Financial Theory and Corporate Policy (4th edition) by Copeland Chapter 2: Investment Decisions: The Certainty Case

Introduction In the investment decision, must decide how much to not consume today so as to enjoy more consumption in the future Should maximize expected utility over the planning horizon Individuals, corporate managers, and public sector managers must all make the allocation between current and future consumption Initially interest rates are known and constant Also assume there are no imperfections in capital markets The firm objective is to maximize the wealth for its shareholders Fisher Separation: The Separation of Individual Utility Preferences from the Investment Decision It is difficult to determine individual utility functions (how happy is happy?) Assuming no market friction, individuals can delegate investment decisions to firm managers Managers should choose to invest until the rate of return equals the market-determined rate of return Maximizing shareholders wealth is equivalent to maximizing the present value of their lifetime consumption
C1* W0 = C + 1+ r
* 0

This implies the slope of the capital market line is (1+r) The individual shareholders all prefer the same investment decisions at the firm (called the unanimity principle) The individuals can adjust for their risk/reward tolerance by borrowing or lending at the risk-free rate The Agency Problem The shareholders wealth is the present value of cash flows discounted at the opportunity cost of capital Owners must find a way to monitor (at a cost) the behavior of managers Owners must balance the monitoring costs with incentive-type compensation (e.g. stock dividends)

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Shareholder Wealth Maximization Dividends vs. Capital Gains Shareholder wealth could be defined as the present value of future dividends
S0 =
t =1

Divt

(1 + k s )

The above formula works if the dividends and discount rates are known with certainty The effect of capital gains is effectively in the formula above If the dividend stream is growing at a rate g,

S0 =

Div1 ks - g

The Economic Definition of Profit Economic profits equal the mean rates of return in excess of the opportunity cost for funds To determine this, must know the timing of the cash flows and the opportunity cost In this section, dividends include any cash flows that could be paid to shareholders; this includes items such as capital gains, spin-offs to shareholders, and repurchase of shares Assume you have an all-equity firm in a no-tax environment The sources of funds are revenues (Rev) and sale of new equity (m shares at S dollars per share) The uses of funds are wages, salaries, materials, and services (W&S); investment (I); and dividends (Div) For each time period,

Sources = Uses Revt + mt St = Divt + (W & S )t + I t

Assuming no new equity is issued,

Divt = Revt - (W & S )t - It S0 =

t =1

Revt - (W & S )t - It

(1 + ks )

The accounting definition does not deduct gross investment; rather, it deducts a portion as depreciation (dep)

NIt = Revt - (W & S )t - dept

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Can reconcile the two definitions by realizing the change in asset book value during the year is the gross investment less the depreciation
DAt = I t - dept S0 =
t =1

NI t - DAt

(1 + ks )

The economic definition focuses on the actual timing of cash flows Managers should not just try to maximize earnings per share, which is based on accounting profits; rather, should maximize shareholder value For example, FIFO (first-in, first-out) accounting method results in higher earnings per share but lower cash flows because more is paid in taxes So LIFO (last-in, first-out) is better for shareholder value even if it is worse for earnings per share Capital Budgeting Techniques Problems for managers making investment decisions 1. Searching out new opportunities in the market 2. Estimating expected cash flows of projects 3. Evaluating projects according to sound decision rules Criteria for essential property of maximizing shareholder value 1. All cash flows should be considered 2. Cash flows should be discounted at the opportunity cost of funds 3. Select from mutually exclusive projects the one that maximizes shareholders wealth 4. Consider one project independently from others (value-additivity principle) Summing the values of all the projects will compute the firm value Widely used capital budgeting techniques 1. Payback method 2. Accounting rate of return (ARR) 3. Net present value (NPV) This is the only method consistent with shareholder maximization 4. Internal rate of return

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Cash flows for four mutually exclusive projects Year A B C D PV Factor @10% 0 -1000 -1000 -1000 -1000 1.000 1 100 0 100 200 0.909 2 900 0 200 300 0.826 3 100 300 300 500 0.751 4 -100 700 400 500 0.683 5 -400 1300 1250 600 0.621 The Payback Method Project A has the shortest payback method, only 2 years However, this method does not consider all the cash flows and does not discount them This violates the first two criteria for maximizing shareholder value The Accounting Rate of Return (ARR) The ARR is the average after-tax profit divided by the initial cash outlay Similar to the return on assets (ROA) and the return on investment (ROI) Assuming the cash flows in the table above are profits, the average after-tax profit for project A is:

-1000 + 100 + 900 + 100 - 100 - 400 = -80 5

And the ARR is -80 / 1000 = -8% Project B has the highest ARR at 26% The problems for the ARR method is it uses accounting profits instead of cash flows and does not consider the time value of money

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Net Present Value (NPV) The net present value is simply the present value of the free cash flows less the initial investment
NPV =
t =1 N

FCFt

(1 + k )

- I0

Using the table above, just multiply the product cash flows by the discount factors Should accept projects that have a NPV greater than zero Project C has the highest NPV of 530.85 If the projects are mutually exclusive, then only Project C is accepted If the projects are independent but not mutually exclusive, then accept Projects B, C, and D since they all have positive values Internal Rate of Return (IRR) The IRR is the rate which equates the present value of cash outflows and inflows Solve for the rate that makes the NPV = 0
NPV = 0 =
t =1 N

FCFt

(1 + IRR )

- I0

Project D has the highest IRR of 25.4% Should accept any project that has an IRR greater than the cost of capital Of course can only accept one project if they are mutually exclusive Comparison of Net Present Value with Internal Rate of Return IRR and NPV can lead to different project choices NPV is appropriate because it uses the market-determined opportunity cost of capital The IRR method does not discount at the opportunity cost of capital The Reinvestment Rate Assumption The NPV approach assumes shareholders can reinvest at the market-determined opportunity cost of capital Under the IRR method, it is assumed shareholders can reinvest at the IRR

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The Value-Additivity Principle IRR does not adhere to the value-additivity principle The results change when different projects are combined NPV always follows the value-additivity principle Multiple Rates of Return There will be multiple IRR solutions when the sign changes more than once in a cash flow stream Could use the opportunity cost of capital to accumulate the positive cash flows in the calculation to eliminate the multiple roots This makes sense because the cash flows lent to the firm should be at a reasonable rate Summary of Comparison of IRR and NPV Problems with IRR 1. Does not obey value-additivity principle 2. Assumes funds invested in projects have opportunity costs equal to the IRR for the project 3. Cash flows cannot be discounted at the market-determined cost of capital 4. Multiple roots can emerge if the sign of the cash flows change more than once Cash Flows for Capital Budgeting Purposes This section adds debt and taxes Investment funds can be provided by creditors and shareholders Debt holders expect to receive a stream of payments unless the firm is bankrupt; shareholders get the residual value Both creditors and shareholders should receive their expected risk-adjusted rates of return Use the following assumptions in a simplified example An initial investment of $1000 is required to buy equipment that will depreciate at $200 per year for 5 years The owners will borrow $500 at 10% interest The cost of equity is 30%

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The table below illustrates the pro forma income statement Rev VC FCC dep. EBIT kdD EBT T NI Revenue 1300 600 Variable costs Fixed cash costs 0 Noncash charges (depreciation) 200 Earnings Before Interest and Taxes 500 Interest Expense 50 Earnings Before Taxes 450 Taxes @ 50% 225 Net Income 225

Assuming the residual cash flows continue forever,

S=

Residual Cash Flow 225 = = 750 30% ks Interest Payments 50 = = 500 10% kb

The present value of the bondholders wealth, B, is:

B=

Thus, the market value of the firm, V, is: V = B + S = 1250 Define the weighted average cost of capital (WACC) in the following manner:

B S k = WACC = kb (1 - t c ) + ks = ( 0.10 )(1 - 0.5)( 0.4 ) + ( 0.30 )( 0.6 ) = 20% B+S B+S
Cash flows for capital budgeting purposes is free operating cash flows minus taxes on free operating cash flows

( DRev - DVC - DFCC ) - t c ( DRev - DVC - DFCC - Ddep ) - DI = ( DRev - DVC - DFCC )(1 - t c ) + t c Ddep - DI = EBIT (1 - t c ) + Ddep - DI
Notice the cash flows are independent of the capital structure (debt and equity mix); that is taken into account in determining the WACC Discounting at the WACC separates the investment decision of the firm from its financing decision Must assume the capital structure stays constant or the cost of capital would change each period The definition of cash flows includes working capital requirements

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Relaxing the Assumptions Will need to introduce uncertainty Also must account for manager flexibility (e.g. could defer the start date, increase or decrease the scale) This means the NPV approach systematically undervalues every project Recommended Problems You can certainly work all the problems, but the ones below are particularly valuable in your exam preparation. 1, 4, 5, 8, 9 Solutions to Recommended Problems 1. First calculate the net income: Revenue Variable and fixed costs Depreciation Earnings Before Interest and Taxes Interest Expense Earnings Before Taxes Taxes @ 40% Net Income 140,000 100,000 10,000 30,000 0 30,000 12,000 18,000

