BA 351 CORPORATE FINANCE

Transcription

1 BA 351 CORPORATE FINANCE LECTURE 1 INTRODUCTION John Graham (adapted from S. Viswanathan) FUQUA SCHOOL OF BUSINESS DUKE UNIVERSITY 1

2 LECTURE 1 INTRODUCTION Corporate Finance is about the VALUATION of companies, business plans, projects etc. By valuation we mean: 1. The measurement of value. 2. The creation and management of value. Corporate Finance is not just something that a finance specialist should know. In fact, it is an area that anybody who is involved in decision making that affects the value of the company must have a critical understanding of. Thus a marketing manager who is introducing a new product must understand of what the value of that product is to the company. Similarly, R&D managers must understand the value of research undertaken by the company. In the same vein, the distinction between corporate strategy and corporate finance is non-existent in practice. Corporate strategy must ultimately create value and thus the tools and methods of corporate finance must be used to evaluate alternative corporate strategies. One of the fundamental ideas that we will emphasize is that corporate financial analysis is not just a numbers exercise. For corporate financial analysis to be useful, we must be able to use it in a meaningful way to identify what is the value of the project under varying scenarios and what are the sources of the value. Thus the objective of corporate finance is not simply to place a number on a project but to explain what are the fundamental economic or strategic reasons as to why the project has a positive NPV. Additionally, the individual doing the analysis must be able to understand what the critical assumptions are (on market 2

3 demand, growth, technological innovation etc.) so that he/she can have an informed discussion with others on the merits of these assumptions. As we will see during the course, the measurement of the NPV of a project is especially difficult in cases where the project involves technological innovation and that makes it hard to forecast the costs in the industry (example, biotechnology, supercomputers). When the focus of corporate finance is on the management and creation of value, corporate finance must get involved in the incentive systems within a company. Poor incentive systems distort the objectives of the managers in the company and can lead to decisions that are clearly not value-improving. Hence, the company may maintain divisions that would have greater value if sold. Or it may maintain expenditures that are clearly poor investments when better options are available. An example of this is GM spending $60 billion on research and development in the 1980s, an amount that greater than the market value of Toyota and Honda combined! A better option for GM might have been to purchase the required technology from Toyota or other Japanese manufacturers (GM did do this to some extent with the Fremont plant in California). It seems clear (at least in hindsight) that the incentives within GM led individuals not to do a value-improving analysis but rather to support what was perceived internally (within the corporation) as the right decision to make. In cases like this, the company may end up being an acquisition target. If the company is too big (like General Motors or IBM) the internal restructuring may require strong leadership from the Board of Directors. Often the Board intervention will be too late and too little. One way to avoid these long run costs is make the corporate finance based approach to valuation an integral part of corporate decision making. 3

4 Understanding taxes is another critical area in Corporate Finance. Government and state tax policies lead to distortions that yield benefits to individuals and companies that understand the nature of these tax policies. For example, Scholes and Wolfson (1992, Prentice Hall) note how Japanese corporations have skillfully used the double taxation treaties between the US and Singapore and Singapore and Japan to minimize their taxes. Taxes are relevant for another important (and related) reason. The cost of capital of a corporation, a key element in its decision-making process, is affected by the tax structure. These tax consequences are important in structuring transactions like acquisitions and in the lease-versus-buy decision. Also, it is extremely important for a treasurer to understand the tax consequences of the firm's financial decisions on its shareholders, a theme we will return repeatedly to in this course. The goal of this course is to introduce the fundamental ideas of valuation. In particular we will emphasize three issues: 1. Understanding tax structure and its implication for financial decision-making. 2. Practical issues that arise in real valuations. 3. Incentives, internal controls and the nature of financial contracts. We will cover these issues at length during the term. Our approach will be to cover these issues at some length and then undertake a long problem, exercise or case. The problem, exercise or case will force you to analyze the issues raised during the lectures. Thus the lectures and problems/cases will complement each other. 4

