Class Notes Week Ix: Reading Assignment GT Ch.19

CLASS NOTES
WEEK IX
READING ASSIGNMENT
GT Ch.19
Slides 36-47 are optional (challenge)
Alex Kane 1 IRPGEN422 Investments
Management Inside Information
and Divergent Incentives
• So far we ignored the inside information of
executives when we dealing with incentive issues
• Management statements conveying info are not
credible -- the info gap cannot be easily closed
• Shareholders must rely on accounting data
• Executives have discretion in composing the
firm’s financial statements
• All this brings to the fore the importance of
signals -- informational (credible) content of
dividends and capital structure policies
Alex Kane 2 IRPGEN424 Corporate Finance
The ITT example (1984)
• Dividends were cut by 64%
• CEO announced cut was needed to fund
investments (implying a positive NPV decision)
• Stock price fell by 32%, total loss of $1B
• Implications:
– Had cut been perceived as permanent, price would
have fallen by 64% for a loss of $2B
– Fall of 32% suggests investors estimated the deep cut
to be temporary, but assigned half of it to a
permanent decline in firm’s value
– The fall in price resulted from the new information
revealed by the cut
– Investors assigned little credibility to the CEO’s
statement
Other reasons for Less than Full disclosure
and Types of Signals
• In addition to credibility
– Information may be valuable to competitors
– Legal liability in making forecasts
– Information may be difficult to quantify/substantiate
• Substitute signals
– Dividend policy
– Stock splits and stock dividends
– Financing choices and capital structure
– Executive shareholdings
• The signals are costly: the cost is essential to the
signal, hence cannot be disposed of
Result of Signaling Element in Decisions
• Management signals to convey favorable
information, are value-reducing
• Management decisions that are intended to
increase value should be differentiated from
those that are intended to signal information
• Often, value-creating decisions will reduce stock
prices (ITT’s positive NPV decision signals less
cash from existing operations)
• Often, value-destroying decisions can be taken as
favorable signals, e.g., excess dividend, debt
Bad Decisions Conveying Favorable Signals
• It’s difficult to interpret stock price reactions to

decisions because of the accompanying signal
• If stock prices react favorably to a dividend
increase, one can interpret this as shareholder
preference for larger dividends. More likely,
price increase may be due to the information
content of the decision
• We must differentiate the substance from the
signaling intent of management decisions
How Differential Information Creates Conflict
Exhibit 19.1: Conflicting Incentives That Motivate Management
On the Conflict Between Short- and Long-
Term Value Maximizing
• The incentive conflict supports the old complaint
about U.S. corporations that became prominent
in the 1980s, when hysteria about Japanese
domination permeated the U.S. public
• If stock price driven by public info, management
will maximize relative to this info, not inside info
(intrinsic value) which is the long-run
maximizing strategy
• Keep in mind that such market friction is
inherent in a market economy. This failure can
only be mitigated, not cured, by incentive
contract design -- at significant cost
Valid Reasons for Short-/Long Term Conflict
• The conflict has three sources:
– Conflict of interest between executives (if want to
sell shares soon) and shareholders
– Signaling problems - conflict between value creation
and signals that affect current share price
– Interest of short-term oriented shareholders. This is a
preference issue, not a system design problem!
• Conflict between short- and long- horizon
constituents are prevalent in society and the
source of many a political struggle
• In countries where populace saves more the
conflict is lessened
Reasons Why Managers Worry About
Short-Term Stock Prices
• Optimal financing calls for issuing new equity
• Executives wish to sell stock
• Threat of takeover at less than intrinsic value
• Incentive compensation depends on current stock
prices
• Firm’s attractiveness to stakeholders depends on
perception of stock (falling stock prices repel
stakeholders)
• Result: Managers maximize a weighted average of
short-term and intrinsic stock value
IBM and the Joint Venture with
Motorola and Apple
• Analysts are concerned with two issues
– The value creation content of the joint venture and its
implication for the value of IBM
– The signaling implication of IBM’s willingness to
participate in the joint venture
• IBM willingness to participate isn’t
unambiguous
– Positive: A signal that IBM feels able to finance the
projects anticipated from the venture
– Negative: A signal of negative assessment of main-
frame business and IBM’s ability to go it alone in the
PC/workstation market
Management and Accounting
• Accounting research finds evidence that
managers affect earnings substantially
– Increase current earning at expense of future
earnings, using control over: depreciation schedules,
inventory valuation (LIFO/FIFO) and timing of
accrual, e.g., investments/liquidation, charges against
bad debts, estimates of life of equipment/salvage
value, cost of warranties, actuarial practices of
pension funds, interest on capitalized leases
– Smooth earnings by switching between ordinary and
extra-ordinary items
The GM Example
• Despite falling sales, GM was able to increase
reported earnings by
– 1986: raising expected returns on pension assets,
allowing decrease in contributions (annual impact:
$195 mil)
– 1987: raise estimate of useful life of plant/equip
reducing depreciation charges (annual impact $1.2B)
• Some earning-affecting accounting practices
have negative NPV (LIFO/FIFO), others affect
stakeholders (pension fund contributions)
Timing of Accounting “Actions”
• Greatest tendency to affect earnings appear to
coincide with managers’ gain -- prior to initial
and seasoned equity offerings
• Some manipulations are downwards -- prior to
union negotiations and appeal to government for
aid against foreign competitors
• Cash flows are subject to manipulation to a lesser
degree and hence used extensively by analysts.