CF = ( DRev - DVC - DFCC )(1 - t c ) + t c Ddep - DI = (140,000 - 100,000 )(1 - 0.4 ) + ( 0.4 )(10, 000 ) = 28, 000
CF = EBIT (1 - t c ) + Ddep - DI = ( 30, 000 )(1 - 0.4 ) + 10, 000 - 0 = 28, 000 NPV =
t =1 10

28, 000

(1.12 )

- 100, 000 = 58, 200

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4. Calculate the net cash flows and discount back at 12% to find the net present value At time t = 0 (buy new machine, sell old machine, take tax loss on sale)
-100, 000 + 15, 000 + ( 40, 000 - 15, 000 )( 0.4 ) = -75, 000

In years 1 to 8 (increase in earnings, tax savings from new depreciation amount)

100, 000 - 12, 000 40, 000 - 0 ( 31, 000 )(1 - 0.4 ) + (1.12 ) ( 0.4 ) 8 8
8 -t t =1

= ( 4.968 ) [18, 600 + 2400] = 104,328

-8

In year 8 (salvage value of new machine)

(1.12 ) (12, 000 ) = 4, 847

Note there is no tax effect because this portion of the investment was never deducted for tax purposes; only 88,000 was deducted over the life of the new machine NPV = -75,000 + 104,328 + 4,847 = 34,175 5. Note the financing of the project is irrelevant.

10, 000 NPV = ( 3000 )(1 - 0.4 ) + ( 0.4 ) ( 2.991) - 10, 000 = -2, 223.40 5
8. The financing information in this project is also irrelevant. The annual cash flows are increased due to the revenue increase, cost reduction, and tax savings from the depreciation:

[ 200 + 360] (1 - 0.4) + ( 0.4 )

1200 = 496 3

3 -t NPV = (1.10 ) 496 - 1200 = 33.55 t =1

9. First calculate the cash flow difference with and without the proposal CF = ( DRev - DVC - DFCC )(1 - t c ) + t c Ddep = ( 0 - -290 - 0 )(1 - 0.5 ) + ( 0.5 )(180 ) = 235 Then calculate the NPV at the weighted average cost of capital

5 -t NPV = (1.10 ) 235 - 900 = -9.12 t =1

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Financial Markets and Corporate Strategy by Greenblatt & Titman Chapter 18: How Managerial Incentives Affect Financial Decisions (Study Note FET-162-08)
Introduction Learning Objectives 1. Distinguish between managerial incentives and shareholder incentives 2. Understand how differences affect ownership structure, capital structure, and investment policies 3. Describe ways to design compensation contracts that minimize managerialshareholder incentive problems Purposes of Chapter 1. View how financial decisions are actually made in light of incentive problems 2. View how financial decisions should be made in light of incentive problems Why might management decisions not maximize firm value? 1. Managers take advantage of position and benefit at shareholders expense For example, Armand Hammer used Occidental funds to build a museum for his personal art collection 2. Managers serve more than just shareholders (e.g. employees) 18.1 The Separation of Ownership and Control Most large corporations are effectively controlled by management that own a very small stake in the company Whom Do Managers Represent? 1. Investors (e.g. equity holders and debt holders) 2. Customers and suppliers 3. Employees Managers spend more time with the last two groups relative to investors

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What Factors Influence Managerial Incentives? 1. Length of time on job Longer time increases loyalty to those who the manager frequently interacts (e.g. customers and employees) 2. Proportion of company stock owned by management Only a fraction of the perquisites (e.g. corporate jet) is paid by the manager How Management Incentive Problems Hurt Shareholder Value Share prices normally increase when entrenched executives leave New CEOs can make the tough decisions that benefit shareholders even if employees are hurt Why Shareholders Cannot Control Managers For most companies, CEOs own a very small fraction of the company (less than 1%) The ownership of outside shareholder is too diffuse to make a change Free-rider problem: individual investors are not inclined to discipline management even though it would be in the best interest of the shareholders as a group Proxy fights are very expensive and the cost must be borne by the individuals that wage them These individuals are only getting a fraction of the benefit; the other shareholders are getting a free ride Why is Ownership so Diffuse if it Leads to Less Efficient Management? Investors must balance the desire to have a diversified portfolio with the need to control management An investor that sacrifices diversification for control would benefit other shareholders, but only the investor would bear the lack of diversification cost

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Can Financial Institutions Mitigate the Free-Rider Problem? Large institutional investors (like mutual funds) could control a significant stake in a company and still be diversified Mutual funds and insurance companies in the US are precluded by law from owning more than 5% of the stock of any individual firm Pension funds have begun to exert more influence, but there is still some reluctance in private ones Companies dont want other private pension plans to monitor their actions, so they provide the same courtesy to other companies with their pension plan Public pension funds are even more aggressive at monitoring managers of corporations because they do not have concerns about other plans monitoring them Changes in Corporate Governance Changes in the mid-1980s that made managers more responsive to shareholders include: 1. Active takeover market 2. Increased usage of executive incentive plans 3. More active institutional shareholders The SEC changed two rules in the early 1990s to encourage this Fuller disclosure of executive compensation packages Made it easier for shareholders to get information about other shareholders; this reduced the cost of proxy fights

Board members are becoming more effective at monitoring management 1. Smaller number of members with greater percentage of outsiders 2. Receive more compensation in stock options to align incentives CEOs are now more likely to lose their jobs for poor performance Corporate Governance Problems Differ Across Countries? Some countries, like the US and UK, provide strong legal protection for outside shareholders Other countries, like Russia, have very weak protection The countries with strong protection have more active markets

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18.2 Management Shareholdings and Market Value The ownership in many corporations is quite concentrated Many of the large shareholders are the company founders (e.g. Michael Dell) The Effect of Management Shareholdings on Stock Prices A person like Bill Gates may choose not to sell his Microsoft stock for tax reasons or to avoid sending bad signals to the market Executives in the industries with the greatest potential incentive problems retain the largest ownership The market expects the entrepreneur will work harder if he or she retains a larger ownership position Management Shareholdings and Firm Value: The Empirical Evidence One study showed higher management concentration was good up to a point (5%), but then it hurt the value of the corporation This is tough to measure because market-to-book ratios are affected by many factors Closed-end mutual funds often trade at a significant discount to the net asset value (NAV) This indicates investors dislike the large shareholders; negative effects of management ownership outweigh the positive benefits 18.3 How Management Control Distorts Investment Decisions The Investment Choices Managers Prefer 1. Making Investments that fit the Managers Expertise This makes it harder to fire and replace the manager Mangers want to become entrenched and irreplaceable 2. Making Investments in Visible/Fun Industries Media companies are more fun to manage than chemical companies 3. Making Investments that Pay Off Early Managers are focused on short-term results even if the decisions hurt the long-run

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4. Making Investments that Minimize the Managers Risk and Increase the Scope of the Firm Managers want to avoid bankruptcy to keep their jobs This also explains why managers prefer large empires Unsystematic risk matters to managers even though it does not matter to shareholders, so managers prefer diversified structure Managers also prefer less debt Managers also like larger companies because pay is correlated with size Outside Shareholders and Managerial Discretion Outside shareholders can reduce management discretion though fixed assets and other technologies Flexibility is more valuable in uncertain environments, so outside shareholders may be better off monitoring the managers rather than restricting the decisions The cost of discretion is greater when manager and shareholder interest do not coincide 18.4 Capital Structure and Managerial Control Increasing debt may motivate the manager simply trying to avoid bankruptcy and keep job The Relation between Shareholder Control and Leverage Companies managed by individuals with a strong interest in the stock price tend to have higher leverage

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How Leverage Affects the Level of Investment Using debt to limit the firms ability to invest in the future may be beneficial; it avoids poor investments by management Large debt limits managements ability to use corporate resources Selecting the Debt Ratio that Allows a Firm to Invest Optimally Shareholders should use more debt if management has a tendency to overinvest In Example 18.3 on page 641 A firm is financed with initial investment of $100 In one year, the firm can invest an additional $100 in a project that has the following potential payoffs in different states of the economy: Good Value with additional investment Value without additional investment Incremental value added $250 50 200 Medium $175 50 125 Bad $125 50 75

The $100 additional investment in the bad state of the economy should not be made because it will lose $25 To prevent management from making the second investment in the bad economy state, could structure the initial $100 investment to restrict future choices For example, the initial investment could be $70 of senior debt and $30 of subordinate debt The value with the additional investment (the first row in the table above) must first pay back the $70 of senior debt Then only if there are sufficient funds could it support the additional $100 investment In the bad state of the economy, there would only be $55 remaining, which is clearly not enough to support the $100 additional investment Thus, management is prevented from investing in a negative NPV project This restriction will only work if the internal cash flows of the company are not sufficient to cover the additional investment

