Module 2
Introduction Limited liability and the separation of ownership and control, Role of management with diffuse ownership. Classic directive to management, extended stakeholders, Conflicts of interest, Contracts and a revised directive
According to Sec (1) of the Indian Companies Act 1956, “A company formed and registered under the act”. According to Sec (3) of the Act, “on incorporation a company becomes a body corporate or a corporation with a perpetual succession and a common seal.” According to N.D.Kapoor, “ It is a voluntary association of persons formed for some common purpose, with capital divisible into parts, known as shares, and with a limited liability. It is a creation of the law and is sometimes known as an artificial person with a perpetual succession and a common seal. It exists only in the eyes of the law, i.e., it is regarded by the law as person, just as a human being. But it has no physical existence.”
In a large corporation where stock is widely held, stockholders exert very little control or influence over the operations of the company. When the control of a company is separate from its ownership, management may not always act in the best interests of the stockholders. Management are often said to be “satisfiers” than “maximisers” Management may be happy to “play it safe” and only seek acceptable level of growth than maximising value of the firm to shareholders.
Mangement of this sort works for its own survival as an objective and will be unwilling to take risks for fear of making mistakes. How to determine whether the management is acting in the interests of the shareholders i.e. maximisation of wealth? Opportunity cost is the least measure – if there can be a measure of outcome had the firm attempted to maximise the shareholder wealth.
Objective of corporate finance is to maximise the Value of the Firm. Investment, Financing and Dividend decisions should be directed towards this objective. “Firm” generally implies both equity investors and lenders (debt holders). Lenders protect themselves contractually and therefore the managers should focus on maximising the wealth of those who hired them – the Shareholders.
The objective therefore gets narrowed from maximising the firm value to maximising the shareholder value or shareholder wealth. How to measure the shareholder wealth?? In a publicly listed and traded company, stock price is an observable and real measure of stockholder wealth. The objective therefore gets further narrowed from maximising the stockholder wealth to maximising the stock prices Stock price maximisation is the narrowest of the value maximisation objective. It seems to be the unique objective of corporate finance and those managing the affairs of the company.
Stock prices are the most observable measure that can be used to judge the performance of a publicly traded company Stock prices reflect the long term effects of the firm’s decisions. Stock price is a real measure of stockholder wealth as stockholders can sell their shares and receive their value instantly.
Profit maximisation is not as inclusive a goal as that of maximising the wealth of the shareholders (reflected in stock prices) Total profits are not as important as EPS. A firm could always increase total profits by investing in Treasury bills. Merely increasing EPS is not an appropriate objective: It does not specify the timing or duration of the expected returns – time pattern of returns. It does not consider risk or uncertainty or the prospective earnings stream - some projects may be more riskier than others. It does not reflect the Financial risk arising out of mix of debt & equity.
All these leads to the objective of wealth maximisation reflected in market price which takes into account present and prospective future EPS. Market price is an index or report card, how well management is doing on behalf of shareholders.
Hire & fire managers Board Annual Meetings
BOND HOLDERS (DEBT)
STOCKHOLDERS
Lend Money
No Social Costs MANAGERS
Protect Bondholder interests
Reveal information honestly & on time
Maximise Shareholder Wealth
SOCIETY Costs can be traced to the firm
FINANCIAL MARKETS
Markets are efficient & assess Firm Value
I) Managers put aside their own objectives and focus on maximising shareholders wealth measured by the stock prices. ◦ The power of shareholders in replacing the management. ◦ The management itself owns substantial stake in the firm that drives them to maximise stockholder wealth.
II) The lenders feel secured and their interests protected and the firm live upto contractual obligations. ◦ Loan covenants restrict the company in taking any actions which will hurt the lenders. ◦ Any adverse effect will be long term and the firm will find it difficult to borrow in future.
III) The managers are transparent and do not mislead the financial markets about their future prospects ◦ Markets have sufficient information to make judgement about the effects of the firm’s actions on its value. . ◦ Markets are assumed to be rational in their assessments of these actions and its effect on the stock price.
IV) There are no disruptions caused to the society in the form of health, pollution, infrastructure costs in the process of stockholder value maximisation. ◦ All costs created by the firm in its pursuit of stockholder wealth maximisation can be traced and charged to the firm.
In the process of Stock holder value maximisation, it is assumed that no other group is hurt and the stock prices reflect the stockholder wealth. Managers can therefore concentrate on one objective – maximizing stock prices.
Shareholders hire Managers to run their firms for them…. Because stockholders have absolute power to hire and fire managers…. Managers set aside their interests and maximize stock prices. Because markets are efficient…. Shareholders wealth is maximised…. Because lenders are fully protected from shareholder actions….. Firm Value is maximised…. Because there are no costs created for society…. Society wealth is maximised….
In an ideal situation……. Managers focus on stock price maximisation because of the power shareholders have over them. As the information revealed to markets is unbiased and timely, maximizing stock prices also maximizes shareholder wealth. The bond holders are protected as shareholder wealth is maximised and thus firm value is maximised. In the absence of social costs, wealth maximisation by firms results in wealth maximisation for society.
