UNSW Business School
School of Banking and Finance
FINS5514: Capital Budgeting and Financial
Decisions
Lecture 1: Introduction to Corporate Finance and
Agency Theory
FINS 5514: Capital Budgeting and Financial Decisions
• Capital budgeting and financing decisions are primarily
concerned with the major financial decisions faced by
firms
• These decisions can be broadly categorized as the
investment policy, the financing policy, the
dividend/repurchase policy, and the restructuring policy.
• This course will examine the main theories and empirical
evidence surrounding these decisions and to use this
knowledge to help solve typical ‘real’ finance problems.
2
Business Organizations
• There are several different types of company and each
type has certain advantages and disadvantages
compared to the others.
• The most frequently seen types include:
– Sole proprietorships / Partnerships
– Corporations
– Hybrid Organisations (some combination of the above)
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Sole Proprietorships / Partnerships
• Sole proprietorships are owned and run by one
person. Partnerships are two or more people.
• Advantages
– These companies are simple to establish
– Owners keep all the profits
• Disadvantages
– Unlimited liability
– Not quoted
– Difficult to raise large sums of finance
– The firm only lasts as long as the owners want it
12
Corporations
• A corporation is a legally registered company with
distinct groups of owners and managers.
• Corporations are usually listed on a stock
exchange.
• Advantages to a Corporation
– Ownership can be transferred easily
– Limited liability.
• Disadvantages to a Corporation
– Corporate taxation
– Complex legal formalities take time and money to
complete
13
Financial Managers
• The financial managers of a firm makethree
decisions in three primaryareas:
– Investment
– Finance raising
– Dividends
• In theory these decisions are separate butin reality
they areinterconnected.
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Investment Decisions
• These decisions create profits and revenue, as well
asthose that reduce costs andexpenses
• The primary objective is to increase firm value by
deciding which long-term investments or projects
the business should takeon
• Capital budgeting analysis is very important and
includes analysis of:
– The risk of cashflows
– The timing of cashflows
15
Financing Decisions
• In order to invest, firms must raise funds.
• Debt:
– Straight or convertible
– Long or short term
– Fixed or floating rate
• Equity
– Ordinary or preference shares
• The choice depends upon many factors:
– Taxation, external monitoring, risk, signalling,agency
issues, capital structure and soon...
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What are firms for?
• What are the goals of afirm?
– Maximise profit?
– Minimise costs?
– Maximise market share?
– Maximise the value of the company’sstock?
– All of these?
• There are two main answers to thisquestion
17
What are firms for? (continued)
• Corporate wealth maximisation (CWM)
– Satisfy all stakeholders in the firm including debt
holders, employees and society as a whole
– This approach is fairly rare but is seen in Germany and
Japan
–
• Shareholder wealth maximisation (SWM)
– This is the most popular answer
– Main objective of the firm is to increase share price
– Ethical issues may arise as the shareholders
expropriate wealth from other stakeholders
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Agency Theory
• Under SWM, managers should only be
thinking about shareholderwelfare.
• However, due to agency theory this does not always
happen
• Agency theory says:
– The principal hires the agent to represent his/her best
interests.
– In this case, the shareholders (principals) hire the managers
(agents) to run their company
19
Agency Problems
• However, all stakeholders in the firm are
primarily concerned with self-interest
• This leads to potential conflicts of interest.
– These conflicts are the agency problem
• There are two main areas where it arises
– Shareholders and managers
– Shareholders and debt holders
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Agency Problems For Managers and
Shareholders
• In many countries, such as Australia, the UK and the
US, the owners do not manage the firm on a day-to-
day basis.
– This is often called the separation of ownership and
control.
• The owners and the managers may not have the
same objectives and this can result in problems.
– Managers prefer to increase their job security, power, status,
or to generate perks for themselves
– This may be at the expense of SWM
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Agency Problems For Managers and
Shareholders (continued)
• Agency costs arise as the shareholders
attempt to control the managers
• Direct costs:
– Managers act in their own interests, reducing value for the
shareholders
– Managers need to be monitored to ensure their actions
are in the owners best interests. This generates
monitoring costs
– Setting up contracts also costs money
• Indirect costs:
– Lost opportunities to create value for the shareholders
22
Possible solutions for Managersand
Shareholders (continued)
• Internal mechanisms for solving this problem
include:
1. The Board of Directors
– Employing executive & non-executive directors on the
Board.
2. Major shareholders, such as institutions, can
exert considerable influence on the company.