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A Monitoring Role for Banks Banks could monitor the firm position much better than diffuse debt holders Many debt holders would have the same free-rider problem discussed above The bank could review the prospects before deciding to lend additional funds This is a more flexible option compared to Example 18.3 above However, if banks have too much influence it could make management too conservative for the likes of equity holders Borrowing from a bank can be done discretely; this is advantageous if the firm is trying to keep proprietary secrets from its competitors A Monitoring Role for Private Equity Private equity suppliers (e.g. venture capital firms) could also provide monitoring services They are likely to provide more monitoring because 1. They have substantial equity stake 2. Their investment is not liquid, so interested in long-term viability of firm 3. They have the needed expertise 18.5 Executive Compensation Stockholders are the principals and management is the agent hired by the principals The Agency Problem The tenant farmer (the agent) and the owner of the farm (the principal) The farmer compensation should be tied to the output, but not too much because outside influences (e.g. weather) can dramatically affect the crop and is not controllable by the farmer Two Components of an Agency Problem 1. Uncertainty the agent cannot control 2. Lack of information for the principal (cannot monitor the agent all the time) Measuring Inputs versus Measuring Outputs The principal can either closely measure the agent input (labor intensity) or indirectly monitor the agent by measuring the output In the mid-1970s it was popular to measure the input; however, it was difficult to measure the quality of the input even if the quantity was objective Now there is a tendency to monitor the output

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Designing Optimal Incentive Contracts Managers should not be penalized for factors outside their control So should not tie the managers to the overall stock return; rather, should compare to the stock return of other firms in the industry Minimizing Agency Costs Agency costs are the difference between actual firm value and hypothetical value if the management and shareholder incentives were in sync Is Executive Pay Closely Tied to Performance? The Jensen and Murphy Evidence In a 1990 article they argued executive compensation is not tied to performance enough More Recent Evidence Subsequent evidence hints Jensen and Murphy underestimated the sensitivity They failed to capture the future CEO compensation relationship to performance Positive actions taken by the CEO are immediately reflected in the stock price on a present value basis; the investors assume the positive results will continue into the future It is more important to compare cumulative compensation to cumulative stock gains over many years Cross-Sectional Differences in Pay-for-Performance Sensitivities The performance sensitivities differ greatly by industry Industries that have more potential agency problems tie the pay more to performance Higher performance sensitivities is observed at smaller companies Growth firms in volatile industries have smaller pay-for-performance sensitivities; too much of the performance is outside the managers control Is Pay-for-Performance Sensitivity Increasing? It has increased over the past 20 years, mainly through stock options

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How Does Firm Value Relate to the Use of Performance-Based Pay? Empirical studies tend to show performance-based pay does improve financial results However, the positive correlation does not imply causation Managers may be inclined to accept performance-based pay if they expect high returns in the short term Thus, the implementation of performance-based pay could be a form of market signaling Is Executive Compensation Tied to Relative Performance? Relative performance compensation tie the managers pay to performance relative to a benchmark Stock options are the dominant form of performance-based compensation, and they are not based on relative performance Bonuses are easier to tie to relative benchmarks Relative benchmarks could encourage too much competition within the industry Stock-Based versus Earnings-Based Performance Pay Stock-Based Compensation Advantageous because ties managers directly to shareholder desire Disadvantages include: 1. Stock prices change for reasons outside the managers control 2. Stock prices change due to changing expectations, not just realizations This penalizes managers if the market has a favorable opinion of them in advance Earnings-Based Compensation Advantageous because numbers are available for separate business units and privately held firms Disadvantages include: 1. Difficult to determine the appropriate measure 2. Accounting numbers can have quirks Value-Based Management Based on economic cash flows Adjusts for the amount of capital used

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Compensation Issues, Mergers, and Divestitures Stock-based compensation is not as useful at motivating heads of business units since their actions are not as impactful on the stock price Spin-Offs and Carve Outs Spin-offs create a new company by distributing shares to the existing shareholders Carve outs create a new company through an IPO Both of these could be done to better motivate the division heads Mergers Mergers combine separate firms into a single entity Many divestitures undo past mergers

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Financial Markets and Corporate Strategy by Greenblatt & Titman Chapter 19: The Information Conveyed by Financial Decisions (Study Note FET-163-08)
Introduction Learning Objectives 1. Understand how financial decisions are affected by well-informed managers 2. Indentify situations in which managers may want to distort accounting information 3. Explain how dividend choice, capital structure, and real investments affect stock price 4. Interpret empirical evidence regarding stock price reaction to financing and investing decisions Introduction The stock market reacts greatly to dividend changes and other financial restructurings Managers often have inside information that cannot be disclosed to investors The information could give the company a competitive advantage or the management team may simply want to hide unfavorable news Investors strive to interpret indirect news from management called signals These actions (e.g. management purchasing shares) often speak louder than words Managers often want to maximize the short-term stock price simply to boost their own pay Must distinguish between decisions that create value and decisions that simply signal positively to shareholders 19.1 Management Incentives When Managers Have Better Information Than Shareholders Should the manager strive to maximize the current market value of the firms which is based on public information or the true value of the firm (the intrinsic value) based on private information? Long-term shareholders prefer the maximization of intrinsic value Short-term shareholders prefer the maximization of the current value At times they even want management to conceal bad news

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Conflicts between Short-Term and Long-Term Share Price Maximization Reasons for management concern of current stock prices 1. May plan to issue equity or sell some of own stock 2. Prevent acquisition at a low price 3. Boost management compensation 4. Need higher price to attract customers and outside stakeholders Managers want to increase the weighted average of the current and intrinsic value; must determine these weights based on the particular circumstances Good decisions can reveal unfavorable information and bad decisions can reveal favorable information This means stock price reactions do not necessarily imply the decision was good or bad 19.2 Earnings Manipulation Managers often increase reported earnings in the current year at the expense of future years Depreciation and inventory methods can be used to manage earnings Some of the methods are disclosed, but other estimates left to manager discretion are hidden from shareholders Incentives to Increase or Decrease Accounting Earnings Earnings are manipulated most when it is most advantageous For example, earnings will be increased prior to a stock issue Sometimes the earnings will be lowered (e.g. prior to union negotiations or plea for government assistance)

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19.3 Shortsighted Investment Choices Savvy investors rarely take the reported earnings at face value Sometimes cash flow numbers are more reliable Managements Reluctance to Undertake Long-Term Investments Some investments will not generate significant profits for many years Analysts are skeptical about management claims of future profits; they are more concerned about the current year profits This causes reluctance for managers to invest in long-term projects A manager only concerned about maximizing intrinsic value would still undertake good long-term investments What Determines a Managers Incentive to be Shortsighted? The weights assigned to the current value and intrinsic value determine the shortsightedness 19.4 The Information Content of Dividend and Share Repurchase Announcements Empirical Evidence on Stock Returns at the Time of Dividend Announcements Stock prices increase about 2% on announcement of a dividend increase; the jump is greater if no previous dividends have been paid Stock prices drop about 9.5% when dividends are cut or omitted However, this does not mean increased dividends are good for intrinsic value maximization

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A Dividend Signaling Model Operating Cash Flow = Investment Expenditures Change in Equity + Dividends A company must use the internal cash flows for investments or give it back to shareholders Information Observed by Investors Assume investors cannot observe the operating cash flows and investment expenditures They can observe the dividends paid and amount of capital raised The Information Content of a Dividend Change Increased dividends could mean higher operating cash flow (which is good) or reduced investment expenditures (which is bad) Dividend Signaling and Underinvestment If the manager is focused on the current stock price, will likely forgo some investment opportunities to increase the current dividends Often this will hurt the intrinsic value of the company Do Positive Stock Price Responses Imply That a Decision Creates Value? Not necessarily As mentioned above, increased dividends could actually mean the company is not making proper investments Also, dividend cuts could be viewed negatively by the market when it is the prudent decision for management to make worthwhile investments Share Repurchases versus Dividends Share repurchases are equivalent to dividends, ignoring transaction costs and taxes Studies have shown stock prices react favorably to share repurchase announcements A greater stock price reaction is observed for tender offers compared to purchases made in the open market This occurs because tender offers are usually larger in size and at a premium Simultaneous dividend cuts and share repurchases should be a wash in the market However, the market may view the share repurchase as a one-time event and the dividend cut as permanent Share repurchases are more tax efficient for the investor There is very limited empirical evidence on simultaneous dividend cuts and share repurchases