Still, the array of possible manipulations affects
cash flow as well
Problem with Long-Term Projects
• Many long-term projects yield low CFs in early
years
• Investors can’t believe management claims that low
CFs are due to good long-term projects
• Stock prices are low until payoffs arrive
• Only if management is concerned solely with
intrinsic value, will they brave the problem
• The need to consider short-term stock prices
creates a bias against back-loaded long-term
projects
Reluctance to Undertake
Long-Term Investments (Ex. 19.2)
• Micro Industries alternative long-term strategies
Cash Flows ($ mil)
Year 1 Year 2-10 True value
• Good long-term 40 80 840
• Front-loaded 60 50 560
• Bad long-term 40 40 440
– Investors are aware of bad strategy and won’t believe
low CFs are due to good strategy. When they see 40
in Yr 1, firm value will be 440 (rising to 840 next
year). If they see 60, value will be 560
Lesson from Example 19.2
• The choice of management will depend on the
weight they assign to the short/long stock values. In
19.2, need less than .7 on short-term value to select
good strategy.
• Revisiting the U.S. Japan comparison
– U.S. managers place more value on short-term value
• Reasons: U.S. managers are
– more closely monitored by institutional investors (??)
– more subject to takeover threats
– have larger part of compensation tied to short-term
performance
– more likely to change jobs more often
• Some evidence suggests Japanese managers face
similar pressure
Excessive Dividends and Under-Investment
• Response of stock price to dividends is ambiguous
– Investors have preferences for certain dividend polices
– Dividends convey information
• Dividend informational content is problematic
– Ideally, dividends will convey information on cash flow
surprises. Hence, stock prices should respond positively
to higher than expected dividends, and vice versa
– But management will exploit this fact and tend to pay
excessive dividends at the expense of optimal investment
• GT’s section on dividend signaling models isn’t all
that clear. The topic is truly difficult. the 12
appended slides (optional) explain these rational
expectations models. Skipping these slides won’t
affect your potential grade, they are offered as a
challenge to interested students
Johnson Trucking (Ex. 19.4)
• Possible dividend and investment when op.cf=25mil
• D=$10M D=$15M D=$20M
• I = 15 I = 10 I= 5
• Intrinsic Value 220 210 200
• Market Value 190 210 215
• Intrinsic value refers to long-horizon value
• Any of the options is possible, depending on the
weights management assigns to values
• Max intrinsic value: D*=10 ; I*=15. with equal
weights: D = 15 ; I = 10.
• Market value shows investors on to div/invest
choice, but signal of greater CF dominates
Share Repurchase as Alternative to Dividends
• Absent tax/transaction cost, repurchase is
identical to dividends
• Research report on repurchase by tender offer:
– Av. tender offer =15% of shares at premium = 22%
– Av. return to sh = 16%. Is this reasonable? Yes!
