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1 TOPICS (1) Product Market Competition (2) Earnings Manipulation 8th set of transparencies for ToCF.

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Presentation on theme: "1 TOPICS (1) Product Market Competition (2) Earnings Manipulation 8th set of transparencies for ToCF."— Presentation transcript:

1 1 TOPICS (1) Product Market Competition (2) Earnings Manipulation 8th set of transparencies for ToCF

2 2 CORPORATE FINANCE IN INDUSTRIAL CONTEXT: THE FIRM AND ITS SUPPLIERS AND COMPETITORS Industrial organization Corporate finance Borrowing level & structure. Collateral pledging. Allocation of control rights. Liquidity. Etc. Horizontal: Vertical: product market competition supply chain Questions (1)Does competition facilitate or hinder financing? (2)Using the financial structure to impact product market competition. (3)Using the financial structure to influence contracts with third parties.

3 3 COMPETITION AND FINANCING 2 identical firms, i=1,2. (1) (a) Basics: profit destruction and benchmarking effects. must develop a new technology to enter / serve market = M if only firm to succeed,  D if both firms succeed,  0 if firm fails. profit: Fixed investment model. Net worth A

4 4 Equilibrium in which both receive financing. Independent realizations Reason: incentive constraint is still since Equilibria in which one firm receives financing. Holmström sufficient statistic result implies that compensation should not be linked to other firm’s realization.

5 5 Benchmarking: correlated realizations Assume perfect correlation conditional on efforts infinite risk aversion at zero rather than limited liability. Both entering and behaving in equilibrium if So if then competition may facilitate financing.

6 6 Basic points: a) One firm’s financial structure or corporate governance depends on its rivals’ choice in the matter. b) The quest for pledgeable income may make these choices strategic complements when they otherwise (i.e., in terms of NPV) would be strategic substitutes: More discipline in rival firm lowers pledgeable income and calls for more discipline to satisfy investors. (b) Industry influence on financial structure /corporate governance : Aghion-Dewatripont-Rey. Choice can be (depending on application). a refocusing on line of business, high-powered monitoring, vertical integration, allocation of control rights,... anything that a) disciplines manager and makes the firm more competitive in market.

7 7 Thus action raises investor value, but decreases value overall. Previous model except that entrepreneur can give control right to investors. (Undescribable) action taken at interim stage raises probability of success by (from to or from to ). Imposes nonmonetary cost on insiders Simple control right version: Investors will take the action if receive control right (bear none of private cost). Entrepreneur will not take action if retains control (bears entire cost, receives only part of benefit.

8 8 Look at equilibria in which both firms receive financing (ADR call this the “shirking region”). Equilibrium in which entrepreneurs surrender control rights Note: uniform shift implies incentive constraint unchanged: ADR call this the “bonding region”. Equilibrium in which entrepreneurs retain control rights and

9 9 Corporate governance decisions are: where strategic complements from pledgeable income perspective: strategic substitutes from NPV perspective:

10 10 Variant of previous model. COMMITMENT TO BE TOUGH: BRANDER-LEWIS (1986) Suppose firm 1 chooses corporate governance before firm 2. Then firm 1 may choose to be very competitive in order to deter entry (financing of firm 2) Brander-Lewis a bit different (Cournot : Issues debt. Creates a limited liability effect “Stackelberg” leadership.)

11 11 COMMITTING THROUGH THE FINANCIAL STRUCTURE (2) PRELIMINARIES: IO: McGee vs Telser (a) SIMPLE MINDED LONG-PURSE STORY [Fudenberg-Tirole 1985] One firm has long purse (self-financed), other is financially weak. At date 0, financially weak firm is self-financed. Date-0 profit will be date-1 net worth/equity. Rival in market can take costly action (predation) that reduces both firms’ date-0 profits. In particular, weak firm’s date-0 profit falls from A to a

12 12 (a)STRATEGIC SECURITY DESIGN: BOLTON- SCHARFSTEIN 1990 Financially weak firm can reduce occurrence of predation through long-term contracting. Basic points: Tension between minimizing agency problems and minimizing rival’s incentive to prey. Long-term contracts that protect against predation are often renegotiation proof.

13 13 Assumptions: Two identical periods, except that at date 0: private benefit of misbehaving B 0 (not crucial), strong firm can prey at date 0 (no incentive to prey at date 1). Predation results in zero profit at date 0 for both. Predation not observed by investors. Weak firm: probabilities and of refinancing in case of success and failure.

14 14 Assume Rent (reinvestment is desirable) and (dearth of pledgeable income) at date 1 if reinvestment note: more generally

15 15 Optimal contract: Predation deterrence (strong firm) Date-0 incentives (weak firm)

16 16 Weak firm’s NPV (in the absence of predation) would like but not incentive compatible. On the other hand, (PD) requires Either and sufficiently large. Interpretation: credit line. “Deep-pocket strategy”. Or bring down and “Shallow-pocket strategy”: low. Depends on initial wealth. Renegotiation proof (entrepreneur likes continuation, investors don’t). not too large.