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Dividend Policy and Investment Incentives Investors and analysts rarely know details about the investment opportunities of the firm Can Dividend Cuts Signal Improved Investment Opportunities? Management must convince the shareholders the investments are worthwhile Sometimes the shareholders will believe management, other times they will not Dividend Cuts and the Incentive to Overinvest Managers may overinvest simply to see the firm grow rather than add value for the shareholders Studies have shown companies with better investment opportunities (measured by the ratio of the market value to the book value) have smaller market reactions to dividend cuts and dividend increases This could simply show people who invest in growth stocks (high MV to BV ratio) are not interested in dividends Dividends Attract Attention There is more incentive for management to attract attention when it feels the firm is undervalued Stock dividends and stock splits also usually increase the share price even though they do not affect the firms cash flows This could be due solely to the attention the announcement solicits 19.5 The Information Content of the Debt-Equity Choice Two key pieces of information in the debt/equity choice 1. Managers will avoid debt if think it will be difficult to repay; therefore, debt issues express the management confidence in future cash flow 2. Managers would be reluctant to issue equity if they thought the shares were underpriced; therefore, equity issues may signal overpriced shares A Signaling Model Based on the Tax Gain/Financial Distress Trade-Off When issuing debt, management must weigh the tax benefits with the cost of financial distress Management that expects large future cash flows will favor debt financing Management may even increase leverage when it reduces the intrinsic value just to pump up the current stock price In order for this to be a credible market signal firms with poor prospects must find it difficult to issue debt JAM May 2012 1.03 SN 163 Page 5 of 9

The Credibility of the Debt-Equity Signal Sometimes a firm will take on more debt than desired just to send a strong market signal Investors must take into account the motives of management For example, the CEO would like to increase the stock price right before a sale of his or her personal shares The investors must determine if management (in particular the CEO) has a long-term or short-term agenda Adverse Selection Theory Adverse selection is displayed when individuals choose among various medical or dental insurance plans Managers have the greatest incentive to sell stock when it is a lemon (overpriced) Adverse Selection Problems When Insiders Sell Shares An entrepreneur must consider the following when deciding how many shares to sell: 1. Diversification benefits 2. Tax costs 3. Whether the shares are undervalued or overvalued Investors watch carefully the buying and selling by insiders The big inside investors must convince the market that selling shares is not a bad signal for the company stock Adverse Selection Problems When Firms Raise Money for New Investments Firms may pass up good investments just to avoid issuing equity This is especially true if the current stock price is below the intrinsic value Using Debt Financing to Mitigate the Adverse Selection Problem With debt financing, a company should take on a new project provided it has a positive NPV Management does not have to worry about the current stock price be undervalued Management may still pass up good investments if it increases the risk of bankruptcy too much Adverse Selection and the Use of Preferred Stock Preferred stock has fixed payments like a bond but avoids the financial distress risk because missing payments does not cause bankruptcy Preferred stock may be a good option for firms that are experiencing temporary financial problems

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Empirical Implications of the Adverse Selection Theory 1. The reluctance of managers to issue equity when the stock price is undervalued explains why the stock price drops when equity is issued 2. Also explains why managers prefer the following order for financing projects: a. Retained earnings b. Debt c. Equity 19.6 Empirical Evidence What is an Event Study? Examine stock price responses to announcements The stock price often moves a few days before the announcement because information is leaked to the public Also, sometimes the stock price reacts slowly to the news over several days Therefore, many studies average the total return or excess return over several days Excess return calculations adjust for the market returns, which is most important for small samples Event Study Evidence Capital Structure Changes Leverage-increasing events (e.g. stock repurchase, exchange debt for preferred) tend to increase stock prices and leverage-decreasing events (e.g. conversion-forcing call, common stock sale) tend to decrease stock prices Issuing Securities In general raising capital is viewed negatively by the market It implies the company has generated insufficient internal capital The negative reaction is much more severe for equity issues because it also implies management thinks the stock is overpriced Debt issues get almost a neutral market reaction because the market likes the increase in leverage

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Explanations for the Event Study Results The empirical findings above are consistent with the adverse selection theory Equity issues are most subject to adverse selection (management knows the stock price is overvalued) and short-term bank debt is least subject to adverse selection Management is enticed to buy back shares when the stock price is undervalued Managers also are willing to take on debt when they expect the future profits to be sufficient to cover the cash flow needs Summary of the Event Study Findings Stock prices react favorably to 1. Distributing cash to shareholders 2. Increasing leverage Stock prices react negatively to 1. Raising cash 2. Decreasing leverage Differential Announcement Date Returns Announcements of equity issues will be perceived less negatively if investors realize the company cannot easily issue debt The empirical evidence supports this conclusion Postannouncement Drift The market often underreacts to important information Studies have shown the market underreacts to dividend initiations and omissions It also underracts to equity issues and share repurchases Investors may place too much confidence in their own analysis of the firms value before the announcement

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How Does the Availability of Cash Affect Investment Expenditures? The borrowing capacity and availability of cash affect a firms ability to invest Too much debt financing can hurt the companys credit rating, which could affect its ability to attract customers Empirical Evidence in the United States Studies have shown companies limit investments based on cash flows This is especially true for companies that pay lower dividends Empirical Evidence in Japan A keiretsu family is a group of firms with interlocking ownership structures It makes it difficult for another firm to take them over The family is usually held by a large bank that can supply the capital needs Therefore, investment decisions are not greatly impacted by cash flow

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The New Corporate Finance Where Theory Meets Practice (Third Edition) by Chew Chapter 31: Theory of Risk Capital in Financial Firms (Study Note FET-170-09)
Introduction Primarily focused on principals in business parties that engage in asset-related (e.g. lending) and liability-related (e.g. deposit taking) activities Distinguishing features of principal financial firms 1. Credit-sensitivity of customers Because customers can be major liabilityholders Customers prefer high credit quality 2. High cost of capital Because of opaqueness to customers and investors The detailed asset holdings and business activities are not publicly disclosed Changes can occur quickly and cannot be easily monitored by customers and investors This causes high agency and information costs 3. Profitability is highly sensitive to cost of capital Because operate in competitive financial markets Must correctly charge for the capital commitments Difficult to allocate capital to business units What is Risk Capital? Smallest amount to insure value of the firms net assets against a loss Net assets are the gross assets less the customer liabilities The riskiness of the net assets depends on riskiness of gross assets and customer liabilities Risk capital differs from both regulatory capital (based on accounting standard) and cash capital (cash required to execute transaction)

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Measuring Risk Capital Hypothetical Example New firm (Merchant Bank) with no initial assets Only deal is one-year $100 million bridge loan paying 20% interest The risk-free rate is 10% Three potential scenarios 1. Anticipated Return of $120 million 2. Disaster Return of $60 million 3. Catastrophe Return of $0 Possibilities with No Customer Liabilities 1. Risk Capital and Asset Guarantees Finance with risk-free note that pays $110 million at maturity For $5 million Merchant Bank can buy insurance that guarantees a return of $110 million on the bridge loan The price of the loan insurance is the risk capital Accounting Balance Sheet Assets Liabilities Bridge Loan $100 Note (default free) $100 Loan Insurance 5 Shareholder Equity 5 Risk-Capital Balance Sheet Assets Liabilities Bridge Loan $100 Note (default free) $100 Loan Insurance 5 Risk capital 5 The payoff scenarios are as follows: Scenario Bridge Loan Loan Insurance Loan Insurance Note Shareholder Anticipated 120 0 120 110 10 Disaster 60 50 110 110 0 Catastrophe 0 110 110 110 0
Bridge Loan +

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2. Risk Capital and Liability Guarantees Rather than purchasing insurance on the bridge loan, the parent of Merchant Bank could guarantee the note Accounting Balance Sheet Assets Liabilities Bridge Loan $100 Note (default free) $100 Shareholder Equity 0 Risk-Capital Balance Sheet Assets Liabilities Bridge Loan $100 Note (default free) $100 Note Guarantee G Risk capital G (from parent) Since economically it is the same as purchasing insurance on the bridge loan, G must equal $5 million The shareholder payoffs are the same 3. Liabilities with Default Risk Now Merchant Bank will finance by issuing a liability with some default risk The risky note is only worth $95 million since $5 million must be subtracted for the default risk Risky Note = Default-free Note Note Insurance The economic effect and shareholder payoffs are again the same Accounting Balance Sheet Assets Liabilities Bridge Loan $100 Note (risky) $100 Shareholder Equity Assets Bridge Loan Asset insurance (from note holder) Liabilities $100 Note (default free) $100 5 Risk Capital 5 D D

The accounting balance sheet for the above three examples could be different, but the risk-capital balance sheets are all very similar

