Agency Costs of Free Cash Flow, CorporateFinance, and Takeovers. The Role of Debt in Motivating Organizational Efficiency

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Baldwin Ramsey
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1 Agency Costs of Free Cash Flow, CorporateFinance, and Takeovers A++ Conflicts between Managers and Shareholders Pursue Growth: Agency theory Payouts to shareholders reduce the resources under manager s control, so managers have incentives to cause their firms to grow beyond the optimal size. Increases in managers compensation Changes in compensation are positively related to the growth. Tendency to reward managers through promotion It requires growth to supply the new positions to satisfy the promotion needs. Pursue Efficiency: Competition in the product and factor markets It drives prices towards minimum average cost. Managers must motivate organizations to increase efficiency. Firm s internal control system and the market for corporate control are more important. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies. The Role of Debt in Motivating Organizational Efficiency Way to pay out free cash flow Strength of promise Suitable firm Equity Announcing a permanent increase in dividends Weak, because dividends can be reduced in the future Rapidly growing organizations with large and highly profitable investment projects but no free cash flow Debt Borrowed money and interests Strong, otherwise may cause bankruptcy Organizations that generate large cash flows but have low growth prospects and organizations that must shrink

2 Evidence from Financial Restructuring Capital structure transaction Stock price increases Leverage increasing: Ways stock repurchases exchange of debt or preferred for common exchange of debt for preferred exchange of *income bonds for preferred 2-day gains range from 21.9% to 2.2% Stock price decreases Leverage decreasing: Ways sale of common exchange of common for debt or preferred exchange of preferred for debt call of *convertible bonds or *convertible preferred 2-day losses range from -9.9% to - 0.4% Exceptions to simple leverage change rule (abnormal price declines): Targeted repurchases due to the reduced probability of takeover Sale of debt and preferred stock consistent with the free cash flow theory because these sales bring new cash under the control of managers Power of effects: The magnitudes of the valued changes are positively related to the change in the tightness of the commitment bonding the payment of future cash flows, for example, the effects of debt for preferred exchanges are smaller than the effects of debt for common exchanges (tax effects). Free cash flow theory Unexpected increases in payouts to shareholders Reductions in payments or new requests for funds *Income bond: a type of debt security in which only the face value of the bond is promised to be paid to the investor, with any coupon payments paid only if the issuing company has enough earnings to pay for the coupon payment.

3 *Convertible bond: a type of debt security that can be converted into a predetermined amount of the underlying company's equity at certain times during the bond's life, usually at the discretion of the bondholder. *Convertible preferred stock: preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date. Evidence from Leveraged Buyout and Going Private Transactions Leveraged buyout: What is leveraged buyout? A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. Frequently financed with high debt, 10 to 1 ratios of debt to equity are common. Suitable candidates for leveraged buyout Firms or divisions of larger firms that have stable business histories and substantial free cash flow. Situations where agency costs of free cash flow are likely to be high. Strip financing: What is strip financing? The practice in which risky nonequity securities are held in approximately equal proportions. It limits the conflict of interest among such securities holders and therefore limits bankruptcy costs. An example Firm A Firm B Financing Entirely with equity Highly leveraged with senior subordinated debt, convertible debt and preferred as well as equity

4 Securities sold / Only in strips (a buyer purchasing X percent of any security must purchase X percent of all securities, and the securities are stapled together so they cannot be separated later) Consequences Firm B strip holders have recourse (ex bankruptcy or board representation) to remedial powers not available to the equity holders of firm A. It is easier and quicker to replace managers in firm B. Every security holder in firm B has the same claim on the firm, so there are no conflicts among senior and junior claimants over reorganization. Evidence from the Oil Industry Background: From 1973 to the late 1970 s Crude oil prices increased tenfold. Accompanied by increases in expected future oil prices and an expansion of the industry. Late 1970 s and early 1980 s Consumption of oil fell, expectations of future increases in oil prices fell. Real interest rates and exploration and development costs also increased. Profits were high, due to average productivity increased while marginal productivity decreased. Thus, the industry had to shrink. Oil industry managers actions: Spend heavily on E&D activity even though average returns were below the cost of capital. Launch diversification programs to invest funds outside the industry purchases of companies in retailing, manufacturing, office equipment, and mining. it turned out to be unsuccessful, because of bad luck and a lack of managerial expertise outside the oil industry. but also generated social benefits to the extent they diverted cash to

5 shareholders that otherwise would have been wasted on unprofitable real investment projects. Two studies: (oil industry exploration and development expenditures have been too high) John McConnell and Chris Muscarella announcements of increases in E&D expenditures by oil companies in the period were associated with systematic decreases in the announcing firm s stock price. B. Picchi on average the industry did not earn even a 10% return on its pretax outlays in the period Takeovers in the Oil Industry Merging process in oil industry large increase in debt paid out large amounts of capital to shareholders reduced excess expenditures on E&D reduced excess capacity in refining and distribution large gains in efficiency and in value, about $200 billion in 98 firms Restructuring of Phillips and Unocal and Arco restructuring stockholder gains ranging from 20%-35% of market value, totaling $6.6 billion repurchase of from 25%-53% of equity increased cash dividends, sales of assets, and major cutbacks in capital spending Diamond-Shamrock s reorganization reduced cash dividends by 43% repurchased 6% of its shares for $200 million sold 12% of a newly created master limited partnership to the public increased expenditures on oil and gas exploration by $100 million/year

6 Free Cash Flow Theory of Takeovers Free cash flow theory shows how takeovers are both evidence of the conflicts of interest between shareholders and managers, and a solution to the problem. Conflicts Acquisitions are one way managers spend cash instead of paying it out to shareholders. Managers are more likely to undertake low-benefit or even value-destroying mergers, ex: diversification programs. Low-return mergers are more likely in industries with large cash flow. Solution It creates the crisis to motivate cuts in expansion programs and the sale of those divisions which are more valuable outside the firm. The proceeds are used to reduce debt to a more normal or permanent level. This process results in a complete rethinking of the organization s strategy and its structure. Takeovers financed with cash and debt will generate larger benefits than those accomplished through exchange of stock.

American Economic Association

American Economic Association Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers Author(s): Michael C. Jensen Reviewed work(s): Source: The American Economic Review, Vol. 76, No. 2, Papers