17 17 Empirical work Weakness measured by high leverage Zingales (JoF 98). Trucking industry (average reduces probability that firm survives an increase in competition. Chevalier (AER 95, JoF 95), Chevalier-Scharfstein (AER 96). Supermarket industry. Entry and expansion of non- LBO firms more likely in markets with LBO firms. Cyclical behavior of supermarket pricing.

18 18 COMMITTING VIS-A-VIS SUPPLIERS OR CUSTOMERS (3) Papers on debt as a commitment to be a tough bargainer: Perotti-Spier, Spiegel (JEMS 96), Spiegel-Spulber (RJE 94), Bronars-Deer (QJE 91),.. Firm/union; utility/regulator ; defense contractor/government; incumbent management- raider;... Several possible versions: “Soft budget constraint” (not usual one): lack of liquidity. “Debt oberhang” version.

19 19 Example: Assume Optimal financing: issue senior debt to dispersed bondholders (plus unanimity rule) : overleverage, consume before bargaining stage. Supplier forced to offer input at marginal cost (zero).

20 20 Renegotiation proofness issue. Transaction costs (here). Caillaud-Jullien-Picard (Econometrica 95) on asymmetric information. Spier-Whinston (RJE 95) on reliance. Alternatives:

21 21 MANIPULATION OF EARNINGS Additional forms of moral hazard (gaming the incentive system). (1) Timing of income recognition (moving income forward/backward). (2) Risk management (increasing/decreasing risk). Effort incentives incentives are aligned along intertemporal dimension, risk dimension. Multitasking problem.

22 22 INTERTEMPORAL MANIPULATIONS (1) Topical: 3G mobile, ENRON, Worldcom, etc. choice of reserves/provision for loan losses, choice of date at which sale is recorded, capitalize or expense maintenance and investment costs, balance sheet window dressing (banks’ bad risks transferred to nonconsolidated subsidiaries; lease backs: sell HQ and lease it in order to realize capital gain),... Two categories of earnings management: (a)Accounting methods (“cooking the books”, exploiting flexibility in generally accepted accounting principles) Cost (besides fooling investors): time spent by managers; “bribes”; psychological cost?

23 23 delay shipments or ask customers to take early delivery, delay/speed up maintenance, replacement of inventories, run end-of-period sales,... (b)Operating methods Cost (besides fooling investors): bad timing, overtime pay, production disturbances,...

24 24 MANAGERIAL “MYOPIA”: THE INCENTIVE FOR POSTURING Disciplining management: Adverse selection or moral hazard considerations may want to Instruments: takeovers, strong board, control rights (e.g., venture capital), limited liquidity (short term debt), vesting of stock options,... fire/liquidate downsize, interfere. at intermediate stage in case of bad performance/signals. Popular press, Porter 1992,...: “Anglo-Saxon short termism”.

25 25 Fixed investment model. can liquidate/replace manager at intermediate stage, learning about manager’s ability. Model [Literature: Stein QJE 89. Related literature on second sourcing in regulation/procurement, e.g., Laffont-Tirole RJE 88.] New ingredients: Timing: Example: replace manager by new, unknown one.

26 26 Entrepreneur would like to always keep her job: Assumptions But guaranteed tenure does not generate enough pledgeable income: while: In the absence of manipulation, liquidate with probability when bad signal: note:

27 27 Entrepreneur can generate signal for sure by (secretly) manipulating earnings.” Cost: probability of success falls uniformly by Manipulation Let and denote the probabilities of continuation for signal r and q. If entrepreneur does not know signal when deciding whether to manipulate, the condition for no manipulation (NM) is: or

28 28 OTHER FORMS OF POSTURING Back to Diamond 1984 model. Two projects A, B per period, two periods. Entrepreneur has no responsiveness to monetary incentives. Private benefit per period Keeps job at date 2 if and only if. (1)Risk preferences and career concerns p unknown (r with probability with probability ). chooses independent or perfectly correlated projects.

29 29 If plays conservatively (independent projects). If wants to take risk (correlated projects). Let “Gambling for resurrection”. denote posterior probability conditional on one success and independence. Chevalier-Ellison JPE 97: risk taking by mutual funds. Poor performance in first three quarters: gamble for resurrection. Good performance in first three quarters: conservative.

30 30 Scharfstein-Stein 90 God and bad managers (they don’t know). Good managers get an informative signal (the same one). (2)Herding behavior Hence incentive to herd (possible choice of an inefficient investment). Countervailing forces Profit incentives. Debt and limited liability. Superstar effects. Creativity is valued talent. See also Zwiebel JPE 95 on benchmarking.

31 31 FOSD and SOSD moral hazard Bester-Helwig 1987 (see also Alger 2000). Induce effort (FOSD) reward in upper tail (“stock option”). Multitasking problem: encourages risk taking. Fixed investment model

32 32 (ii) Agency cost: Investors can control R Substitute p FOC:

33 33 Moral hazard (i) No agency cost: max NPV = Pledgeable income condition Hence

34 34 Results (1) (2) (3) Pure debt contract is not optimal wants some sharing at the margin: 2nd order loss/1st order gain. (4) Pure equity contract is not optimal (5) Optimal contract: mixture:

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