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Possibility with Fixed Customer Liability Assume a firm has risky assets worth $2.5 billion The price of complete insurance for the asset portfolio is $500 million The firm has issued one-year guaranteed investment contracts (GICs) promising 10% on the face value of $1 billion Junior debt with a face value of $1 billion and promised return of 10% is used with $500 million of equity to fund the balance Partial insurance on the investment portfolio has been purchased for $200 million; it will cover the first $300 million of losses Insurance on the entire $2.5 billion portfolio is valued at $500 million; this is the value of an at-the-money put option on the risky asset portfolio Assuming the GIC has a market value of $990 million (11% yield) and the junior debt has a market value of $900 million (22% yield), the accounting balance sheet looks like: Assets Investment portfolio Third-party insurance Total Assets Liabilities $2,500 GICs (par $1,000) 200 Debt (par $1,000) Equity 2,700 Total Liabilities $990 900 810 2,700

The risk-capital balance sheet of the firm is as follows: Assets Investment portfolio Liabilities $2,500 Cash Capital (default free) Customers (GICs) $1,000 Asset Insurance Debtholders 1,000 Equityholders (residual) 190 Equityholders 500 Insurance Co. (third-party) 200 Total Cash Capital 2,500 Debtholders (disaster) 100 Customers (catastrophe) 10 Risk Capital (Equityholders) 500 Total Insurance 500 Total Assets 3,000 Total Capital 3,000

The debtholder and customer asset insurance is simply the par value minus the market value (1000 900 = 100 and 1000 990 = 10) The equityholder asset insurance is just the plug to make the total equal $500, which is the value of complete insurance on the risky assets

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Basic functions of capital providers 1. All provide cash capital 2. All are sellers of asset insurance (to varying degrees) Customers usually offer the least amount because they prefer the contract values not be tied to the firm 3. Provision of risk capital Possibility with Contingent Customer Liabilities Assume a company issues a liability that credits the total return on the S&P 500 Consider three investment strategies for the company 1. Invest all in risk-free securities In this case the gross assets are risk-free, but the net assets (gross assets less liabilities) are very risky Effectively the company is short the S&P 500 index The company could protect itself by purchasing a call option on the index, so that represents the risk capital of the company 2. Invest in the S&P 500 Now the gross assets are risky, but the net assets are risk-free Hence no risk-capital is required 3. Invest in a customized stock portfolio Now both the gross assets and net assets are risky The net assets are risky to the extent the customized stock portfolio does not track the S&P 500 index Accounting for Risk Capital in the Calculation of Profits Risk capital is used to implicitly or explicitly purchase insurance on the net assets of the firm The gains and losses on this insurance should affect profitability External insurance commonly shows up as an expense on the income statement; internal transactions should do the same If the parent company provides a guarantee, the cost of the guarantee (i.e. insurance premium) should show up as an expense for the subsidiary This will not affect consolidated earnings, but it will impact the results by line

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The Economic Cost of Risk Capital The expected economic cost of capital must be calculated to adjust the expected profits If insurance can be purchased at its fair value, then risk capital will not be costly Usually a spread is built into the price of insurance, which turns out to be the economic cost The spread is needed to cover various forms of insurance risk, such as: 1. Adverse selection (the insurance company cannot distinguish good risks from bad risks) 2. Moral hazard (cannot monitor the actions of the insured) 3. Agency costs (due to inefficiency or mismanagement) Spreads are relatively high because the principal financial firms are opaque in structure The cost of the capital is dependent on the form Shareholders in all equity firms will have high agency costs (flexibility for management) but low moral hazard (no incentive to increase risk haphazardly) Debt financing has high moral hazard but less agency costs The transparency could be increased to reduce the cost of risk capital, but then would give away potential competitive advantages The full insurance premium is deducted when measuring the profits after the fact; only the economic cost is deducted ex ante Hedging and Risk Management Firms that speculate on the direction of the market will require more risk capital Market risk can be hedged with derivatives like futures, forwards, swaps, and options Hedging broad market risks is usually not that expensive because the spreads are small

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Capital Allocation and Capital Budgeting Could assume the capital for a particular business is just the risk capital applicable to that business; this ignores the benefits of diversification The amount of risk capital is needed (in addition to just the economic cost) to calculate the profits after the fact The diversification benefit will be more pronounced when the businesses are not that correlated Notice in Table 3 on page 450 the total risk capital should be $394 rather than $294 Marginal capital should be used for each business rather than the risk capital required on a stand-alone basis Correlations among business units affect the total economic cost of capital Technical Appendix The risk capital in Table 1 (on page 450) is based on the price of a put option If the net assets were invested risklessly, they would grow to ( A0 - L0 ) erT The shortfall in net assets relative to the riskless return is ( A0 - L0 ) e rT - ( AT - LT ) Insurance to permit default-free financing is effectively a put option on the net assets with a strike of ( A0 - L0 ) erT The put option value can be approximated with the following formula
Risk Capital = ( 0.4 ) A0s T

! is the volatility of At/Lt

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Capital Allocation in Financial Firms by Andre Perold (Study Note FET-114-07)

Introduction The approach in this article is similar to the risk-adjusted return on capital (RAROC) Risk capital is determined by the loss exposure of its stakeholders It is very important to financial firms because customers only want policies from highlyrated entities Most of the risk is borne by equity-holders and uninsured debt holders, not customers who purchase low-default-risk liabilities Low-default-risk (cash capital) and risk-bearing (risk capital) funding is provided by the various stakeholders Firms should try to most efficiently manage risk capital (i.e. minimize blended deadweight costs) Sources of deadweight capital costs 1. Information costs Financial firms are secretive and can change quickly, thus making it impossible for outsiders to adequately monitor them 2. Higher taxes and agency costs of free cash flow The tendency of companies to waste excess cash flow on low-return projects Decreasing firm-wide risk can reduce the cost of guarantees Diversified firms have more investment opportunities because the risk capital is reduced Should not operate a transparent business (e.g. S&P 500 index fund) within an opaque financial firm Outsiders cannot clearly see the holdings and strategies of opaque financial firms Risk Capital Often calculated with value at risk (VaR) Merton and Perold definition of risk capital Smallest amount that can be invested to insure the value of the firms net assets against a loss in value relative to a risk-free investment Using the above definition, the risk capital for a treasury bond is the price of a put option struck at the forward price of the bond VaR ignores the magnitude of the loss in the extreme tail of the distribution Diversification benefits can be very large

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Allocation of the Cost of Risk Capital Diversified financial firms should have lower capital costs and thus greater returns Opaque financial firms should use low-cost hedging instruments when possible Capital can be allocated on a stand-alone, fully allocated, or marginal basis Example Assume both business units A and B have stand-alone capital requirements of 100 The correlation of their profits is zero The fully allocated risk capital for both businesses is 1002 + 1002 = 141.4 The marginal capital for each is 141.4 100 = 41.4 Different investment decisions will be made based on the choice of capital allocation Many firms only recognize diversification within business units, not between them A Model of the Financial Firm In this example, SwapCo is a low-cost swap dealer SwapCo is in business for one time period; all contracts are due at time 1 SwapCo hedges the liabilities, but there is some residual basis risk that is unhedged SwapCos profits are , which is the present value of the spread over the fair value of the customer liabilities The initial price for the customer is L(0) + , where L(0) is the default-free value L(0) is invested in the hedge portfolio H; is invested at the risk-free rate The cumulative hedging error is E(t) = H(t) L(t), which makes the total end-of-year operating profits equal (1 + r) + E(1) Assume the profits are normally distributed with mean of (1 + r) + " and standard deviation of !; the term " represents the risk premium for exposure of the hedging error to systematic risk SwapCos Balance Sheet The initial assets consist of a hedge portfolio, external guarantee, and a cash cushion C (part of which is from the spread) The external investment required = C + Cost of Guarantee The net assets (excluding the external guarantee) at time 1 are:

S = C (1 + r ) + E (1)
The payoff from the external guarantee is S - = Max {-S ,0} Only has a positive payoff if the net assets are negative

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Deadweight Costs 1. Guarantor monitoring SwapCo Modeled as a fraction, m, of the shareholder deficit, Sm V {S - } , where V {S - } is a present value calculation (defined below)

This makes the total cost of insurance equal (1 + m ) V {S - } 2. Double taxation and free cash flow agency costs Modeled as a fraction, d, of the shareholder surplus, S+ The shareholder equity is therefore worth (1 - d ) V {S + } Valuation
+ NPV = (1 - d ) V {S + } - ( C - m ) - (1 + m ) V {S - } = m - dV {S } + mV {S }

So the net present value is the firms operating profits less the value of the deadweight capital

V {S + } = z=

s [ n( z ) + zN ( z )] 1+ r

V {S - } =

s [ n( z ) - zN (- z )] , where 1+ r

and n( ) and N( ) are the standard normal and cumulative standard s normal distributions ! is the risk-neutral standard deviation of the hedging error Minimization of Deadweight Costs Higher initial cash will reduce the guarantee premium and monitoring costs but increase the double taxation and free cash flow agency costs Minimize total deadweight costs when the shortfall probability = The initial cash cushion that minimizes the deadweight costs is
d d +m

