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FIN355 - Corporate Finance Chapter 1 Intro to Corporate Finance -

Corporate Ownership Structure and Agency Issue

Siqi Wei, Ph.D.†

† Department of Finance, Financial Planning, and Insurance David Nazarian College of Business and Economics

California State University, Northridge

[B [email protected]] Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 1 / 35

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The Big Picture: Where we are? Who we are? and how we get there?

Personal Finance

Corporate Finance

Investments and Financial Markets

Financial Engineering & Quantitative Finance

Behavioral Finance

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 2 / 35

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The Big Picture: Where we are? Who we are? and how we get there? Cont’d

Corporate Finance Firm financial planning Coporate governance & Corporate Control Executive comensation & managerial incentives Mergers & Acquisitions Capital Structure

Investments and Financial Markets Financial Markets Security analysis and valuation Fixed income analysis Portfolio management Risk Management Options, futures, and other derivatives Financial intermediaries and institutions

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 3 / 35

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The Big Picture: Where we are? Who we are? and how we get there? Cont’d

Financial Engineering & Quantitative Finance Complex derivative modeling Portfolio formation Hedge Fund High frequency trading

Behavioral Finance Behavioral Science + advanced statistics Psychology + experimental studies

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 4 / 35

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Three areas Managers Org Structure

Corporate Finance has three main areas of concern

Capital budgeting: What long-term investments should the firm take on? Capital structure: Where will we get the long-term financing to pay for the investment?

How should we pay for our assets? Should we use debt or equity?

Working capital management: How do we manage the day-to-day finances of the firm?

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 5 / 35

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Three areas Managers Org Structure

Financial Managers

What is a financial manager? the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf (↩ in an ideal world; will be discussed ).

Chief Financial Officer (CFO): The top financial manager within a firm Treasurer: Oversees cash management, credit management, capital expenditures, and financial planning. Controller: Oversees taxes, cost accounting, financial accounting and data processing

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 6 / 35

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Three areas Managers Org Structure

Orgnizational Chart

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 7 / 35

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Three areas Managers Org Structure

Forms of Business Organization in the U.S.

a) Sole Proprietorship: A business owned by one person. This is the simplest type of business to start and is the least regulated form of organization.

Advantages: Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income

Disadvantages: Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 8 / 35

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Three areas Managers Org Structure

Forms of Business: Partnership

b) Partnership: A business formed by two or more individuals or entities. Advantages:

Two or more owners More capital available Relatively easy to start Income taxed once as personal income

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 9 / 35

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Three areas Managers Org Structure

Forms of Business: Partnership, Cont’d

Disadvantages: Unlimited liability: General partnership1 OR Limited partnership2

Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership

1In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement or a lengthy, formal written document

2In a limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner’s liability for business debts is limited to the amount that partner contributes to the partnership. This form of organization is common in real estate ventures, for example.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 10 / 35

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Three areas Managers Org Structure

Forms of Business: Corporation

Corporation: The corporate form of organization are often called joint stock companies, public limited companies, or limited liability companies, depending on the specific nature of the firm and the country of origin.

Advantages: Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital

Disadvantages: Separation of ownership and management Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 11 / 35

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Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize sales? Avoid financial distress and bankruptcy? Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

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Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit?

Minimize costs? Maximize sales? Avoid financial distress and bankruptcy? Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

Major Issues Goal

Principal-Agent Problem Mkts & Corp

Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit? Minimize costs?

Maximize sales? Avoid financial distress and bankruptcy? Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

Major Issues Goal

Principal-Agent Problem Mkts & Corp

Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize sales?

Avoid financial distress and bankruptcy? Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

Major Issues Goal

Principal-Agent Problem Mkts & Corp

Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize sales? Avoid financial distress and bankruptcy?

Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

Major Issues Goal

Principal-Agent Problem Mkts & Corp

Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize sales? Avoid financial distress and bankruptcy? Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

Major Issues Goal

Principal-Agent Problem Mkts & Corp

Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize sales? Avoid financial distress and bankruptcy? Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

Major Issues Goal

Principal-Agent Problem Mkts & Corp

Goal of Financial Management in Corporates What should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize sales? Avoid financial distress and bankruptcy? Maximize the Corporate Social Responsibility (CSR, ESG)?

Goal of financial management The goal of financial management is to maximize the current value per share of the existing stock. The stockholders in a firm are residual owners. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

The total value of the stock in a corporation = value of the owners’ equity. ∴ a more general definition: MAXIMIZE THE MARKET VALUE OF THE EXISTING OWNERS’ EQUITY.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 12 / 35

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A separate note on CSR & ESG...