5 LECTURE 1B THE GOAL OF THE FIRM This course is mainly concerned with the financing and the investment decisions of corporations. The corporation is by far the most important form of commercial organization; corporations constitute approximately 90% of the sales dollars generated in the business sector. What is a corporation? It is an artificial being or construct that has existence in law. In fact, Chief Justice John Marshall (who was very influential in charting the role of the Supreme Court) stated that a corporation exists only in the contemplation of the law. The list of potential goals of a corporation is large and includes: 1. Shareholder wealth maximization. 2. Market value maximization - bondholder plus stockholder wealth. 3. Stakeholder maximization - maximizing a complex goal that is a mixture of shareholder maximization and the objectives of labor, community etc. 4. Satisficing - achieving a minimum level of profits. 5. Maximizing accounting earnings. 6. Maximizing sales. 7. Maximizing management's wealth and perquisites when ensuring a satisfactory return for shareholders. 8. Profit maximization. These objectives have been mentioned at various times and may have occurred in reality. For example, in 1987, NCR promoted the stakeholder concept in a series of advertisements which stated that participants in its operations (stakeholders) deserved as much attention as 5

6 its shareholders. These stakeholders (according to NCR) included its customer, employees, suppliers, the world wide communities in which we operate and our shareholders. Thus shareholders were only one among many groups that NCR thought to be important. In fact, anti-takeover laws in certain states are justified by the stakeholder concept. For example, Minnesota passed a statute in 1987 to thwart hostile takeovers. This statute, Statute 302A.251 (5), (Supplement 1988), allows a firm in considering the best interests of the corporation, to consider the interests of the corporation's employees, customers, suppliers, and creditors, the economy of the state and the nation, community and societal considerations. However, the legal interpretation of such laws is unclear as courts have often interpreted the best interest of the corporation as the best interests of the shareholders. Maximizing the total market value of the firm (bondholders plus stockholders) is another possible objective. This is not the same as maximizing the value of shareholder wealth. The best example of this distinction occurred when RJR Nabisco's management announced a LBO on October 8, The value of stock jumped from $56 to $75 while the value of the bonds fell considerably (bondholder loss was estimated to be about $575 million). ITT and Metropolitan Life, both large bondholders, sued RJR's management for having breached an implicit covenant with them, claiming that the management of the company should have taken the bondholders' interests into account. However, the courts threw the case out ruling that management did not have to consider bondholders' objectives. Normatively, at least, the objective of the firm (and courts seem to agree with this) is to Maximize Shareholder Wealth. However, this is easier said than done. Ever since the diffusely owned corporation became an important organizational form in the 1920s and 1930s, it has been argued that 6

7 shareholders really do not control the corporation. For example, General Motors in 1986 had 2 million persons and institutions holding GM stock. Berle and Means and a large number of others argue that this diffuse shareholder body cannot force management to maximize shareholder wealth. Instead, management will maximize its own objective, subject to ensuring that shareholders get some minimal return. Others have argued that while this diffuse ownership is a problem, there are external and internal controls that can be used to regulate management and punish managers who do not maximize shareholder wealth. These devices include: 1. Voting for the board of directors, who decide on the management team and management compensation. 2. Executive Compensation arrangements such as stock option plans and performance based pay. 3. Takeovers by another group or company if management undertakes policies that do not maximize shareholder value. 4. Competition in managerial labor markets. Better performing managers are lured away and are given better positions at other firms. 5. Rise in institutional shareholders like pension funds and mutual funds (to monitor managers). These methods attempt to better align managerial objectives with shareholder objectives. However, none of them is perfect. Voting for the board of directors is usually a tame affair where management puts its own slate up and gets easily re-elected. It is only when a proxy contest occurs that voting rights become important. However, in firms where both voting 7

