corporate finance: creating value

Prof. Ian GiddyNew York University

Corporate Finance

Copyright ©1998 Ian H. Giddy Corporate Finance 4

What the Module is About...

Corporate finance: shareholder value can be affected by financial decisions: investment, financing choices, debt design & risk managementCorporate investment decisionsCorporate financing choicesDesigning debtRisk management


The Decisions that Create Shareholder Value

CREATINGCORPORATEECONOMICVALUE

CORPORATEINVESTMENTDECISIONS

CORPORATEFINANCINGCHOICES

CORPORATEPAYOUTPOLICIES

CORPORATERISKMANAGEMENT


The Goal of Financial Management

What are firm decision-makers hired to do?“General Motors is not in the business of making

automobiles. General Motors is in the business of making money.”

Alfred P. Sloan Possible goals: Size, market share, profits Three equivalent goals of financial

management:Maximize shareholder wealthMaximize share priceMaximize firm value


The Goal of Financial Management

Value-based management drives our performance targets and incentives. We have set ambitious short and medium-term financial and operating targets and, to help meet these, have aligned the interests of management and employees with those of our shareholders and customers. Our incentive systems are linked to key aspects of shareholder value, such as margins and asset productivity. Our strategic focus is centred on profitable growth, better margins through innovation and higher productivity, improved asset management, and turnarounds in operations whose past performance has not been world class.

Onecompany’sstatement


First Principles

Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the

financing mix used - owners’ funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows

generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon

the stockholders’ characteristics Minimize unnecessary financial risks.

Objective: Maximize the Value of the Firm


The Objective in Decision Making

In traditional corporate finance, the objective in decision making is to maximize the value of the firm.

A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.

All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.


The Criticism of Firm Value Maximization

Maximizing stock price is not incompatible with meeting employee needs/objectives. In particular: - Employees are often stockholders in many firms - Firms that maximize stock price generally are firms that

have treated employees well. Maximizing stock price does not mean that

customers are not critical to success. In most businesses, keeping customers happy is the route to stock price maximization.

Maximizing stock price does not imply that a company has to be a social outlaw.


Why Maximize Stockholder Wealth?

Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).

If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.

The objective of stock price performance provides some very elegant theory on: how to pick projects how to finance them how much to pay in dividends


The Classical Objective Function

STOCKHOLDERSMaximizestockholder wealth

Hire & fire managers- Board- Annual Meeting

BONDHOLDERS

Lend MoneyProtectbondholderInterests

FINANCIAL MARKETS

SOCIETYManagers

Reveal information honestly and on time

Markets are efficient and assess effect on value

No Social CostsCosts can betraced to firm


The Agency Problem

The agency relationship Will managers work in the

shareholders’ best interests?Agency costsCorporate governanceIncentive issues

Control of the firm -- there is a market for corporate control

Shareholders

Board ofDirectors

Managers

Allocationof Resources


What Can Go Wrong?

STOCKHOLDERSManagers put their interests over shareholders’

Have little control over managers

BONDHOLDERS

Lend Money

Bondholders can get ripped off

FINANCIAL MARKETS

SOCIETYManagers

Delay bad news or provide misleading information

Markets make mistakes and can overreact

Significant Social CostsSome costs cannot betraced to firm


I. Stockholder Interests vs. Management Interests

Theory: The stockholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors.

Practice: Neither mechanism is as effective in disciplining management as theory posits.


The Best Boards ...


And the Worst...


Illustration:Overpaying on Takeovers

The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover.

The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms. Stock prices of bidding firms decline on the takeover announcements a significant proportion of the time.

Many mergers do not work, as evidenced by a number of measures. The profitability of merged firms relative to their peer groups,

does not increase significantly after mergers. An even more damning indictment is that a large number of

mergers are reversed within a few years, which is a clear admission that the acquisitions did not work.


II. Stockholders' Objectives vs. Lenders' Objectives

In theory: there is no conflict of interests between stockholders and lenders, including bondholders.

In practice: Stockholders may maximize their wealth at the expense of debtholders.Increasing leverage dramaticallyIncreasing dividends significantlyTaking riskier projects than those agreed to.


1. Increasing leverage dramatically and making existing bonds less valuable


2. Increasing Dividends Significantly

-2

-1.5

-1

-0.5

0

0.5

t:-15

-12 -9 -6 -3 0 3 6 9 12 15CAR (Div Up)CAR (Div down)

EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES

Day (0: Announcement date)

CAR


The Modified Objective Function

For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected: Maximize Stock Price: This will also maximize firm value

For publicly traded firms in inefficient markets, where bondholders are protected: Maximize stockholder wealth: This will also maximize firm

value, but might not maximize the stock price For publicly traded firms in inefficient markets, where

bondholders are not fully protected Maximize firm value, though stockholder wealth and stock

prices may not be maximized at the same point. For private firms, maximize stockholder wealth (if

lenders are protected) or firm value (if they are not)


Finance in the Corporation

Chairman of the Board andChief Executive Officer (CEO)

Board of Directors

President and ChiefOperations Officer (COO)

Vice PresidentMarketing

Vice PresidentFinance (CFO)

Vice PresidentProduction

Treasurer Controller

Cash Manager Credit Manager Tax ManagerCost AccountingManager

CapitalExpenditures

FinancialPlanning

FinancialAccountingManager

Data ProcessingManager


“Internalization”: Is an activity best done within the company, or outside it?

Issue: why are certain economic activities conducted within firms rather than between firms?

