EXP 482 Corporate Financial Policy Clifford W. Smith, Jr. Winter 2007 Presentation 3 * Covers readings on course outline through Brickley/Smith/Zimmerman, Chap 14 and 15 EXP 482 – Overhead 3

Capital Structure Management  Trade Off Hypothesis  Pecking Order Hypothesis  Market Timing Hypothesis

EXP 482 – Overhead 3 Pecking Order Hypothesis  There is an important information asymmetry between stockholders and managers  “What you don’t know CAN hurt you”.  If firm issues securities, those value depends on firm value investors price-protect themselves.  This cost is largest for equity, then risky debt; internally generated capital is least expensive.

EXP 482 – Overhead 3  If there is an “optimal” capital structure, the firm spends a lot of time away from it.  Extreme Version: There is no optimal capital structure – observed capital structure is just the result of a sequence of myopic financing choices. Pecking Order

EXP 482 – Overhead 3  Regression results are strong and robust.  Look at tails of distribution. Pecking Order

EXP 482 – Overhead 3 Market Timing  Firm only issues equity when it’s overvalued  There is no optimal capital structure

EXP 482 – Overhead 3  Determine the optimal capital structure for the economic balance sheet.  Look at the trajectory of capital structure.  Whenever the costs of deviating from target exceed the cost of adjustment - adjust. Strategic Capital Structure Management

EXP 482 – Overhead 3 Adjustment Costs Leverage Time Target Leverage

EXP 482 – Overhead 3 Adjustment Costs Firm Value Leverage Target Leverage

EXP 482 – Overhead 3  Differ by transaction ─ Costs of share issues are higher than that for debt ─ Costs of share issues are higher than that of share repurchases  Exhibit fixed costs and scale economics ─ Equity offers are rare while bank loans are common ─ Optimal adjustment frequently involves overshooting ─ Most companies spend considerable time away from their target Adjustment Costs

EXP 482 – Overhead 3 Strategic Capital Structure Management  But investment opportunities are not smooth – they are lumpy and episodic.  Suppose you have a large growth option – it will increase firm value by 50% and take three years to exercise.  How do you finance this project?

EXP 482 – Overhead 3

 Pecking Order Hypothesis  Market Timing Hypothesis  Tradeoff Hypothesis Strategic Capital Structure Management

EXP 482 – Overhead 3

 Benchmark Compensation Plan Suppose I offer a corporate manager a series of prespecified salary payments -- from the time he is hired until the time he retires -- with the only contingency that if the firm goes bankrupt, he will be fired, and his salary payments will be terminated.  What are the conflicts of interest that will likely arise between owners and managers under this benchmark compensation plan? Executive Compensation EXP 482 – Overhead 3

Conflicts of Interest between Owners and Managers Effort Problem Horizon Problem Differential Risk Exposure Problem Over Retention Problem (Payout Policy) Under Leverage Problem EXP 482 – Overhead 3

 Choice of Organizational Structure Potential "Solutions" to the Owner/Manager Conflicts

EXP 482 – Overhead 3  Choice of Organizational Structure Potential "Solutions" to the Owner/Manager Conflicts Board of Directors CEO CFO/COO Middle Management Production Workers  Internal and External Labor Markets

 The Market for Corporate Control  Incentive based compensation contracts – explicit contracts – implicit contracts Potential "Solutions" to the Owner/Manager Conflicts EXP 482 – Overhead 3

“Suffice it to say that one is the result of an extremely hostile takeover.”

EXP 482 – Overhead 3 "Fixed" Compensation Salary Pension Insurance Perks

Salary  Typically largest component (but not always)  Within contracting period salary is fixed (close to our benchmark case)  Implicit contract to renegotiate salary in good faith based on performance  No one in the firm determines his/her own salary (compensation committee of board comprised of outside boardmembers) EXP 482 – Overhead 3

Pension Plans Defined Benefits vs defined contribution plans Vested vs nonvested plans (ERISA) EXP 482 – Overhead 3

Tax Deferral Effect of Pensions Salary Pension Raise  Contribution  Taxes  Interest  Interest  5.00 Taxes  Taxes  2.50 Total52.50 Total55.00

 Stock options granted to managers – Typically have approx. 5 years to expiration – European options (cannot be exercised early) – Restricted (cannot be sold before expiration) – The option is actually a warrant (when exercised, the number of shares outstanding increases), but dilution effect is small. Stock Option Plans EXP 482 – Overhead 3

Impact of option plan on: – effort problem – horizon problem – risk exposure problem – payout problem Stock Option Plans Stock Option S* X EXP 482 – Overhead 3

 Stock Appreciation Rights (SARs)  Restricted Stock  Phantom Stock  Dividend Units  Base manager's pay on "abnormal" stock return Other Stock-Based Compensation Plans EXP 482 – Overhead 3

Bonus (over 90% of medium to large size firms in US have some form of bonus plan) Pool of Available Funds Accounting-Based Performance Plans Contributions to Pool Earnings EXP 482 – Overhead 3

Bonus (over 90% of medium to large size firms in US have some form of bonus plan) Pool of Available Funds Accounting-Based Performance Plans Contributions to Pool Earnings

EXP 482 – Overhead 3 Bonus (over 90% of medium to large size firms in US have some form of bonus plan) Pool of Available Funds Accounting-Based Performance Plans Contributions to Pool Earnings

Bonus Plans  Impact of bonus plan on –effort problem –risk exposure problem –payout problem –horizon problem  Long-term performance plans -- similar to bonus plans, but based on 3 to 7 year earnings performance  Performance units EXP 482 – Overhead 3

 The use of accounting numbers vs stock prices for incentive compensation plans – Accounting numbers allow disaggregation of performance measures – Accounting numbers can provide perverse incentives – Accounting numbers subject to manipulation  Top managers (who set accounting policy) typically compensated with stock-based plans. Lower level managers more likely to receive bonus. Bonus Plans EXP 482 – Overhead 3

 Choice of Organizational Structure Potential "Solutions" to the Owner/Manager Conflicts Board of Directors CEO CFO/COO Middle Management Production Workers  Internal and External Labor Markets

What determines where a divisional manager's bonus payment falls along this spectrum? Divisional Firm Performance Bonus Plans EXP 482 – Overhead 3

Investment Opportunity Set Leverage HighLow Compensation Level of Pay LowHigh Conditional on Performance LowHigh Assets in Place Growth Opportunities EXP 482 – Overhead 3

Click here to type page Firm Characteristics Level of Compen- sation Use of Stock Options Use of Bonus Plans Growth Options (Merck)Higher Lower Credence Goods (Eastern)Higher Product Warranties (Yugo)Higher Future Product Support (Yugo/Wang) Higher Supplier Financing (Campeau)--- Closely Held FirmHigher SizeHigher RegulationLower Tax Credits--- Marginal Corporate Tax Rate---Lower Marginal Personal Tax Rate---Higher EXP 482 – Overhead 3

Investment Opportunity Set Assets in Place Growth Opportunities Cost of Debt Low High (Underinvestment) Benefits of Debt High Low (Free Cash Flow) Predicted Leverage High Low EXP 482 – Overhead 3