P=price/share
1.16 1.15 This price is explained in

$1.00
the next slide
Announcement ExRepurchase date
Time
Calculation of value post repurchase
• Suppose pre-announcement value of firm=$A with
No. of shares outstanding=A (price=1$/share)
– Gain of 16% post-announcement (pre ex-repurchase
date) means price per share is = 1.16
– Value of firm now is $1.16A
– Repurchase expenditure =.15A(1+.22)=$.183A
($.183/share, similar to the reported 19% of firm value
repurchased)
– Ex-repurchase value of firm = (1.16–.183)A = .977A
– Ex-repurchase value per share: .977/.85=$1.1494 (1.15)
– Investor who tendered 15% of shares has .85 shares at
1.1494 = $.977
– Shareholder gain = .183–(1–.977)=.16 (16%)
Repurchase on Open Market
• Repurchase of smaller fraction of shares are
usually done on open market
• Repurchase of 3–7% of shares result in average
gain of about 3%
• This is similar to gain from initiating dividends
(after growth period with zero dividend)
• Research shows this is not all due to size of
repurchase. When repurchase is on open market,
Announcement is not legally binding to follow through
The commitment of a tender offer to sizable premium is
a strong signal
Debt as Signal: I. The Set Up
• Investors/managers are risk neutral
• There are two types of 1-Year firms
– Firm A will earn $a next period, V1A = a
– Firm B will earn $b next period, V1B = b
– True value of firms: V0A=a/(1+r)
V0B=b /(1+r)
– a > b, but only managers have this inside info
• Investors cannot differentiate A from B
– Suppose a fraction q of Firms is type A and (1–q) is B
– All firms sell for: V0=qV0A + (1–q)V0B
Alex Kane =[qa+(1–q)b]/(1+r)
23 IRPGEN424 Corporate Finance
II. Debt and Value
• Suppose firm A takes on debt with face value F
• There are no bankruptcy costs
• Next period value of A’s debt and equity claims:
– D1 = Min[a, F] ; E1 = Max[0, a–F]
– D1 + E1 = a = V1A
– MM proposition holds: V0A = D+E = a/(1+r)
• The strategy of B firms would be to issue same
debt levels as A firms, so investors still won’t be
able to distinguish between them
III. Incentive Pay to Managers
• Suppose managers’ incentive compensation is:
– M = (1+r)γ0V0 + γ1 {= V1 if V1 ≥ F
γ1 { =V1-L if V1 < F
– L represent punishment for bankruptcy (it’s as if
managers bear all bankruptcy costs)
A manager will not choose F>a (leading to BR) because:
– MA(F>a) = (1+r)γ0V0 + γ1(a–L)
– MA(F≤a) = (1+r)γ0V0 + γ1a
• But if B manager chooses F=a to fool investors
– MB(F=a) =(1+r)γ0a/(1+r)+γ1(b–L) = γ0a+γ1(b–L)
– MB(F=b) =(1+r)γ0b/(1+r)+γ1b = γ0b+γ1b
– Difference: MB(F=a)–MB(F=b) = γ0(a–b)– γ1L
– This is negative if:
Alex Kane 25 L>(a–b) γ0/ γ1
IRPGEN424 Corporate Finance
IV. Debt is a Marker of Type
• If the compensation parameters: L, γ0 , γ1 are set
so that L>(a–b) γ0/ γ1
• Managers of type A firms will choose: a ≥ FA > b
• Managers of type B firms will choose FB≤ b
• Now F is a marker of who is type A and who is
B and firm values will reflect this knowledge
• V0A=a/(1+r)
V0B=b /(1+r)
IV. Incentive-Signaling Equilibrium
• An incentive equilibrium requires that
– The signal will differentiate the players
– In spite of this, the incentives are such that none has a
motive to change the signal
• We have already seen that B has no incentive to
issue F>b and fool investors to think this is a
type A firm, because MB(F>b) < MB(F=b) when
L>(a–b) γ0/ γ1
• Obviously, type A managers will not issue F≤b
(check)
Lessons from Incentive Signaling Models
• Incentives to managers must balance current and
future levels
• When the balance is right, the signal (debt,
dividend) will differentiate “good” from “bad” firms
• Investors then bid stock prices accordingly
• The signaling equilibrium condition on the incentive
scheme is that managers will lose from issuing a
false signal to fool investors
• In realistic cases, the signal will differentiate firms,
but cannot reflect fundamentals accurately -- as in
the dividend signaling equilibrium (appended)
Credible Level of Debt (Ex.19.7)
State CF (Pr=1/3): Low Medium High Value
• CEO (Intrinsic) 300 400 500 400
• Market (V0) 250 350 450 350
• CEO Announces his assessment plus intention to
sell half his shares (k=1–k=.5)
• Financial distress costs = $60 mil
• Credible debt in the range of $250-450
• V(M) = .5 Market value + .5 Intrinsic value
• CEO wishes to raise Market value by $50 mil
• How much debt should the CEO raise?