3. Compensation packages for the managers that give
them an incentive to act in the best interests
of the shareholders
– The use of stock options / stock grants
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Possible solutions for Managersand
Shareholders (continued)
4. The market for corporate control (mergers
and acquisitions) can help partially address the
agency problem
– Shareholders can threaten to sell their shares in a
hostile takeover
– If the takeover goes ahead, the firms
managers are likely to be firedafterwards.
– This is viewed as the “court of last resort” (Jensen
1988)
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Agency Problems For Debtholders and
Shareholders
• If a firm has debt, the debtholders have a claim
on part of the earnings of the firm, or some of
the assets if the firmgoesbankrupt.
• The interest rate on debt is based on the riskiness
of current and future projects and the company’s
current and expected future capitalstructure.
– This is a risky investment for debt holders but they do
not have any control over the company on a day-to-
day basis.
• This is another form of agencyproblem
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Types of AgencyProblems
• More formally, there are two types of agency
problems
1. Moral Hazard (HiddenAction)
– Although the principal and the agent have the
same initial set of information, the principal
cannot observe the action chosen by the agent
2. Adverse Selection (Hidden Information)
– Both the principal and the agent know that the
agent has information which is valuable to the
principal but which the principal cannotsee.
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An Example of Moral Hazard
• Consider car insurance.
• If my car is insured why should I drive
carefully?
– The answer to this is the adoption of an incentive.
– If I drive carefully my premiums will remain low.
• This form of coinsurance will ensure that I try
to limit my exposure to a claim as I will have to
pay part of the costs if I do not.
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An Example of Moral Hazard
(continued)
• In the case of firms, moral hazard arises in
many different ways.
– For example, imagine that both shareholders and
managers know how much money a firm has
(annual accounting figures).
– But, the shareholders cannot see how the money
is invested until after the investment ismade.
– If the shareholders do not like the choice of
investment strategy there is nothing they can do
about it.
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An Example of Adverse Selection
• Life insurance is a good example of hidden
information.
– A person insuring their life knows many things about
the state of their health that is not known by the
insurance company.
– The population will be heterogeneous with respect to
risk and some individuals will have a higher
probability of dying young thanothers.
– If everyone pays the same premium then high-risk
individuals will take out more insurance and low-risk
individuals will take out less.
29
An Example of AdverseSelection
(continued)
• The solution here is to use market signalling
where the person who has the superior
information signals what he knows through
his actions.
– For example, an insurer may offer lower premiums
if the person taking out the policy accepts very
limited benefits in the first fewyears.
– The presumption is that anyone who knows that
their health is very poor and who may die within
this period will not take out that insurance policy
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Asymmetric Information
• One potential cause of agency problems is
asymmetric information
– This means that some people know a lot more than
others.
• Managers have much more information than
outsiders including shareholders and debtholders
• Without good information, markets will break
down
31
Akerlof’s Market for Lemons
• Akerlof (1970) wrote an academic paper which
illustrates the problems that arise from a lack of
information
• He used the market for second hand cars as an
example
– Two types of second handcars
– Lemons – poor quality cars which are worth $400
– Peaches – good quality cars which are worth $2,000
– Each type of car represents 50% of themarket
32
Akerlof’s Market for Lemons(cont)
• There are 3 scenarios to consider
1. Peaches and lemons can be accurately
identified by everyone in themarket.
– Here is there is no problem because everyone
has all the necessary information.
– Cars will be sold at their correct values and the
market will continue to operate
– A peach will be sold for $2000 and a lemon for
$400.
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Akerlof’s Market for Lemons(cont)
2. No-one knows whether any particular car is a
peach or a lemon
– So, all cars will sell at $1200
2 2
– Assuming risk neutrality, buyers will work out
what they are prepared to pay:
E(Value)= Proportion of lemons×(Valueof lemon)
+Proportion of peaches×(Valueof peach)
– In this example, this is:
E(Value)= 1×($400)+ 1×($2000)=$1200
34
Akerlof’s Market for Lemons
3. Asymmetric information in which the sellers
know the quality of the car but buyers do
not.
– Here the market will break-down
– Sellers of good cars will only accept $2000 but
buyers will not pay more than$1200
– Therefore, no good cars will be sold and the only
cars on the market will belemons
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Gresham’s Law
• The market for lemons is an example of
Gresham’s Law which says that:
• “Bad money drives out good”.
– In other words, if there are two items of different
quality which have the same market value, only the
lower quality item willbe traded
– In this case, lemons and peaches are all worth $1200 to
the buyers (due to information asymmetry), despite the fact
that they are of different quality. Therefore the only cars
in the market will be lemons.