C (1 + r )

C =
*

Z ( dm +m )s 1+ r

, where Z( ) is the inverse of the cumulative normal distribution

At the optimal cash cushion, the value of the deadweight costs is

s
dV {S + } + mV {S - } = 2p

2 m 1 ( d + m ) exp - 2 Z ( d +m )

1+ r

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Main Result NPV = m - kR where s 2 m R= k = ( d + m ) exp -1 2 Z ( d +m ) 2p (1 + r ) R is the value of the put option on the hedging error, which is the Merton and Perold measure of risk capital k is the minimized cost of deadweight capital Numerical Example Risk-free rate = r = 10% = 150 ! = 250 d = 10% m = 100%

R=

150 s = 90.7 , which means the return on capital is 165% = 90.7 2p (1 + r )

Z ( dm +m ) s 1+ r = Z ( 0.909 )( 250 ) 1.1 = 303

C* =

N(1.335) = 0.909
2 2 m 1 1 k = ( d + m ) exp - 2 Z ( d +m ) = (1.1) exp - 2 (1.335) = 45.1%

The return on capital (165%) is clearly more than the deadweight cost of capital (45.1%) Cost of the Guarantee
= 1.3332 s 250 1 1 2 n( z ) = N (- z ) = 0.0912 exp - 2 z = 0.1641 2p s [ n( z ) - zN ( - z ) ] ( 250 ) [ 0.0425] V {S - } = = = 9.66 1+ r 1.1 Guarantee Cost = (1 + m ) V {S - } = 19 z= C (1 + r ) =

( 303)(1.1)

Total Investor Capital = C

+ Cost of Guarantee = 172

NPV = m - kR = 150 - ( 45.1% )( 90.7 ) = 109

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Application of the Model to Capital Allocation Within the Firm Should seek to maximize NPV of the firm Capital Budgeting If k is constant, then for any project just need the marginal effect on the profits and firmwide risk capital Should accept the project if Dm - k D R > 0 The incremental risk capital can be approximated with DR = bR , where b is the correlation coefficient of the projects profits with firm-wide profits If b is negative, then the project will act like a hedge Risk Management Any risk that can be costlessly hedged should be hedged Costly hedges should be evaluated like any other project Comparison with RAROC In this model the numerator (#) is the economic value of profits and the denominator (#R) is the marginal risk capital The hurdle rate (k) measures the firms deadweight cost of capital

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Corporate Finance Theory by Megginson Chapter 2: Ownership, Control, and Compensation

(Study Note FET-166-09)
Introduction Corporate finance theory usually assumes perfect capital markets A countrys legal, cultural, and historical environment affect finances Successful countries (e.g. US, Japan, and Germany) have different structures An economic system must simultaneously promote competition and cooperation Companies must be monitored and disciplined Legal Forms of Business Organization in the United States Basic forms of business ownership in the United States 1. Sole proprietorship 2. Partnership 3. Corporation The forms differ in the number of people that own the business, legal responsibility of members, and tax treatment There are also hybrid organizations such as limited partnerships Regular corporations constitutes most of the business The Sole Proprietorship Form A sole proprietorship is a business with a single owner All business assets belong to the owner personally They are easy to start and terminate The tax reporting is also simple Sole proprietorships dominate industries in which the optimal size is small Key disadvantages 1. Limited life 2. Limited access to capital Can only access capital from reinvested profits and personal borrowings 3. Unlimited personal liability

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The Partnership Form Like a proprietorship, but more than one owner All partners can execute contracts binding on others, and all partners are personally liable Usually the partnership agreements are in writing Partnership income is only taxed at the personal level Advantageous because people can pool resources and expertise Partnerships strive in industries that should not separate ownership and control Also competitive in knowledge-intensive businesses that need little financial capital Advantages 1. Income only taxed once 2. Can raise funds from multiple partners Disadvantages 1. Limited life 2. Limited access to capital 3. Unlimited personal liability The Corporate Form A corporation is a separate legal entity It can own property, sue and be sued, and execute contracts Benefits 1. Limited liability for shareholders 2. Perpetual life 3. Can contract with many managers, suppliers, customers, and employees 4. Many ways to raise capital 5. Ownership shares can be traded freely if it is a public corporation Disadvantages 1. Corporate income is taxed at both the company and personal levels This is a huge incentive to remain a sole proprietorship or partnership 2. Transaction costs of setting up and running corporations SEC filings, shareholder communications

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3. Monitoring and disciplining corporate executives (separation of ownership and control) Shareholders are residual claimants that can diversify No individual shareholders steps up to effectively monitor management even though it is in their collective best interest Individual shareholders are looking for a free ride Executives effectively seize control of the corporation The Limited Partnership Form Combines the best features of the general partnership and corporate organization Limited liability without the double taxation Only the general partners are legally liable Usually there are many passive investors (limited partners) Common for commercial real estate ventures and research and development Investors can utilize tax losses in the early years Disadvantages include long lives and illiquidity Also difficult to set up and monitor The S Corporation Form Allows shareholders to be taxed as partners while retaining limited liability status To be eligible, must have less than 35 non-corporate shareholders and cannot be a holding company Only a single class of equity can be outstanding Can easily switch to a C corporation if outgrows the 35 shareholder limit Organizational Choices Confronting US Business Owners The forms differ from each other in ease of formation, length of existence, access to capital, liability of equity investors, and tax treatment Public companies have stock listed on the exchange Private companies rarely report much information Capital requirements usually force companies to choose C corporations, despite the tax disadvantage

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Forms of Business Organization Used by Non-US Companies Worldwide Patterns In most capitalistic economies, some form of joint-stock, limited liability structure dominates They are similar to publicly traded US companies State-Owned Enterprises and Privatization Outside the US, state-owned enterprises (SOEs) were common in industries such as telephone, television and airline Privatization programs are transforming this The British government privatized much of their industry in the 1980s The success of Britain led to similar programs in other countries Ownership Structure and Corporate Policy Three basic models 1. Open corporate model (common in large American corporations) 2. Closed or entrepreneurial model (common in large private companies in western Europe and east Asia) 3. Industrial group model (e.g. Keiretsu in Japan) The Open Corporate Model Limited liability company with transferable claims Professional managers with many financing sources These companies dominate business in the US, Canada, and Great Britain Many of these corporations are very large Key financial characteristics 1. Rely on public capital markets for external financing (but finance most internally) 2. Shares are held by many shareholders that each hold a small percentage 3. Countries rely on formal legal contracting, government regulation, and private litigation to control 4. Large, liquid, and informationally efficient stock and bond markets 5. Regulations designed to protect small stockholders 6. Controlled by professional managers 7. Equity-based compensation for managers and employees 8. Active market for corporate control JAM May 2012 1.06 SN 166 Page 4 of 10

Weaknesses 1. Separation of ownership and control Many agency problems Managers may select directors who are loyal to management Difficult to control managers that have enough free cash flow Institutional investors could take a more active monitoring role, but American security laws prevent this Takeovers are expensive and difficult to execute successfully 2. Entrenchment incentives 3. Lack of powerful, informed monitors 4. Excessive, mandated information disclosure Reduces value of proprietary information Strengths 1. Can raise enormous sums to finance corporate investments 2. Financing transparency promotes investor and political support (reduces mistrust) 3. Allocational efficiency corporate resources given to most successful managers Disciplined by internal governance and market competition Focus on value-maximizing activities since shareholders want to maximize earnings 4. Specialization of labor through ownership separation 5. Promotes private pension plans 6. Risk-tolerant equity markets promote entrepreneurial growth 7. Technology lowers information acquisition and monitoring The Closed, (Entrepreneurial) Corporate Form Sometimes appears to be a younger, not-yet-mature open corporation However, many choose to remain small Consists of non tradeable shares and a very tight ownership structure Many are controlled by their entrepreneur/founders Typical of the financial-intermediary-based corporate finance systems Geographic Distribution More important outside the US (Europe and east Asia) These economies are much smaller than the US, so smaller companies are optimal