Two opposing views about the value for CSR policies - - stakeholder value maximization view and shareholder expense view.

CSR activities focus on interests of all stakeholders (i.e. customers, employees, debtholders) and thereby increase their willingness to participate in a firm’s operation, which further increases shareholders’ wealth as well as accomplishing societal goals Milton Friedman holds that the sole “social responsibility of business is to increase its profits," wherein CSR can be regarded as a manifestation of managerial agency problems in a sense that firm managers engaging CSR activities that benefits themselves at the expense of outside shareholders. (Firm managers engaged in CSR activities can possibly be distracted from their main focus of their responsibilities, and thereby make decisions that could be sub-optimal to the outside shareholders.)

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 13 / 35

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Agency-induced incentive plan? Employee Well-being v.s. Land of Profit???

Free employee food service at Google...

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 14 / 35

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Retail investor attention on Environmental, Social, and Governance (ESG)

Retail investor attention on Environmental, Social, and Governance (ESG) over the term 2004 to Sep 8 2022

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 15 / 35

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ESG in the news (Barron’s, 09.08.2022)

In the news: how does the market intereprete ESG??? an article from a mainstream investments media - BARRON’S (https://www.barrons.com/articles/ esg-sector-etfs-volatile-51662588284?mod=hp_LEAD_7) “ESG Sector ETFs Could Be Volatile. What to Do Instead."

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 16 / 35

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Agency Problem - The HEART of corporate finance

Separation of ownership and control

Agency relationship: Principal hires an agent to represent his/her interests3

Agency problem: Conflict of interest between principal and agent4

*Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

a simple generic illustration: https://www.youtube.com/watch?v=ydh_TXrkj54

3Stockholders (principals) hire managers (agents) to run the company 4Management goals and agency costs (these costs can be direct or indirect)

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 17 / 35

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Agency Problem - The HEART of corporate finance

Separation of ownership and control Agency relationship: Principal hires an agent to represent his/her interests3

Agency problem: Conflict of interest between principal and agent4

*Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

a simple generic illustration: https://www.youtube.com/watch?v=ydh_TXrkj54

3Stockholders (principals) hire managers (agents) to run the company 4Management goals and agency costs (these costs can be direct or indirect)

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 17 / 35

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Agency Problem, Cont’d

Some ways to manage agency conflicts: Managerial compensation

Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal

Corporate control The threat of a takeover may result in better management Proxy fights could be used to replace existing management

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 18 / 35

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An Example of Agency Problem Outcome

One example of agency problem (Separation of ownership and control) - Share Pledging

It involves executives or directors borrowing capital from lenders and providing personally owned shares of firm equity as collateral for the loan.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 19 / 35

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Example of Agency Problem Outcome, Cont’d

Three Example Cases of Share Pledging

(a) WorldCom (b) Chesapeake Energy Corporation

(c) Keurig Green Mountain Inc.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 20 / 35

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WorldCom

The former CEO of WorldCom, Bernard J. Ebbers, borrowed more than 400 million dollars pledging his beneficial shares of WorldCom as collateral Ô⇒ ranches, timberlands, a yacht-building company, etc. In 2000, share price of WorldCom started dropping drastically due to the dot-com bubble in the US Mr. Ebbers, got margin calls from banks requiring him to supply more capital (put up additional stocks) as collateral or pay off a portion of the loan. Mr. Ebbers was trying to “indirectly" manipulate firm’s earnings to maintain the share price of WorldCom

implemented “tracker stock" on a well-performing subsidiary (MCI) to prop up the share price

*The case of WorldCom, Inc. led the SEC to require firms’ disclosure of relevant information on share pledging in 2006.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 21 / 35

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Chesapeake Energy Corporation

Aubrey K. McClendon, CEO of Chesapeake, has been a steady aggressive buyer of Chesapeake Energy shares. On Oct 10, 2008, Chesapeake released the news that it would further reduce its capital spending by some $1.5 billion in 2009 and 2010. The news caused the share price to drop on 10.13.2008 by 43%.

30,217,232 shares (94%) of his stake were involuntarily sold to meet margin loan requirements from investment bank Goldman Sachs Group Inc.

The forced sale of Mr.McClendon’s shares pushed sinking stock prices down even more quickly afterwards. From July 2, to Oct 10, 2008, Chesapeake’s share price dropped from $69.40 to $16.52 (76% in total).

*Hurt firm’s stock performance and jeopardize a company’s long-term goals.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 22 / 35

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Keurig Green Mountain Inc.