As a rule, it is more costly to build than to buy—markets make better decisions than bureaucrats

Hence there must be some good reason, some synergy, that makes an activity better if done within a firm

Eg: the production of proprietary information Often, these synergies are illusory


Takeovers as a Solution to “Agency Problems”

There is a conflict of interest between shareholders and managers of a target company—Eg poison pill defenses

Individual owners do not have suffcient incentive to monitor managers

Corporate takeover specialists, Eg KKR, monitor the firm's environment and keep themselves aware of the potential value of the firm under efficient management

The threat of a takeover helps to keep managers on their toes—often precipitates restructuring.


Who Gains What?

Target firm shareholders? Bidding firm shareholders? Lawyers and bankers? Are there overall gains?

Changes in corporate control increase the combined market value of assets of the bidding and target firms. The average is a 10.5% increase in total value.


The Price: Who Gets What?

Daimler Chrysler Combined

Market value before dealleaked

$52.8 $29.4 $82.2

Value added by merger $18.0

Merged Value $100.2

Shareholders get 57.2% 42.8% 100%

Which is now worth $57.3 $42.9 $100.2

Shareholders' shares ofthe gain

$4.5 $13.5 $18

Premium, as % 9% 46%


A Case Study: Kodak - Sterling Drugs

Eastman Kodak’s Great Victory


Earnings and Revenues at Sterling Drugs

Sterling Drug under Eastman Kodak: Where is the synergy?

0500

1,0001,5002,0002,5003,0003,5004,0004,5005,000

1988 1989 1990 1991 1992

Revenue Operating Earnings


Kodak Says Drug Unit Is Not for Sale (NYTimes, 8/93)

Eastman Kodak officials say they have no plans to sell Kodak’s Sterling Winthrop drug unit.

Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as “massive speculation, which flies in the face of the stated intent of Kodak that it is committed to be in the health business.”


Sanofi to Get Part of Kodak Drug Unit (6/94)

Taking a long stride on its way out of the drug business, Eastman Kodak said yesterday that the Sanofi Group, a French pharmaceutical company, had agreed to buy the prescription drug business of Sterling Winthrop, a Kodak subsidiary, for $1.68 billion. Shares of Eastman Kodak rose 75 cents yesterday, closing

at $47.50 on the New York Stock Exchange. Samuel D. Isaly an analyst , said the announcement was

“very good for Sanofi and very good for Kodak.” “When the divestitures are complete, Kodak will be entirely

focused on imaging,” said George M. C. Fisher, the company's chairman and chief executive.


Smithkline to Buy Kodak’s Drug Business for $2.9 Billion

Smithkline Beecham agreed to buy Eastman Kodak’s Sterling Winthrop Inc. for $2.9 billion.

For Kodak, the sale almost completes a restructuring intended to refocus the company on its photography business.

Kodak’s stock price rose $1.25 to $50.625, the highest price since December.


Goals of Acquisitions

Rationale: Firm A should merge with Firm B if [Value of AB > Value of A + Value of B + Cost

of transaction] Synergy Gain market power Discipline Taxes Financing

Example:Ciba-Geigy/Sandoz


Most Value is Created on the Asset Side (Operational Restructuring)

Discounted Cash Flow (DCF) analysis for project evaluation

Value-Based Management for performance evaluation

?

Wärtsilä NSD (from Wärtsilä Diesel & New Sulzer Diesel


Wärtsilä NSD now has the world’s most extensive portfolio of heavy duty engines. Its 4-stroke engines are mainly Wärtsilä design, while the 2-stroke engines are based on Sulzer design. The engine range consists of lean burn gas engines, dual fuel engines and gas diesels. Market share is strong and production is being consolidated or out-sourced, particularly for low-speed engine technologies.

Wärtsilä NSD: Consolidating Production and Distribution


Wärtsilä NSD: Gains Market Power


0

5

10

15

20

25

30

Cre

dito

Wie

se

Con

tinen

tal

Ban

co d

e la

N

acio

n

Inte

rban

c

Latin

o

Del

Sur

Lim

a

San

tand

er

Nue

vo

Mun

do

BBV ACQUISITION

SANTANDER ACQUISITION

Peruvian Banks: Market Share by Deposits, %

Sometimes, Too Late is Too Little


Framework for Assessing Restructuring Opportunities

RestructuringFramework

1

2

CurrentMarketValue

3

Totalrestructuredvalue

Potentialvalue withinternal+ externalimprovements

Potentialvalue withinternalimprovements

Company’sDCF value

Maximumrestructuringopportunity

Financialstructureimprovements

4

Disposal/Acquisitionopportunities

Operatingimprovements

Current marketoverpricing orunderpricng

5

(Eg Increase D/E)


Using The Restructuring Framework($ Millions of Value)

RestructuringFramework

1

2

CurrentMarketPrice

3

Optimalrestructuredvalue

Potentialvalue withinternaland externalimprovements

Potentialvalue withinternalimprovements

Companyvalue as is

Maximumrestructuringopportunity

Financialengineeringopportunities

4

Disposal/Acquisitionopportunities

Strategicand operatingopportunities

CurrentperceptionsGap: “Premium”

5

$ 25

$ 975

$ 300

$ 1,275$ 350

$ 1,625

$ 10

$ 1,635

$ 635

$1,000

Eg Increase D/E


First Principles of Corporate Finance

Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and

reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend

upon the stockholders’ characteristics. Manage financial risk


www.giddy.org

Ian GiddyNYU Stern School of BusinessTel 212-998-0332; Fax [email protected]://www.giddy.org

corporate finance: creating value

Documents