8 and nonvoting shares exist (dual class shares), voting shares command up to 3% to 4% premium. This indicates that voting rights do have some value. Properly executed executive compensation plans are an ideal way to motivate managers. If manager who generates $100 million in additional profit is compensated an additional $3 or $4 million, the compensation package is doing its job. But it is often claimed that executives get compensated highly even when companies are doing poorly (Former CEO Roger Smith's one million dollar pension at GM!). This issue came up when President Bush visited Japan in 1992 along with auto industry CEOs. Japanese newspapers gleefully highlighted the fact that while profits in certain segments of American industry had fallen, the CEOs had actually increased their salaries. Additionally, a sticking point in the proposed merger between Damler-Benz and Chrysler is the "extreme" compenstation US exectives receive, compared to the "paltry" compensation of German executives. Historically, the important area of executive compensation has received inadequate attention. Takeovers are another form of managerial discipline. Raiders claim that this is the way to ensure that managers maximize shareholder value. The following is T. Boone Pickens view: The separation of ownership and control is one of the biggest problems in corporate America today. The goal of most professional managers is like that of a bureaucrat. The emphasis is on bigger budgets and expanding empires instead of serving the interests of owners. Takeovers are costly and require access to capital that is not always available. It is less available today than it was in the mid-1980s. For example, in 1985, Pantry Pride, a small supermarket chain that had recently emerged from bankruptcy, made a bid for Revlon, a 8

9 company five times its size. Pantry Pride was able to make this bid by borrowing $2.1 billion. In fact, Pantry Pride's junk bond issue was a public issue. Today, it would be difficult for Pantry Pride to raise the same kind of financing. In general, though, capital is easier to access today than it was in the early 1980s (see Grinblatt and Titman, Chapters 1 and 2). An important structural change that has occurred in capital markets in the last twenty years is the large increase in institutional shareholdings. The question arises as to what impact institutional shareholders have on corporate governance. On the one hand, institutional shareholders are very sensitive to market value and thus market value maximization becomes all important (an institutional shareholder who passes up an opportunity to get higher returns may have legal action to contend with). On the other hand, institutional shareholders are often passive shareholders who rarely sit on the board of a company. In fact, many of them avoid large shareholdings. A shareholding of 5% or larger may lead to requiring a Section 13(d) disclosure. It has never been clear whether this applies to a group of mutual funds (Fidelity for example) or each individual mutual fund in the group (Fidelity Magellan and Fidelity Puritan are separate funds). In any case, Fidelity and other funds are very careful not to violate this rule (though it was not initially intended for them) as they have to disclose all trades that they undertake once they cross the 13(d) threshold. Mutual funds that try to buy large positions in a firm have other problems as well. First, SEC regulations prohibit a firm that holds a 10% or larger equity position in a company from advertising itself as a diversified mutual fund. Secondly, mutual funds can run afoul of the IRS, particularly from Sub Chapter M of the Internal Revenue Code. Normally, mutual funds pass income and capital gains through to their shareholders as there is no tax at the 9

10 mutual fund level. The rational behind this is that the mutual fund is considered an intermediary; thus taxing the mutual fund would be double taxation. However, this exemption is allowed (by Revenue Act of 1940) only if: 1. No more than 5% of the portfolio is in any one company's stock and, 2. The mutual fund owns no more than 10% of any company's stock. There is an exemption in the law that allows half of the mutual fund's investment to be concentrated; however, even in this situation, the fund cannot hold more than 25% of the stock of any one company. Since pass-through tax status is extremely important for any mutual fund to be successful, mutual funds are unlikely to pressure management to change course. Thus it is not clear whether the rise of institutional holdings has significantly aligned corporate objectives to that of its shareholders. Recently, Michael Weisbach of the University of Arizona has shown that when TIAA-CREFF (a large institutional investor representing mainly teachers) informally talks to the management of a company, in the vast majority of cases the firm institutes the change TIAA-CREFF wants -- even without the issue ever becoming a "proxy contest." In the 1970s, Donaldson interviewed CEOs to ascertain managerial objectives. He concluded that managers were influenced by three underlying motivations in defining the corporate mission: 1. Organizational survival - Management must have enough resources to support the firm's activities. 2. Independence - Management must have enough freedom to make decision and take action without encountering external parties or depending on outside financial markets. 10

11 3. Self-sufficiency - Managers do not want to depend on external parties. From these motivations, Donaldson concludes that the basic financial objective of managers is the maximization of corporate wealth. Corporate wealth is that wealth over which management has control and is closely associated with corporate growth and size. This is not necessarily the same as shareholder wealth. The conclusions that we arrive at are as follows: The normative objective that a manager should follow is to Maximize Shareholder Value. While there are methods in the real world to ensure that this happens, these methods are not perfect. Thus managers may not undertake decisions that maximize shareholder value. They may instead be maximizing Corporate Wealth. 11