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Characteristics of Financial-Intermediary-Based System of Corporate Finance 1. Many mid-sized, closely-held companies; few large, publicly-traded companies 2. A few strong commercial banks dominate corporate financing and governance 3. Commercial banks also serve as investment banks 4. Capital markets play small, but growing role 5. Little mandated information disclosure, so less transparency 6. Less reliance on professional managers and stock-based compensation 7. Rare struggles for corporate control; protection from hostile foreign acquisition Strengths of Financial-Intermediary-Based System of Corporate Finance 1. Intermediaries are natural corporate monitors; European bankruptcy laws favor creditors over shareholders and managers 2. Commercial banks have comparative advantage in raising investment capital compared to public capital markets 3. Intermediaries can build long-term relationships with client firm management teams 4. Can better handle borrower financial distress 5. Better at funding multi-year investment programs Weaknesses of Financial-Intermediary-Based System of Corporate Finance 1. Conflict of interest for bankers acting as creditors and shareholders 2. Very little public transparency 3. Higher costs for large scale financing 4. Information processing technology is reducing value of bank franchises Strengths of Closed Corporate Form 1. Important decisions can be made quickly and executed by people with a stake in the business 2. Very few agency problems since managers and shareholders tend to be the same people 3. Develop niche marketing strategy that is focused Weaknesses of Closed Corporate Form 1. Current stockholders cannot diversify or attract professional managers with equity 2. Often become trapped in hostile control coalition (nobody can leave) 3. Financially constrained (usually limited to debt issues)

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Large Industrial Groupings Virtually no role in the US since the early 1900s; now mostly prominent in Asia Key features 1. Close alliance of manufacturing, marketing, and banking companies 2. Group held together with cross-shareholdings and joint ventures 3. A commercial bank typically provides financing Successful examples are in Japan and South Korea Historical Evolution Japan began to industrialize at a rapid rate around 1870 Large, family-controlled corporate groups led the way (called Zaibatsu) The Zaibatsu were broken up following World War II, but reemerged as Keiretsu in 1955 Characteristics of Industrial Group System 1. National economies dominated by small number of large and powerful industrial groups 2. Commercial bank leads a group of manufacturing, distribution, and assembly companies 3. The lead company exercises control through direct majority shareholdings or managerial authority 4. Leading exporters for country, so close relationship with national government 5. Some are run by founding families while others are run by professional managers 6. Capital markets play a very small role 7. Stock-based compensation is almost never used Strengths of the Industrial Group Corporate Finance System 1. Good for rapid economic development without need for foreign investment or heavy government involvement 2. Groups become very strong and discourage foreign competitors 3. Banks can provide financing and monitoring 4. Can quickly share information within the group

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Weaknesses of the Industrial Group Corporate Finance System 1. Group will become unstable unless all members grow at the same rate 2. Difficult to consider competitor inputs even if cheaper or better quality 3. Reliance on national products prevents consumers from getting cheaper foreign products 4. Only Japan and Korea have had success Korea seemed to copy Japanese model, but the lead companies have tighter control over group companies How Corporate Control is Exercised Corporations should benefit society in general and shareholders specifically Internal Corporate Governance Mechanisms in the United States Publicly-traded US companies must disclose a lot of information (e.g. revenues, expenses, compensation) Must also hold annual shareholder meetings, which are described in advance by a proxy statement The most important shareholder vote is electing the board of directors The director vote can be interesting if a proxy fight occurs In a proxy fight both the managers and rival team will solicit shareholders for votes Shareholder votes are also needed to approve items such as corporate mergers The board must hire, fire, monitor, and compensate the firms managers The board is a fiduciary for the shareholders It is difficult for shareholders to make managers and the board act in their best interest Corporations can become hijacked by entrenched managers The US Market for Corporate Control Corporate combinations can occur through acquisitions or mergers The combination type affects 1. Accounting treatment Acquisitions use purchase method of accounting while mergers use pooling of interest treatment 2. Method of payment Acquisitions involve cash payments; mergers involve stock exchanges

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3. Role of target firms board of directors and both firms shareholders Mergers require negotiations between the boards An acquirer can make a tender offer and bypass the target firms board A friendly offer is supported by the target board Entrenched insiders use defensive strategies such as share repurchases and poison pills Patterns in American Market 1. There are takeover waves in the corporate market; usually occur during times of economic expansion 2. Net synergistic gains usually come with significant ownership changes; this contradicts public opinion 3. Target firm shareholders usually yield large returns from a takeover; shareholders from bidding firms sometimes lose and sometimes win 4. Insider shareholdings tend to increase equity values for all firms, thus increasing the returns for the target firm shareholders Less profitable and smaller firms are often targets for takeover 5. The federal government is now more open to horizontal mergers Alternative Means of Exercising Corporate Control Hostile takeovers and proxy fights are expensive Institutional investors, particularly pension funds, could exert their influence Non-US Corporate Governance Systems Other countries have monitoring difficulties also, but they have fewer large companies to monitor Japanese firms are monitored by the lead company, but this does not help individual shareholders European companies are generally monitored by banks Governance Systems Employed by US Venture Capitalists Great at shifting business risk onto the entrepreneur while giving him incentive to accomplish appropriate goals It is a pretty restrictive arrangement

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Compensation and Incentives: Theory and Evidence Appropriate compensation arrangements can reduce agency costs that arise between managers and stockholders Components of Standard Compensation Packages in US Firms Compensation packages become more complex as one moves up the corporate ladder Typical components of compensation package 1. Base salary Protects the manager from financial ruin if the company has few bad quarters 2. Cash bonus based on business-unit performance Rewards good short-term performance 3. Stock options Focus all managers on common corporate goal 4. Deferred cash or stock payments contingent on remaining with the company These are called golden handcuffs Specialized Compensation Techniques and Instruments Golden parachutes are cash payments made if an executive loses his or her job after a takeover Phantom stock gives managers cash payments that mirror those received by shareholders; this minimizes shareholder dilution Some companies allow a new executive the right to purchase a large block of stock at a reduced price

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Risk measures: how long is a risky piece of string? CSFB Handbook, Chapter 9
Why think about risk measures? One does not know the ending value of a risky portfolio The distribution contains a lot of information, including mean, standard deviation, and probability of losing more than $A So the distribution cannot be represented by a single number A single dollar measure is needed to communicate at a high level with audiences such as regulators, senior management, and investors Examples of risk measures The profit distribution is normally skewed to the left (i.e. small chance of very big losses) Risk measures include 1. Mean (expected) loss 2. Standard deviation of loss 3. Value at Risk (VaR) Find a value Q such that P(X<Q) = p, a given tail probability 4. Conditional VaR The expected loss given the loss exceeds Q
CVaR = E [ X | X < Q ]

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Artzner's theory Coherent risk measure axioms 1. Homogeneity If the distribution is scaled by a multiple $, then the risk is scaled in proportion
Risk (q X ) = q Risk ( X )

2. Translation If A is a constant,
Risk ( X + A ) = Risk ( X ) - A

The risk measure should be reduced as noted above because we are concerned with downside risk, not just uncertainty 3. Monotonicity
If X Y in all states of the world, then Risk ( X ) Risk (Y )

Again, the focus is on downside risk; this means the risk of Y is greater than the risk of X because it is always worse 4. Subadditivity The risk of a portfolio is never more than the sum of the risks of its constituents
Risk ( X + Y ) Risk ( X ) + Risk (Y )

The risk of a portfolio should be a convex function of asset allocation It is beneficial (or at least not detrimental) to diversify 5. Risk Sensitivity The risk measure should decrease as the mean increases (because less chance of a loss) and increase as the standard deviation increases d ( Risk ) = S (V ) d m (V ) + U (V ) ds (V ) S (V ) < 0 U (V ) > 0

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Summary Table Homogeneity Translation Monotonicity Subadditivity Mean Loss Standard Deviation VaR CVaR X X X X X X X X X X X X X X X Risk Sensitivity

Subadditivity, convexity and risk sensitivity in more depth This section explains (or defends) some of the boxes in the table above The mean loss, standard deviation, and VaR risk measures are all not risk sensitive The mean loss is not a function of the standard deviation Reducing the mean of the distribution does not necessarily increase the standard deviation Increasing the standard deviation may reduce the VaR, depending on the threshold Conclusion CVaR is the superior risk measure

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Economic Capital Modeling: Practical Considerations Study Note FET-178-12

1. Introduction Required Economic Capital is the amount of economic capital a business thinks it needs Available Economic Capital is the amount of economic capital the business actually has Economic capital can be used to value the business or manage the risk Regulatory pressure from banks (Basel II) and insurers (Solvency II) encourage the use of economic capital analyses Difficult to calculate embedded value at insurance companies 2. What is economic capital? Required Economic Capital is based on a certain probability of default; it is not the same as regulatory capital Available Economic Capital is the excess of the assets over liabilities, both valued on a realistic market basis Specifics needed in defining economic capital What risks are considered? What probability of ruin is acceptable? What time period is used in the ruin measurement? Is future new business considered?

