Managerial Objective Maximize Firm Value

Who are the Players that Influence Firm Value ? n Employees of the Firm: –Board of Directors –Senior/Middle/Line Managers n Competitors of the Firm n Suppliers of goods and Services n Suppliers of capital: –Internal –External

What Does it Mean to “Maximize Firm Value”? n Firm value is measured by market value. n The market value of any asset is the present value of the cash flows generated by that asset. n Therefore, to maximize firm value is to maximize the present value of the cash flows generated by the firm’s assets.

What Decisions Influence the Present Value of the Firm’s Cash Flows? n The present value relationship is given by: n Therefore, the decisions that influence PV and, hence, market value are decisions that influence the level of the cash flows, CF t ; the discount rate, r; the timing, t; and the length of the cash flow stream, N.

A Numerical Example: n Suppose a startup firm wants to invest in assets that will produce expected cash flows of $100,000 a year for each of the next 10 years. n What is the maximum amount manager/owners (or outside investors) should be willing to pay for these assets? n Questions: –What is the value of these assets in the market place? –Are there look-alike assets, i.e., comparable assets whose value can be readily observed from a well functioning market? –How risky are the assets? What risk “counts” in determining value?

Numerical Example (Continued) n What is the market value of the assets? n Suppose the assets are commonly sold to other firms in the startup company’s industry for $ 400,000. Suppose also that the risk of the cash flows implies that the discount rate, r, the company should use is 12%.

Numerical Example (Continued) n The market value of the assets under the startup firm’s management with the cash flows as projected is $565,022. Thus, managers should be willing to pay no more than this amount for these assets. n If managers can acquire the assets for $400,000, like the other firms in the industry, they will be earning a premium on their investment. (The NPV = $165,022; the IRR = 21.4%) n Question: Under what circumstances will such a premium exist?

Numerical Example (Continued): CompetitorsStartup Suppliers

Numerical Example (Continued) n Suppose suppliers and competitors have no obvious way to to prevent the firm from earning the premium. n Suppose, however, that the $400,000 exceeds the financing capacity of the founders. n Question: What implication does the need to resort to “outside” funding have for firm value?

Numerical Example (Continued) n Suppose founders have $225,000 of their own funds for investment and they must raise $175,000 from external sources? n Questions: –Do external capital suppliers believe cash flow projections of the founders? –How much nurturing of the project must managers engage in after external funds have been raised to make sure cash flow projections are realized? –How will external capital suppliers monitor managerial nurturing of their investment? –Will the claims of external capital suppliers be liquid? –What are the implications of control?

Numerical Example (Continued) Founding Shareholders ManagersOutside Capital Suppliers

“The Economics of Organizational Architecture ” by Brickley, Smith, and Zimmerman n Critical Aspects of Corporate Organizations: –The assignment of decision rights within the firm –The structure of systems to evaluate the performance of individuals and business units –The methods of rewarding individuals n Challenges –Managers at different levels have different information. –Managers have different incentives.

Brickley, Smith, and Zimmerman (Continued) n Determinants of Organizational Architecture –Technology –Markets –Regulation –Firm Size n Increased technology may either centralize or decentralize decision making. n Increased competition tends to decentralize decision making. n Increased regulation tends to centralize decision making. n Increased firm size tends to decentralize decision making.

Brickley, Smith, and Zimmerman (Continued) n Costs of Changing Organizational Structure –Direct Costs –Indirect Costs n Costs of Not Changing Organizational Structure

“Total Compensation Strategy” by Stephen F. O’Byrne n The Objectives of Executive Compensation –Alignment –Leverage –Retention –Shareholder Cost n Management Wealth –The value of current stock and option holdings –The present value of salary bonus long-term incentive grants pension

Stephen F. O’Byrne (Continued) n Total Wealth Leverage –{%  Manager’s Wealth} /{ %  Shareholder Wealth} –For “pure” entrepreneurs, this ratio is 1.00 n Total wealth leverage varies by component of the manager’s compensation. For example, –For stocks, leverage = 1.00 –For salary, leverage = 0.00 –For stock options, leverage > 1.00

Stephen F. O’Byrne (Continued) n To replicate “pure entrepreneur” total wealth leverage, different components of the compensation package can be weighted appropriately. n If, for example, options have a leverage factor of 2.0, they could be combined with the present value of salary and pension as follows 1.00 =.5*PV(Salary and Pension) +.5*PV (Options) n That is, half the wealth could could come from salary and pension, and half could come from options.

Stephen F. O’Byrne (Continued) n There are tradeoffs in balancing compensation risks: –Increasing total wealth leverage to align managers’ interests more closely with investors’ interests increases retention risk if the market turns down for reasons managers cannot control. –It also increases shareholder cost in good times that, likewise, may have more to do with broad market movements than with managerial decisions. –Paying more in fixed salary and pension may reduce retention risk, but increase shareholder costs and reduce managerial alignment with shareholders’ interests. n The optimal balance should mix incentives appropriately to maximize shareholder wealth.