What has already been discussed above is a very ideal situation which in reality does not work !! Stockholders, Managers, Bondholders and Society have very different interests and incentives. Conflicts of interests may arise between these different groups. Conflicts create costs for the firm called Agency Costs. Agency Costs can result in the objective of Stock Price Maximisation getting adversely affected.
In a company form of organisation there is a separation of ownership and control. The real owners i.e. equity shareholders (principal) delegate their powers and discretion to pursue objectives of the firm to the managers (agent). Agency theory models a situation in which a principal delegates decision making authority to an agent who receives a reward in return for performing some activity of the principal. Managers end up pursuing their own objectives and therefore shareholders in their pursuit of wealth maximisation have to give appropriate incentives to the managers and by adequate monitoring and control.
STOCKHOLDERS Have little control over Managers
BOND HOLDERS (DEBT)
Significant Social Costs
Lend Money MANAGERS
SOCIETY Some Costs can not be traced to the firm
Bond holders can be exploited
Delay bad news or provide misleading information
Managers put their interests over stockholders
FINANCIAL MARKETS
Markets can make mistakes & overreact
Monitoring expenditures – the cost of audit and control procedures to ensure that managerial behaviour and actions are in the best interest of shareholders. Opportunity costs – cost which result from the inability of large companies from responding to new opportunities. Due to the decision hierarchy and control mechanisms the management may face difficulties in seizing profitable investment opportunities. Structuring expenditures – relate to structuring compensation and incentives to hire the best available managers. Incentive plans may include Stock Options and other performance plans measured by growth in EPS, ROE and other metrics.
Agency Costs can be analysed under different stakeholders: Stockholders and Managers Stockholders and Bondholders The Firm and Financial Markets The Firm and Society
Two mechanism by which Stock holders exercise their power over the Managers : ◦ The Annual General Meetings – a legal forum where they can decide to change the Board of Directors and through them the management if the managers have not done their job to the satisfaction of the shareholders. However, most of the time small shareholders suffer due to dominance of major shareholders who control and manage the company. ◦ The Board of Directors - the elected representatives of the shareholders responsible to oversee the management and protect the interests of the shareholders. However, the capacity of the board to discipline the managers is often diluted due to their inability to devote full time, independent directors having very little or no stake. Often the CEO sets the agenda, chairs the meetings and controls information setting own agenda which may not be in the best interest of the shareholders.
Yes, if neither the AGM nor the Board of Directors effectively control the Managers who are responsible to maximizing the wealth of the shareholders. This happens more often when Manager’s own interests conflict with those of the shareholders. Example of how the Managers react in a situation of hostile takeover. Potential instances of Managers working against the interests of the shareholders : Investing in risky projects. Taking too much or too little debt. Adopting defensive tactics against potentially value increasing takeovers (tactics :Greenmail, Golden Parachute, Poison Pill, White Knight). Overpay in acquiring a company ( justifying reasons – synergy, strategic considerations, target firm is undervalued and badly managed etc).
To avoid conflict of interest with the shareholders, bondholders protect themselves by way of security and covenants (terms) while lending. The interests of the bondholders can be adversely affected by using the borrowed money for purposes other than it was meant to be, exposing them to risk. If the projects turn out to be bad investments, the bondholders risk return of interest and the principal. Enforcement of security and covenants are time consuming and add cost to bondholders.
Stock price is a measure of success or failure of the way a company is managed. Information is the lubricant that enables the markets to measure the success or failure. Market prices are based on information both public and private. The market continuously values the company based on future prospects. Firms often suppress or delay information especially the bad news. Also firms release misleading and fraudulent information to market to keep investors happy and raise market prices.
Two potential barriers to using stock price as a measure of managerial success: ◦ To the extent the information is hidden, delayed or misleading, the market prices will deviate from true value even in an efficient market. ◦ It is argued by some that markets are not efficient even when information is freely available. ◦ In both these cases, decisions of the managers in maximising stock prices may not be consistent with the long term value maximisation.
The information that flows into the market is often delayed, incorrect, and misleading and the stock prices become erroneous estimate of the true value. The market assimilates and aggregates a remarkable amount of information about the current condition and the future prospects of the company into one measure i.e. the Stock Price. No other measure comes close to providing as timely or comprehensive measure of a firm’s standing as Stock Price. It is the best way of knowing how investors perceive the management’s actions and value the company.
The objective of maximising firm or stockholder wealth assumes that either the costs to society are small enough to be ignored or that they can be traced to the firm and the firm can be forced to bear the cost. Most management decisions have social consequences. Examples of companies polluting the air/water , tobacco companies engaged in manufacturing products affecting the health of consumers. Conflicts between the interests of the firm and the interests of society are not restricted to the objective of maximising stockholder wealth. There may never be a complete congruence between social interests and firm interests.
The assumption of stock price maximisation is violated in many ways: The limited power that stockholders have over the managers, the managers may not make decisions to maximise wealth of shareholders, but may choose to protect their own interests. Stockholders may increase stock prices by transferring wealth from the lenders if not restricted contractually by security and covenants. Firms may increase stock prices by feeding misleading or fraudulent information to markets that do not efficiently assimilate the information. Firms can create substantial costs for society while they focus on maximising stock prices.
