Copyright ©1998 Ian H. Giddy Corporate Finance 1 Finance in the Corporation Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operations Officer (COO) Vice President Marketing Vice President Finance (CFO) Vice President Production Treasurer Controller Cash Manager Credit Manager Tax Manager Cost Accounting Manager Capital Expenditures Financial Planning Financial Accounting Manager Data Processing Manager
Prof. Ian Giddy New York University Corporate Finance
Copyright ©1998 Ian H. Giddy Corporate Finance 4 What the Module is About... l Corporate finance: shareholder value can be affected by financial decisions: investment, financing choices, debt design & risk management Corporate investment decisions Corporate financing choices Designing debt Risk management
Copyright ©1998 Ian H. Giddy Corporate Finance 5 The Decisions that Create Shareholder Value CREATING CORPORATE ECONOMIC VALUE CORPORATE INVESTMENT DECISIONS CORPORATE FINANCING CHOICES CORPORATE PAYOUT POLICIES CORPORATE RISK MANAGEMENT
Copyright ©1998 Ian H. Giddy Corporate Finance 6 The Decisions that Create Shareholder Value CREATING CORPORATE ECONOMIC VALUE CORPORATE INVESTMENT DECISIONS CORPORATE FINANCING CHOICES CORPORATE PAYOUT POLICIES CORPORATE RISK MANAGEMENT
Copyright ©1998 Ian H. Giddy Corporate Finance 7 The Decisions that Create Shareholder Value CREATING CORPORATE ECONOMIC VALUE CORPORATE INVESTMENT DECISIONS CORPORATE FINANCING CHOICES CORPORATE PAYOUT POLICIES CORPORATE RISK MANAGEMENT
Copyright ©1998 Ian H. Giddy Corporate Finance 8 The Decisions that Create Shareholder Value CREATING CORPORATE ECONOMIC VALUE CORPORATE INVESTMENT DECISIONS CORPORATE FINANCING CHOICES CORPORATE PAYOUT POLICIES CORPORATE RISK MANAGEMENT
Copyright ©1998 Ian H. Giddy Corporate Finance 9 The Goal of Financial Management l 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 l Possible goals: Size, market share, profits l Three equivalent goals of financial management: Maximize shareholder wealth Maximize share price Maximize firm value
Copyright ©1998 Ian H. Giddy Corporate Finance 10 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. One company’s statement
Copyright ©1998 Ian H. Giddy Corporate Finance 11 First Principles l 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. l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. l 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 l Minimize unnecessary financial risks. Objective: Maximize the Value of the Firm
Copyright ©1998 Ian H. Giddy Corporate Finance 12 The Objective in Decision Making l In traditional corporate finance, the objective in decision making is to maximize the value of the firm. l 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. l All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.
Copyright ©1998 Ian H. Giddy Corporate Finance 13 The Criticism of Firm Value Maximization l 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. l 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. l Maximizing stock price does not imply that a company has to be a social outlaw.
Copyright ©1998 Ian H. Giddy Corporate Finance 14 Why Maximize Stockholder Wealth? l 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). l If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously. l 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
Copyright ©1998 Ian H. Giddy Corporate Finance 15 The Classical Objective Function STOCKHOLDERS Maximize stockholder wealth Hire & fire managers - Board - Annual Meeting BONDHOLDERS Lend Money Protect bondholder Interests FINANCIAL MARKETS SOCIETY Managers Reveal information honestly and on time Markets are efficient and assess effect on value No Social Costs Costs can be traced to firm
Copyright ©1998 Ian H. Giddy Corporate Finance 16 The Agency Problem l The agency relationship l Will managers work in the shareholders’ best interests? Agency costs Corporate governance Incentive issues l Control of the firm -- there is a market for corporate control Shareholders Board of Directors Managers Allocation of Resources
Copyright ©1998 Ian H. Giddy Corporate Finance 17 What Can Go Wrong? STOCKHOLDERS Managers put their interests over shareholders’ Have little control over managers BONDHOLDERS Lend Money Bondholders can get ripped off FINANCIAL MARKETS SOCIETY Managers Delay bad news or provide misleading information Markets make mistakes and can overreact Significant Social Costs Some costs cannot be traced to firm
Copyright ©1998 Ian H. Giddy Corporate Finance 18 I. Stockholder Interests vs. Management Interests l Theory: The stockholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors. l Practice: Neither mechanism is as effective in disciplining management as theory posits.
Copyright ©1998 Ian H. Giddy Corporate Finance 19 The Best Boards...
Copyright ©1998 Ian H. Giddy Corporate Finance 20 And the Worst...
Copyright ©1998 Ian H. Giddy Corporate Finance 21 Illustration: Overpaying on Takeovers l The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover. l 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. l 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.
Copyright ©1998 Ian H. Giddy Corporate Finance 22 II. Stockholders' Objectives vs. Lenders' Objectives l In theory: there is no conflict of interests between stockholders and lenders, including bondholders. l In practice: Stockholders may maximize their wealth at the expense of debtholders. Increasing leverage dramatically Increasing dividends significantly Taking riskier projects than those agreed to.