When considering the amount of capital at an insurance company, it is important to know the basis for valuing assets and liabilities There is a movement towards fair value, but that is difficult for liabilities that are not traded regularly 3. What are the benefits of economic capital analysis? Insurance companies hold capital to take on risk and absorb fluctuations Most hold enough so there is a high probability of meeting financial obligations There is a cost to this capital since shareholders demand a fair return Must balance this cost with the probability of ruin Shareholders want to avoid overcapitalization while regulators are concerned about undercapitalization

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4. How can economic capital analysis be applied? International Regulatory Trends Weaknesses in formulaic approaches in determining required capital No link with effectiveness of company's risk management Formulas can't deal with all types of risk Prudent management is not the same is meeting capital requirements Formulas do not handle new products or risks Diversification is not measured correctly

Solvency II by the European Union is designed to measure required capital on a much more realistic basis Solvency Capital Requirement (SCR) is based on a 0.5% probability of ruin over a one-year period Minimum Capital Requirement (MCR) is calculated with a simple formula and is the minimum allowed by regulators Eventually the SCR will be calculated with internal models; this allows insurers to more correctly manage their risks SCR is similar to economic capital The United States uses NAIC Risk-Based Capital (RBC) For the most part it is formulaic There is slow movement to more realistic calculations (e.g. stochastic projections for variable annuity guarantees) In Canada, principles-based reporting has been around for several years Switzerland uses stochastic modeling and extreme scenarios The International Association of Insurance Supervisors (IAIS) is working on a common assessment of insurer insolvency; recommends a total balance sheet approach European Embedded Value Most leading European life insurers have disclosed information about embedded value The disclosures were designed to give more information than was present in statutory statements Extreme market conditions revealed problems with embedded guarantees European Embedded Value (EEV) principles takes an explicit approach to valuing options and guarantees The EEV principles give much latitude to companies in the calculations

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Risk-Adjusted Return on Equity or Capital (RAROE or RAROC) Insurance products have different levels of risk Should not price all the business and the same discount rate 5. What type of risks should be considered? For economic capital, only focus on the downside risk IAA Risk Categories 1. Underwriting Risk Mortality, morbidity, persistency and lapse risk Shows up in pricing, design, and claims management 2. Credit Risk Default and change in credit quality Includes concentration and counterparty risk 3. Market Risk Driven by interest rates, stock prices, exchange rates, real estate prices, and commodity prices 4. Operational Risk Risk of loss from failed internal processes, people, or external events Operational failure and operation strategic risk 5. Liquidity Risk Assets not sufficient to meet liability needs Function of both assets and liabilities Could be triggered by downgrade in credit rating

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Three Key Components for Modeling 1. Volatility Risk Random fluctuations in frequency or severity Can reduce with diversification, but cannot eliminate Smaller companies are more exposed to this risk 2. Uncertainty Risk Either mistake in the model or the parameters used in the model This risk is not diversifiable Medical insurance has more uncertainty risk because it depends on many factors government policy, medical technology changes, economic environment 3. Extreme Events (Calamity) High impact but low frequency Difficult to account for because may not be in historical data 6. How should each of those risks be measured? Measure effect of specific risk to a company's surplus May consider effect of diversification when calculating aggregate risk Approaches to Measure Losses 1. Scenario-based Model Deterministic or stochastic Scenarios cover multiple risks at the same time 2. Static-factor Model Linear combination of static risk factors multiplied by company-specific amount Basis for NAIC RBC used in the United States 3. Stochastic-factor Model Identify risk drivers Measure delta and gamma for each risk driver Model joint distribution of risk drivers Aggregate losses across all risk types 4. Covariance Model Special case of stochastic-factor model Use first order sensitivities and VaR as risk measure

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Approaches for Risk Types 1. Underwriting Risk Major drivers are mortality, morbidity, longevity and lapse The first three can be separated into diversifiable and systematic components The volatility risk can be measured as the difference between the best estimate and tail liability measurement Systematic risk relates to misestimates of the mean and deterioration of the mean Could test by assuming the sample mean is the 95th percentile of the true distribution Mortality trend improvement can come from medical advances Catastrophic mortality risk should also be considered Policyholder options (e.g. surrender, annuitize) are often dependent on economic conditions Must test by simulating various economic environments 2. Credit Risk Modeled similar to banking standards Consider default, credit migration, spread, and spread volatility Can use models such as CreditRisk+ and KMV Model rates of default and recovery KMV models defaults as an option against the firm's assets 3. Market Risk Often called asset liability management (ALM) for insurance companies Changing asset yields can affect liability values Difficult to value liabilities since there is not an active market 4. Operational Risk Quantitatively modeled or qualitatively assessed Can do with simple add-on models or stochastic frequency-severity models

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7. What modeling decisions should inform the analysis? VaR (Value at Risk) vs. Tail-VaR (Tail Value at Risk) VaR measure the probability of ruin at a given quantile of the probability distribution TAIL-VaR considers the probability and severity; it is the average of losses that exceed a given quantile Shareholders are only concerned with VaR because at that point the position is worthless Regulators are concerned with the magnitude of the losses TAIL-VaR is better for low-frequency high-severity events Conditional tail expectation (CTE) is very similar to TAIL-VaR and is used in US regulations Stochastic Analysis versus Stress Test Both can be used to see impact of extreme events Stochastic Analysis Project future cash flows based on multiple scenarios Must use many scenarios (~10,000) Specify the probability of each scenario; could just assume all equally likely Stress Test Base analysis on a few extreme scenarios The probability of the scenarios are not specified Dynamic Capital Adequacy Test in Canada uses this approach Common to express economic capital as the amount needed to cover losses that can occur over X years with Y% confidence Sometimes difficult to specify a probability (e.g. for a specific government action)

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Real World versus Risk Neutral Risk Neutral Discount all cash flows at risk-free rate Assumes no arbitrage The probabilities are derived so the average present value of the cash flows equals the actual observed price Real World Cash flows are discounted at rates greater than the risk-free rate Difficult to determine the spread to the risk-free rate It is more common to use the real-world approach when determining economic capital Difficult to convert the probability distribution in a risk-neutral world to one in the real world Diversification Effect The total capital required is likely less than the sum of the individual risks Correlation assumptions can be used to determine risk dependencies However, should consider how correlations change in extreme scenarios Copulas is a technique to measure dependency between risks Often used in default risk modeling Copulas are not easy to use; also difficult to determine goodness of fit Regulators are aware of tail dependencies and are thus reluctant to give too much diversification credit Insurance companies that engage in various activities benefit from diversified risk Regulators are concerned about the solvency of each legal entity, so diversification may not be beneficial for a conglomerate

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Time Horizon to Consider Usually either focus on a one-year time period or long-term period (e.g. 30 years) One-year Time Horizon Calculate impact of short-term shock on solvency The risk factor change could have impact on cash flows after one year This method could not be used to calculate VaR or CTE, but the ease is appealing Could determine the capital necessary to have an X% chance of remaining solvent over many stochastic scenarios Multi-year Time Horizon Use stochastic scenarios to check solvency level during or just at end This method may not accurately measure impact of management actions (e.g. investment or dividend policy) The IAA seems to imply a one-year time horizon is adequate Whether to Allow Negative Cumulative Surplus in the Middle of the Time Horizon Must decide if only to check surplus at the end of the horizon More capital is required if do not allow negative surplus in the middle of the time horizon Could allow negative surplus in the middle but use a realistic borrowing rate Whether to Account for Future New Business Should confirm writing new business will not hurt company's economic capital Profitable new business will likely be beneficial in the projection, but still may require more up front capital 8. Illustrative Examples? Example 1: Deterministic Stress Test Apply instantaneous shock to various risk factors Simulates impact to economic balance sheet before management has time to react Common way to determine capital requirements in the UK and Switzerland Shocks could be to such factors as equities, volatilities, or interest rates Could standardize the shocks by making them the same number of standard deviations The economic capital required is the change in capital position after the stress test The stress test can be used to determine the effect of various hedging programs; if effective, they can greatly reduce the capital required JAM May 2012 1.08 SN 178 Page 8 of 9

Example 2: P&L Projection Again based on a unit-linked investment product Main sources of risk 1. Delta measure of the risk that the underlying assets fall; this will increase the value of the guarantee 2. Rho measure of interest rate risk; if rates fall, the present value of the liabilities increase 3. Vega measure of volatility risk; the hedging cost and guarantee value increases when volatility rises Must project P&L across a wide range of realistic scenarios Can calculate the economic capital with VaR or CTE Can test the impact of hedging by graphing the P&L projections Hedging will not eliminate the risks, but can drastically reduce the impact Holistic VaR Aggregation Towards Enterprise Risk Management (ERM) Could use the previous approach for each source of risk independently 1. Market Risk 2. Credit Risk 3. Liquidity Risk 4. Underwriting/Demographic Risk 5. Mortality/Longevity/Morbidity Risk 6. Lapse Risk 7. Policyholder Behavior Risk 8. Expense Risk 9. Operational Risk 10. Group Risk Can aggregate the risks using a correlation matrix Value at Risk could be measured as the difference between the expected value and the lower 5th percentile

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