs across more units Motive for horizontal mergers
$ $$Reduces costsReduces costs
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Sensible Reasons for Mergers
Economies of Vertical Integration Merge with supplier (integrate “backward”) or
customer (integrate “forward”) Control over suppliers may reduce costs Or control over marketing channel may reduce
costs Motive for vertical mergers
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Sensible Reasons for Mergers
Combining Complementary Resources Merging may result in each firm filling in the “missing
pieces” of their firm with pieces from the other firm. A.k.a. “synergies”
Firm A
Firm B
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Sensible Reasons for Mergers
Unused tax shields Firm may have potential tax shields but not have
profits to take advantage of them
After Penn Central bankruptcy/reorganization, it had $billions of unused tax-loss carryforwards
It then bought several mature, taxpaying companies so these shields could be used
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Sensible Reasons for Mergers
To Use Surplus Cash If your firm is in a mature industry with no positive NPV
projects left, acquisition may be a decent use of funds (assuming you can’t/won’t return cash directly to shareholders by dividend or repurchase)
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Sensible Reasons for Mergers
To Eliminate Inefficiencies in the Target
Target may have unexploited investment opportunities, or ways to cut costs or increase earnings
Replace firm with “better management”
Here, there is no “synergy” Goal is simply to improve the target Most likely requires replacing the target management Many “hostile” deals fall in this category
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Sensible Reasons for Mergers
To Eliminate Inefficiencies in the Target: Easier said than done – Warren Buffet says:
Many managers were apparently over-exposed in childhood years to the story in which the imprisoned, handsome prince is released from the toad’s body by a kiss from the beautiful princess… Consequently, they are certain that their managerial kiss will do wonders for the profits of the target company… We’ve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain confident about the potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.
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Dubious Reasons for Mergers
Diversification Investors should not pay a premium for
diversification if they can do it themselves!
“Diversification discount”• Diversified firms sell, if anything, at a discount
Makes sense only to the extent that reduces costs of financial distress
• Which allows merged firm to take on more debt, take advantage of tax shields
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Dubious Reasons for MergersIncreasing EPS Some mergers undertaken simply to raise EPS
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio
After merger, acquiring firm has short term EPS rise
Long term, acquirer will have slower than normal EPS growth due to share dilution.
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Dubious Reasons for MergersLowers cost of debt Merged firm can borrow at lower interest rates
This happens because when A and B are separate, they don’t guarantee each other’s debt After the merger, each one does guarantee the other’s debt; if one part of business fails, bhhs can still get money from the other part
But this is not a net gain Now, A and B’s shhs have to guarantee each other’s debt This loss to shhs cancels the gain from the safer debt
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Estimating Merger Gains
There is an economic gain to the merger only if the two firms are worth more together than apart
Gain = PVAB– (PVA+PVB) = PVAB
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Estimating Merger Costs
Calculation of merger cost depends on whether payment is made in cash or in shares.
If A pays for B in cash, then easy:
Cost = cash paid - PVB
Usually shares of B are bought at a “premium,” so this cost is positive
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Merger Decision
So merger is a positive-NPV to A if:NPV = Gain – Cost = PVAB-(cash-PVB)>0
Notice gain is in terms of “total increase in pie”
While cost is concerned with the division of the gains between the two companies
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Merger DecisionExample PVA=$200m, PVB=$50m Merging A and B allows cost savings of $25m So Gain = PVAB– (PVA+PVB) = PVAB = $25m
Suppose B is bought for cash for $65m a $15m (30%) premium, not unusual
So Cost = cash paid - PVB = 65 – 50 = $15m Note: B’s gain is A’s cost
NPV to A: Gain – Cost = $10m Prediction: Upon announcement of merger, B’s stock will rise
to $65m, A’s will rise by $10m
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Estimating merger costs When merger is financed by stock, cost calculation is
different Cost depends on value of shares in new company received
by shareholders of selling company
If sellers receive N shares, each worth PAB , then:
Cost = N * PAB - PVB
… to illustrate, return to previous example …
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Merger DecisionExample PVA=$200m, PVB=$50m, suppose A has 1m shares outsdg. Gain is still = PVAB– (PVA+PVB) = PVAB = $25m
Suppose B is bought for .325m shares (not cash) Cost to A is not .325*200 – 50
since A’s share price will go up at the merger announcement Need to calculate post-deal share price of A
New firm will have 1.325m shares outstdg., will be worth $275m So new share price is 275/1.325=207.55
Cost = .325*207.55 – 50 = $17.45m NPV to A = Gain – Cost = $25 - $17.45 = $7.55m
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Takeover Vocabulary
Some useful vocabulary
Tender offer: bidder A offers to buy target B’s shares on open market, usually at some premium Goes “over the head” of B’s management… Straight to B’s shareholders
Hostile takeover: the tender offer is unsolicited
Merger/Friendly takeover: agreement between A and B management
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Takeover Vocabulary
White Knight - Friendly acquirer sought by a target company threatened by an unwanted bidder.
Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at a very low price as soon as a bidder acquires 20%
Greenmail – Bribe paid to unwanted bidder to get him to go away (a “targeted share repurchase” since target buys back only shares of raider, and usually at a big premium)
Very upsetting to target shareholders!
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Takeover Vocabulary
Why does B management resist if A is offering B shareholders a premium? Maybe to hold out for a higher bid More likely: Agency problem !!! B managers don’t want to lose job One solution: pay a bribe to B managers so that they
won’t encounter this conflict of interest
Golden parachute – generous payoff if manager loses job as result of takeover
Control, Governance, and Financial Architecture
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 34
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Topics Covered
Leveraged Buyouts Spin-offs and Restructuring Conglomerates
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Definitions Corporate control – the power to make investment
and financing decisions.
Corporate governance –the set of mechanisms by which shhs exercise control over managers They are the “potential solutions” to agency problems in
chapter 12.3
Financial architecture – the whole picture: who has control, what governance mechanisms, what is capital structure, what is legal form of organization, etc. Financial architectures differ a lot across countries Partly because agency problems differ across countries
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Leveraged Buyouts
LBOs differ from ordinary acquisitions:
A large fraction of the purchase price is financed by debt.
The LBO goes private, so its shares are no longer trade on the open market; they are held by a partnership of (usually institutional) investors
If group includes member of existing management team, called MBO
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Leveraged Buyouts
Main sources of value in LBOs
Better incentives • Constant debt service forces a focus on cash flows• Management often takes a higher equity stake
“Buyout specialist” organizing it will serve as monitor
All the debt generates tax shields
Inefficiencies are cut• Capex plans are more closely scrutinized• New mgmt. may find it easier to fire unnecessary employees?
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Leveraged Buyouts
Acquirer Target Year Price ($bil)
KKR RJR Nabisco 1989 24.72$ KKR Beatrice 1986 6.25$ KKR Safeway 1986 4.24$ Thompson Co. Southland 1987 4.00$ AV Holdings Borg-Warner 1987 3.76$ Wing Holdings NWA, Inc. 1989 3.69$ KKR Owens-Illinois 1987 3.69$ TF Investments Hospital Corp of America 1989 3.69$ FH Acquisitions For Howard Corp. 1988 3.59$ Macy Acquisition Corp. RH Macy & Co 1986 3.50$ Bain Capital Sealy Corp. 1997 0.81$ Citicorp Venture Capital Neenah Corp. 1997 0.25$ Cyprus Group (w/mgmt) WESCO Distribution Inc. 1998 1.10$ Clayton, Dublier & Rice North Maerican Van Lines 1998 0.20$ Clayton, Dublier & Rice (w/mgmt) Dynatech Corp. 1998 0.76$ KKR. (w.mgmt) Halley Performance Products 1998 0.20$
10 Largest LBOs in 1980s and 1997/98 examples
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Spin-offs, etc.
Spin-off – new, independent company created by detaching part of a parent company.
Carve-out – similar to spin offs, except that shares in the new company are not given to existing shareholders but sold in a public offering.
Privatization – the sale of a government-owned company to private investors.
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Conglomerates
Sales Rank Company Numebr of Industries
8 ITT 3815 Tenneco 2842 Gulf & Western Industries 4151 Litton Industries 1966 LTV 1873 Illinois Central Industries 26
103 Textron 16104 Greyhound 19128 Marin Marietta 14131 Dart Industries 18132 U.S. Industries 24143 Northwest Industries 18173 Walter Kidde 22180 Ogden Industries 13188 Colt Industries 9
The largest US conglomerates in 1979
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The death of U.S. conglomerates
What were they supposed to achieve? Diversification
• Which we mentioned is a dubious motive
Creation of internal capital markets• Free cash flow in mature industries could be used to fund growing
industries
• But, this avoided discipline of outside markets
Centralized, presumably improved management
Didn’t work On average, conglomerates have market values 12-15% less
than stand-alones
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15 years from nowYou have just seized control of Establishment
Industries, a blue-chip conglomerate, after a takeover battle.
What advice can I give you to add value? (I.e., how do we use this class to get rich?)
1. Spin off the neglected divisions Spinoffs go for a premium Better incentives all around Avoid mess of internal capital market Avoid “diversification discount”
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15 years from now
2. Perhaps sell mature, cash cows to LBO partnerships. No growth there for you Again want to reduce size of internal cap. mkt But valuable to LBO due to its better incentives
3. Focus on core business Possible leveraged restructuring (debt-for-equity
recapitalization) to improve incentives there Give employees, managers equity incentives