Copyright ©1998 Ian H. Giddy Corporate Finance Increasing leverage dramatically and making existing bonds less valuable
Copyright ©1998 Ian H. Giddy Corporate Finance Increasing Dividends Significantly t: CAR (Div Up) CAR (Div down) EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES Day (0: Announcement date) CAR
Copyright ©1998 Ian H. Giddy Corporate Finance 25 The Modified Objective Function l For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected: Maximize Stock Price: This will also maximize firm value l 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 l 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. l For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not)
Copyright ©1998 Ian H. Giddy Corporate Finance 26 Finance in the Corporation Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operations Officer (COO) Vice President Marketing Vice President Finance (CFO) Vice President Production Treasurer Controller Cash Manager Credit Manager Tax Manager Cost Accounting Manager Capital Expenditures Financial Planning Financial Accounting Manager Data Processing Manager
Copyright ©1998 Ian H. Giddy Corporate Finance 27 “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? l As a rule, it is more costly to build than to buy—markets make better decisions than bureaucrats l Hence there must be some good reason, some synergy, that makes an activity better if done within a firm l Eg: the production of proprietary information l Often, these synergies are illusory
Copyright ©1998 Ian H. Giddy Corporate Finance 28 Takeovers as a Solution to “Agency Problems” l There is a conflict of interest between shareholders and managers of a target company—Eg poison pill defenses l Individual owners do not have suffcient incentive to monitor managers l Corporate takeover specialists, Eg KKR, monitor the firm's environment and keep themselves aware of the potential value of the firm under efficient management l The threat of a takeover helps to keep managers on their toes—often precipitates restructuring.
Copyright ©1998 Ian H. Giddy Corporate Finance 29 Who Gains What? l Target firm shareholders? l Bidding firm shareholders? l Lawyers and bankers? l 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.
Copyright ©1998 Ian H. Giddy Corporate Finance 30 The Price: Who Gets What?
Copyright ©1998 Ian H. Giddy Corporate Finance 31 A Case Study: Kodak - Sterling Drugs l Eastman Kodak’s Great Victory
Copyright ©1998 Ian H. Giddy Corporate Finance 32 Earnings and Revenues at Sterling Drugs Sterling Drug under Eastman Kodak: Where is the synergy? ,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5, RevenueOperating Earnings
Copyright ©1998 Ian H. Giddy Corporate Finance 33 Kodak Says Drug Unit Is Not for Sale (NYTimes, 8/93) l Eastman Kodak officials say they have no plans to sell Kodak’s Sterling Winthrop drug unit. l 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.”
Copyright ©1998 Ian H. Giddy Corporate Finance 34 Sanofi to Get Part of Kodak Drug Unit (6/94) l 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.
Copyright ©1998 Ian H. Giddy Corporate Finance 35 Smithkline to Buy Kodak’s Drug Business for $2.9 Billion l Smithkline Beecham agreed to buy Eastman Kodak’s Sterling Winthrop Inc. for $2.9 billion. l For Kodak, the sale almost completes a restructuring intended to refocus the company on its photography business. l Kodak’s stock price rose $1.25 to $50.625, the highest price since December.
Copyright ©1998 Ian H. Giddy Corporate Finance 36 Goals of Acquisitions Rationale: Firm A should merge with Firm B if [Value of AB > Value of A + Value of B + Cost of transaction] l Synergy l Gain market power l Discipline l Taxes l Financing Example: Ciba-Geigy/ Sandoz
Copyright ©1998 Ian H. Giddy Corporate Finance 37 Most Value is Created on the Asset Side (Operational Restructuring) l Discounted Cash Flow (DCF) analysis for project evaluation l Value-Based Management for performance evaluation ? Wärtsilä NSD (from Wärtsilä Diesel & New Sulzer Diesel
Copyright ©1998 Ian H. Giddy Corporate Finance 38 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
Copyright ©1998 Ian H. Giddy Corporate Finance 39 Wärtsilä NSD: Gains Market Power
Copyright ©1998 Ian H. Giddy Corporate Finance Credito Wiese Continental Banco de la Nacion Interbanc Latino Del Sur Lima Santander Nuevo Mundo BBV ACQUISITION SANTANDER ACQUISITION Peruvian Banks: Market Share by Deposits, % Sometimes, Too Late is Too Little
Copyright ©1998 Ian H. Giddy Corporate Finance 41 Framework for Assessing Restructuring Opportunities Restructuring Framework 1 2 Current Market Value 3 Total restructured value Potential value with internal + external improvements Potential value with internal improvements Company’s DCF value Maximum restructuring opportunity Financial structure improvements 4 Disposal/ Acquisition opportunities Operating improvements Current market overpricing or underpricng 5 (Eg Increase D/E)
Copyright ©1998 Ian H. Giddy Corporate Finance 42 Using The Restructuring Framework ($ Millions of Value) Restructuring Framework 1 2 Current Market Price 3 Optimal restructured value Potential value with internal and external improvements Potential value with internal improvements Company value as is Maximum restructuring opportunity Financial engineering opportunities 4 Disposal/ Acquisition opportunities Strategic and operating opportunities Current perceptions Gap: “Premium” 5 $ 25 $ 975 $ 300$ 1,275 $ 350 $ 1,625$ 10 $ 1,635 $ 635$1,000 Eg Increase D/E
Copyright ©1998 Ian H. Giddy Corporate Finance 43 First Principles of Corporate Finance l 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. l Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. l 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. l Manage financial risk
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Copyright ©1998 Ian H. Giddy Corporate Finance 47 Ian Giddy NYU Stern School of Business Tel ; Fax