Solution of Example 19.7
• For credibility, investors need to see:
– (1–k)E(BC) > k∆Market value (given their belief)
– If so, CEO will issue signal only if their beliefs false
• Investors estimate likelihood of financial distress
based on their assessment -- they do not use CEO’s
assessments for credibility
• Since k=.5, k∆Market value = .5x50 = 25
• Hence, E(BC) and Pr(BC) needed to balance:
– (1–k)E(BC)=.5Pr(BR)BC > 25 ; must have
– Pr(BR) > 25/(.5x60) =5/6>2/3
– Must have BR in all 3 states by investor beliefs
– Need debt of $450 mil (but less than 500 insuring BR)
– Answer in GT is wrong
Signaling model solves Example 19.7
• We can solve this problem easily:
– Management knows it’s a type A firm
– Market suspects it’s type B
– CF differential between A and B is (a–b)=50
– Preferences are such that γ0=k= γ1=1–k=.5
– here, L=E(BC)=BC x Probability of BR
– BC=60 and hence, E(BC) =60xPr(BR)
– To assure debt separates type A from B we need :
L>(a–b) γ0 / γ1 =50; 60Pr(BR)>50 => Pr(BR)>5/6
– Must have BR in all states if type B => D≥450
Adverse Selection Problems; can lead
to market for lemons
• The general idea is that one party to a transaction
has inside information about the contract/product
• The party that has no info knows the
knowledgeable party will never agree to the
contract unless it’s beneficial to it -- so the
“ignorant” party is destined to inferior position
• Result: if the problem is severe, no transaction
will take place even if can find contracts/prices
beneficial to both parties = lemon market
Owners wish to sell firm:
Similar setup as for incentive signal model
• There are two types of 1-Yr firms
– Firm A will earn $a next period
– Firm B will earn $b next period
– A and B are in same risk class
– r is the appropriate discount rate
– True value of firms: V0A=a/(1+r)
V0B=b /(1+r)
– a > b, but only owners have this inside info
• Investors cannot differentiate A from B
– A fraction q of Firms is type A and (1–q) is B
Why the Market Can Dry Up?
• Given q and no other information, investors
would be willing to pay up to
– E(V) = [aq+(1–q)b]/(1+r), knowing that in some
cases they will gain and in some they will lose
• However, investors understand that an owner of
type A firm won’t be willing to sell at
– P=E(V)< a/(1+r)
• Therefore, if a stock is up for sale at price=E(v),
it must be a type B firm -- which is overpriced
• Without a credible signal, there will be no
market for equity
Equity Issue by Existing Firms
• When an existing firm issues new equity,
investors will interpret the sale as signal that the
stock is overvalued
• Investors will be reluctant to purchase the stock
at existing value
• Absent other info-- a credible signal -- the stock
price will be bid down
• This will be avoided if investors believe the issue
is sold to raise fund for a positive NPV project
• Since investors cannot be sure, firms will prefer
to issue debt or preferred stock
Rational Expectation Models
• Such a model assumes investors solve the model
for themselves, and form expectations about data
• Management, aware of this, set up the same
model and resultant investor expectations. They
then choose the strategy that maximizes their
objective function in that same model
• This set up is not easy to implement. In many
realistic cases the model quickly becomes
intractable. The following example demonstrates
A Dividend Signaling Model:
I. The Set UP
• For simplicity we assume
– Zero interest rate and cost of capital
– Firms do not use external financing
• A firm has one more period to termination
• The stock price now is determined by: this year’s
dividend plus expectation for the terminal value
• Terminal value is determined by the level of
investment this period.
• By the identity of sources-and-uses-of-funds :
CF (no external financing) = div+investment
II. Cash flow, Dividend and Investment
• Cash flow from past investments
Expected: X*
Surprise: ε Total CF = X* + ε
Investment opportunity and terminal CF: X(I)=I+NPV(I)
Optimal investment is I*, and investing less than I*
reduces NPV by $(I*-I)rI (see next slide)
• With optimal investment: D* = X*+ ε–I*
• V0=D*+I*+NPV(I*)≡D*+I*(1+rI)
• V0 =[X*+ ε–I*]+ I*(1+rI) = X*+ε+ I*rI
• Standard MM result: Value depends on NPV
alone. Surprise component of V0 is ε
Digression: The Optimal Investment
• Why we equate: ∆NPV=∆I*(rI–r)
The optimal level of
How much will a Corp invest? investment is such that that
RiskAdjusted IRR the riskadjusted IRR of
the marginal project is r.