36
Solutions to Asymmetric Information
• The market for lemons is an example of problems
that arise from asymmetricinformation
• There are some solutions:
1. Buyers can gain the skills to improve their
knowledge but this can be expensive
2. Sellers can signal the quality of their product
with guarantees and trial periods
– However, effective signals must be unambiguous and
credible. This can be costly.
– Just saying something is good is not enough
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Solutions to Asymmetric Information
(continued)
• In the context of a corporation, managers try
to signal to investors that the firm is a good
one
through corporate• This can be done
announcements suchas:
– Dividends
– Capital structure
– Takeover plans
– Initial public offerings
39
Corporate Governance
• Corporate governance is the name for any
measures that can be used to close the
incentive gap between managers and
shareholders and reduce agency problems.
• Some firm level solutions are on the previous slides
• To illustrate why this is important, consider a
situation where governance failed:
– The collapse of Enron
40
Some Background to the EnronCase
– Consumers received a 10% price cut and
guarantees that there would be no price
• Background:
– During the 1990’s demand for electricity in
California grew 12%.Supply grew by 1%.
• California’s energy industry was deregulated in
1996
increases until 2002
– The utilities issued US$7 billion in bonds and were
allowed (eventually) to pass this cost on to
consumers.
41
Deregulation in the CalifornianEnergy
Industry
• Deregulation relied on competition to keep
the electricity companiesefficient.
– The share prices of the involved companies nearly
all went upconsiderably.
– Many of the companies sold off their plants for
vastly inflated prices.
42
Deregulation in the CalifornianEnergy
Industry (continued)
• Throughout 2000, the electricity supply in
California failed to meet demand and there
were blackouts
– The State spent US$40 million a day to buy extra
power.
– There was some evidence that the power
companies colluded to push up their profits by
limiting supply at certain times.
43
Enron Corporation
• Enron was formed in July 1985 as a result of
the merger of Houston Natural Gas and
InterNorth of Omaha,Nebraska.
– Enron specialized in energy trading and
distribution and, at one time, was the 7th largest
company in the US(16th in the World),
– Enron was valued at approximately $90 billion but
it had very few hardassets.
44
The Collapse of Enron
mark-to-market
century for use on
• In 1991, Enron adopted
accounting.
– This was devised in the 19th
highly liquid futures markets.
• A trader uses estimates of their profitability to
determine how much money to leave on the exchange
(the margin) to protect theExchangeagainst loss.
• Each day the present market value of the contract is
evaluated and the margin alteredaccordingly.
• This technique allows you to book value before
completing the transaction.
45
The Collapse of Enron (continued)
• Enron used mark-to-market accounting on
long-term contracts and made someerrors:
– Enron only considered the best possible outcome.
– Enron booked the entire profit on the day the
contract was signed
– Enron ignored the time value of money
and interest rate risk
– Enron never updated the numbers
– Enron used fake hedges to hide any losses
46
The Collapse of Enron (continued)
• Enron hid its losses by creating
Special Purpose Entities (SPEs)
– The SPEs were paid (in Enron stock) to guarantee
Enron’s losses
– This sort of guarantee is only viable if the
guarantor is totally independent.
– Guarantors should be firms that operate in
entirely different markets, subject to different
conditions and likely to be making money when
you are not.
– Enron’s SPEs did nothing.
47
The Collapse of Enron (continued)
• Forexample,
Year 1. Enron invests
Estimated outcome in 10years
Estimated profits
$100m
$250m
$150mProfits on the
books today $
Year 3. Actual profits
Loss($150m-$15m)
$15m
$135m
• The SPE is paid $150m (in Enron stock) to guarantee the
$150m profit
– But if share price drops, the stock is no longer worth
$150m.
• If the investment looses money, how can the SPE pay Enron
the $150m it guaranteed?
48
The Collapse of Enron (continued)
• After deregulation Enron grew rapidly and
made a lot of dubious business decisions.
• It also failed to pay any taxes for 4 years at the
end of the 1990’s.
• By using many different and interconnected
SPE’s, Enron hid over US$1 billion in debt.
– In October 2001, the hidden debt was revealed
49
The Collapse of Enron (continued)
• Enron’s accountants (Andersen) concealed the
extend of the problem, saying the company
was solvent
– Both Enron and Andersen shredded documents
concerning the auditing process.
– Enron voluntarily went into Chapter 11
(bankruptcy protection) in December2001
50
The Collapse of Enron (continued)
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51
The Collapse of Enron (continued)
• How much did it cost?
– Shareholders lost $74 billion
– Approximately 22,000 employees lost their pensions
and their jobs
– Other investors (including several major financial
institutions) also lost their investments
– At the time of the Chapter 11 filing, Enron’s liabilities
were estimated to be around $23 billion
52
The Collapse of Enron (continued)
• What went wrong?