An easy answer to stock price maximisation (which is affected by agency costs) is to look for other alternative objectives: Maximisation of Market Share. Profit Maximisation. Maximising Revenue/size. Social Welfare objectives.
Each of these alternatives have their own limitations and do not meet the following criteria : Is the objective clear and unambiguous ? Can the success and failure be easily and promptly measured ? Does it create side costs that may exceed the overall benefits ?
The answer is perhaps “NO”
The objective of Stock Price maximisation suffers due to conflicts between shareholders and managers, shareholders and lenders and firm and society. Managers who take advantage of their stockholders will soon find themselves faced with stockholders revolts and hostile takeover. Lenders hurt by stockholders actions protect themselves in subsequent lending with tight covenants. Financial markets punish firms that have provided with fraudulent information with lower stock prices. Firms that create social costs pay a price in legal costs and lost revenues and reputation.
Stockholders & Managers: Making managers think more like stockholders – stock options. More effective Board of Directors – smaller but effective boards, stock options for directors, selection by a nominating committee rather than by the CEO. Stockholder activism - demand more and updated information, stockholder becoming a part of the incumbent management etc. Threat of Takeover – badly managed firms are targets for hostile takeovers. This works as a disciplinary mechanism for managers to be more responsive to shareholder concerns.
Stockholders and Bondholders: Covenants – restrict the firm’s investment policy, restrict dividend policy, restrict additional leverage. Equity stakes – convertible bonds
Firms and Financial Markets: Improving the quality of information. Making markets more efficient – lower transaction costs, access to company information, etc
Firm and Society: Being socially conscious –example: not engaging child labour, restricting pollution etc. Strive to become a Good Corporate Citizen .
Stock based compensation Hostile takeover Activist investors
BOND HOLDERS (DEBT)
STOCKHOLDERS Managers think like stockholders Reduced Social Costs
Lend Money MANAGERS
Laws & restrictions Investor & customer backlash
Protect themselves with covenants
More external information –Active analysts
SOCIETY
FINANCIAL MARKETS
More liquid markets with lower transaction costs
Edward Freeman, in his book Strategic Management: A Stakeholder Perspective (1984) developed what has come to be known as stakeholder theory. The theory addresses the question of what or who really matters to corporations - whether corporations should be concerned only about their shareholders ? ! Corporations have multiple stakeholders who include not only the shareholders but others – customers, employees, suppliers, the community, the government, the environment and society in general. Corporations need to identify its various stakeholder groups and then attempt to balance their respective needs within the organization's overall strategy.
I. Select 3 individual companies listed in BSE/NSE from the following industries : Automobiles Automobile tyres Banking Chemicals & Fertilizers Consumer Durables Construction & Engineering FMCG Hotels Information Technology Infrastructure Petrochemicals Pharmaceuticals Shipping Telecom Services Textiles Any other listed companies, but operating within the same industry.
II) Download Annual Reports (Balance sheet) of these companies for the last 3 years from the respective company’s website. The latest balance sheet should be of 2013. III) Calculate the Debt/Equity Ratios of 3 companies for the last 3 years. Comment on what has caused the change in the ratio for the last 3 years. (Look for notes for individual items of long term liabilities for redemption and fresh borrowings). IV) Study the Capital Structure of individual companies and comment on changes in the 3 years through inter-firm and intrafirm comparison. Check whether there is any set pattern of capital structure within the same industry. V) Calculate the equity earnings for the 3 year period of individual companies in terms of (a) absolute amounts and (b) earnings per share (EPS). Check and comment on what has caused the change in the earnings of 3 years. Do an inter-firm and intra-firm comparison. VI) Comment on how different capital structures have impacted equity earnings for the last 3 years.
VII) Calculate the ROCE of 3 companies individually for each of the 3 years do an inter-firm and intra-firm comparison. VII) Calculate the P/E ratio of 3 companies based on the market price of share on 1/10/2013 and the EPS in the latest financial year. Comment on what could be the reason for variation in the P/E ratios of each of the 3 companies. IX) Calculate the Dividend Yield and Earnings Yield based on the market price of share on 1/10/2013 and the Dividend Per Share and Earnings Per share in the latest financial year.
Presentation should be in power point format. There should be no repetition of the same companies by different groups. Presentation should include (a) brief background of each of the companies : when established, chief promoter/s, products/services, market position etc. (b) the industry background – major companies, total market size etc. Comparative figures should be in one slide (example: 3 year analysis of Inter-firm and intra-firm comparisons).
Each group will have 6 participants and groups can be formed voluntarily. ( list of groups with names of participants to be mailed to me by the CR before 3/10/2013 to my e-mail address :
[email protected]. No subsequent changes will be permitted in the group participants. All the members in the group need to compulsorily participate in the group assignment – during discussions within the group, preparation and presentation. During presentation, question will be asked to any member of the group. Marks will be allotted to each of the members of the group based on the quality of presentation of the group as a whole and the response to the queries during presentation. Presentation in the class will be on 18/10/2013. Each group will be given 15 minutes to make presentation and 15 minutes to respond to queries.