The founder of Keurig Green Mountain, Robert P. Stiller, lost almost half of his wealth in May 2012. On May 2nd 2012, the company says that “its K-cup sales were lower than expected in the second quarter, leaving it with extra inventory and contributing to more than four percentage points of margin contraction". Around that time, the CEO, Robert P. Stiller, pledged 12,548,933 shares out of his total 15,997,209 personal holdings of beneficial shares as collateral (78%) Mr.Stiller was immediately forced to sell more than 5,000,000 shares to cover the margin call, which further exacerbated the decline of Green Moutain’s share price. Overall, the stock price from May to the end of July declined from $49.74 to $17.91, a drop of 63.99%

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 23 / 35

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An Example from Keurig Green Mountain Inc. (May 2012)

(a) Daily Stock Price of Green Mountain

(b) Return on Green Mountain Stock

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 24 / 35

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Agency-induced pledging outcomes

To alleviate the margin call risk, pledgers tend to adopt conservative policies which are value-reducing to the shareholders. Pledged holdings could lead incentive-weakened executives to take conservative investment and financial policies, which in turn, translates to the reduction of firm performance and the overall shareholder wealth Pledgers may level up the use of the earnings management to support the stock price temporarily in the hope to alleviate the margin call pressure. Institutional investors may take the monitoring role to discipline the practice of the share pledging to protect shareholder value.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 25 / 35

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Possible Solutions to Agency Issue?

Internal Governance (e.g. CEO Incentive design) External Governance (e.g. Litigation lawsuits) Role of institutional investors - especially long-tern institutional investors Hedge Fund Activism Analyst Coverage Disclosure

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 26 / 35

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Possible Solutions to Agency Issue? Institutional Monitors - “Voice" and “Exit" Channel

Long-term institutional investors can influence and monitor firms’ behavior through many ways

Long-term investors communicate directly with managers to influence managerial decisions. (“Voice")

McCahery et al (2016): The most common engagement channels are behind-the-scenes discussions with managemnt and boards of directors

Long-term investors use the threat of selling their shares together with their information about corporate acrivities to influence managerial decision making (“Exit")

Short-term: less likely to remain long enough to reap the corresponding benefits Monitroing-relevant information is high ⇒ Speculative

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 27 / 35

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Possible Solutions to Agency Issue? Institutional Monitors

Chen et al. (2007) argue that more stable institutional investors have better knowledge of the firm and larger influence on management and, thus, are more likely to engage in monitoring efforts Gaspar et al (2005): investment horizon of shareholders affects managerial behavior in corporate control transactions, and weak monitoring by short-term investors allows managers to trade off shareholder interests for personal benefits, including job security and empire building, at the expense of shareholder returns. Bushee (1998) documents that firms dominated by institutional investors with high portfolio turnover and engaging in momentum trading are more likely to cut long-term R&D projects to meet short-term earnings targets.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 28 / 35

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Possible Solutions to Agency Issue? Institutional Monitors

Harford et al. (2016) emphasize the monitoring role of long-term investors by showing that they strengthen corporate governance, restrain managerial misbehavior, discourage financing and investment, and encourage dividend payout as well as innovation outputs. Cremers, Pareek, and Sautner (2016) document that firm value and investment outcomes are also influenced and pressured by short-term institutional investors.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 29 / 35

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Stakeholders

Stakeholders: A stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners.

eg. Employees, suppliers, customers, goverments...

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 30 / 35

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Financial Markets and the Corporation

Financial Markets and the Corporation: A financial market brings buyers and sellers of financial instruments together. In financial markets, it is debt and equity securities that are bought and sold. The most important differences between financial markets concern the types of securities that are traded, how trading is conducted, and who the buyers and sellers are.

* Primary versus Secondary markets: Primary market refers to the original sale of securities by governments and corporations. The secondary markets are those in which these securities are bought and sold after the original sale.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 31 / 35

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Cashflows between the firm and the financial markets

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 32 / 35

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An Internet Example

The Internet provides a wealth of information about individual companies One simple site is https://finance.yahoo.com/ Click on the web surfer to go to the site, choose the company that you are interested and see what corporate information you can find!

Apple (AAPL) Amazon (AMZN) Facebook (FB)

Other sources include: Wall street jounal, Bloomberg, Seeking alpha, etc.

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 33 / 35

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End-chapter questions for you to think about

What is Capital bugeting decistion? What is capital stucture? What is working capital management? IN GENERAL, what is the GOAL of financial management? What is Agency Problem? Why there is an agency problem?

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Q & A

Any Questions?

Siqi Wei, Ph.D (CSUN) FIN355 Chapter 1: Into to Corporate Fin 35 / 35