1. The auditors (Arthur Andersen) failed to pick up on
the true financial situation in the firm.
– Did Andersen deliberately conceal the true
situation?
2. The Board of Directors should have been
working in the shareholders best interests
– Share options made Enron’s Directors interested in short
term price movements rather than the long-term.
53
The Collapse of Enron (continued)
3. Investment banks are supposed to
impartial advice to investors and
provide
provide
banking services to firms
– Enron's investment banks helped design Enron’s partnerships,
and also invested in them. The banks issued "buy ratings“ to
help keep the share price up.
4. Credit rating agencies set ratings that are used
to determine the interest rates at which the
issuer pays its debt
– Enron’s credit ratings were maintained until 5 days before it
went bankrupt.
54
The Collapse of Enron (continued)
5. Lawyers are hired to provide firms with legal
advice. The lawyers are obliged to act in the
company's best interest.
– Enron's lawyers helped the firm set up its
partnership structures. This was a highly unusual
and the lawyers should have been a critical of
theprocess.
55
The Collapse of Enron (continued)
• January 2006
– Company founder and Chairman Ken Lay and former CEO/
COO Jeffrey Skilling faced court in America.
– The charges included:
• Conspiracy to commit fraud
• Security fraud and wire fraud
• Making false statements to auditors
• Insider trading
• Major witnesses for the prosecution include
other Enron management who agreed to testify in
return for reducedpenalties.
56
The Collapse of Enron (continued)
• The trial ended in May2006
• Ken Lay was found guilty of 10 charges of
securities fraud and related offenses.
– Experts expected Lay to spend 20 to 30 years in prison but
Lay died in July 2006 before sentencing so his convictions
were vacated (declared void)
• Jeffrey Skilling was found guilty of 28 charges of
fraud and conspiracy. Sentenced to 24 years and
4 months and fined $45 million
– This was later reduced on appeal
57
The Collapse of Enron (continued)
• Andersen employees faced charges of
obstruction of justice during a federal
investigation
• Andersen surrendered its license in 2002 and
sacked all its employees.
– The conviction was overturned in 2005 but the
few employees still left spend their time dealing
with law suits
58
Some Other Major Bankruptciessince
Enron
Year Corporation Value Business
2002 WorldCom $103.9 billion Telecom
2008 Lehman Brothers $691 billion Finance
2008 Washington Mutual $327.9 billion Finance
2009 General Motors $91 billion Automobiles
2009 CIT $71 billion Finance
2014 Chrysler $39.9 billion Automobiles
2014 Energy Futures Holdings $40.9 billion Utilities
59
Country Level Corporate Governance
• Corporate governance also exists at a country
(macro) level.
• These regulations try to encourage / force firms to
act in the best interests of their shareholders
• However, it is difficult to get the balance correct
between enforcing good governance and still
allowing firms to evolve and react to changing
situations.
60
ASX Corporate Governance Principles
& Recommendations
• P1: Lay solid foundations for management and
oversight
• P2: Structure the board toadd value
• P3: Promote ethical and reasonable decisionmaking
• P4: Safeguard integrity in financial reporting
• P5: Make timely and balanceddisclosures
• P6: Respect shareholder rights
• P7: Recognise and manage risk
• P8: Remunerate fairly andhonestly
61
Sarbanes-Oxley Act (2002)
• KeyProvisions:
• 1. Public Company Accounting Oversight Board (PCAOB). The
PCAOB provides independent oversight of public accounting firms
providing audit services. It registers auditors, defines procedures for
compliance audits, enforces conduct, quality control, and
compliance.
• 3. Corporate Responsibility. Senior executives must take individual
responsibility for the accuracy ofcorporate financial reports.
• 4. Enhanced Financial Disclosures. Details reporting requirements
for financial transactions. Requires firms to have adequate internal
controls for assuring the accuracy of financial reports and
disclosures.
62
Sarbanes-Oxley Act (continued)
• 5. Analyst Conflicts of Interest. It defines the codes of conduct for
securities analysts and requires disclosure of conflicts of interest.
• 8. Corporate and Criminal Fraud Accountability. Details criminal
penalties for manipulation, destruction or alteration of financial
records. Provides protections for whistle-blowers.
• 9. White Collar Crime Penalty Enhancement. Increases penalties for
white collar crime and adds failure to certify financial reports as a
criminal offense.
• 10. Corporate TaxReturns. The CEO must sign the company tax
return.
• 11. Corporate Fraud Accountability. Identifies corporate fraud and
records tampering as criminal offenses and details increased
penalties. Lets the SEC freeze unusual transactions or payments
63