Marginal efficiency of At this point, reducing
capital curve (MEC) investment by $∆I will
Cost of capital (r) reduce NPV by ∆I*(rI–r).
In our example r=0.
Investment in new Projects
The lined area estimates NPV.
III. No Conflict -- Optimal Outcome
• If management has no conflict, it will maximize
value by choosing to invest I* and pay out the
residual D*=X*+ ε–I*
• Investors will be surprised by the ε component of
the dividend, and this will be reflected in the
current value of the firm: V0=D*+I*(1+rI)
=X*+ε+ I*rI
• Terminal value: V1= I*(1+rI)
• It won’t matter whether you sell now or later,
wealth is same (check). Hence, no conflict
IV. The Conflict and Resolution
Suppose investors cannot observe ε
They know, however, the optimal investment, I*
Some investors have a short horizon and they care only
about V0 , that is, V(S)=V0
Other investors have a long horizon and care about the
dividend now and terminal value V(L)= D + V1
Since div policy can affect V(S)≠V(L), a conflict arises
Management cares about both V(S) and V(L), and/or is
driven by incentives based on both. Suppose they
assign weights k to V(S) and (1–k) to V(L)
V(M) = kV0+ (1–k)(D + V1)
Management will choose D and I to maximize V(M)
V. More About the Resolution
• Management program is: Maximize V(M) using
D,I, But once they set D, I= X*+ ε–D
• Management knows investors don’t observe ε
– If dividend increases V0, $ for $, and loss from not
investing the $1 is only rI<1 (100%), then the gain
from excessive dividend will be greater than the loss
from reduced investment
• Therefore, unless k very small (unlikely)
– the optimal dividend will be larger than D* and I<I*
– V0 will be inflated
– V1 (terminal value) will be lower
• Management will maximize V(M) wrt amount
of dividend above D*
VI. Investors are No Fools
• Not knowing ε and aware of the temptation of
management to increase dividends at the expense
of optimal investment:
– investors must bid down the value of the firm (V0) to a
point where it’s no longer clear whether it’s too high
– Otherwise, if it’s clear firm’s value is too high, both
long- and short-horizon investors will sell now
– Equilibrium V0 must reflect this notion
• Even if incentives happen to be balanced and
D = D* investors wouldn’t know! (Since they
don’t know ε, they don’t know when D=D*)
VII. Investor Response
• Expected dividend is E(D)=X*–I*
– Hence, div surprise is: D–E(D)=D–(X*–I*)≡γ
– under-investment = I* – I = γ–ε (unknown to investors)
– Investors must believe γ>ε. Suppose they believe sγ
is“fluff” and only (1–s)γ = ε,
– they belive under investment is: I* – I = sγ
• True terminal value is: E(V1)=[I*–(γ–ε)] *(1+rI)
– True ∆V(L) = γ– (γ–ε)(1+rI). Believed to be: γ– sγ(1+rI)
• Current value is affected by div and believed E(V1)
V0 = [Div] + E(V1)= [E(D)+γ]+E(V1)
=[X*–I*+γ]+(I*–sγ)*(1+rI)
=X*+ I*(1+rI) + γ[1–s(1+rI)]
• So V0 = V(S), and ∆V(S) = γ[1–s(1+rI)]
VIII. Management optimization
Management maximizes: k∆V(S)+(1–k)∆V(L), using γ
∆V(M)= kγ[1–s(1+rI)]+(1–k)[γ–(γ–ε)(1+rI)]
= γ[1–(1+rI)ks)]+(γ–ε)(1+rI)(1-k)
as γ rises from γ=ε, when rI is still small (near zero),
∆V(M) increases with k (short-term incentive)
∆V(M) decreases with s (investor punishment)
∆V(M) decreases with rI (cost of under-investment)
and, since rI gets larger as investment falls, ∆V(M)
decreases with γ at some point, when rI is large enough
In sum, ∆V(M) increases with γ at the beginning, when rI
is small. But at some point, rI becomes sufficiently large
IX. Result of Management Optimization
• Ideally γ = ε, but there is no hope for that since s
cannot be set to exactly entice management to set γ=ε. All
we can hope for is that s will act so that γ will be
pushed down so that it will be increasing in ε
• An equilibrium level of s is such that: If a firm’s
surprise dividend (γ) is greater than a similar firm’s,
investors know it has a larger ε. Only then a solution
for the rational expectations model exists
• Conditions for existence of a signaling equilibrium
is not guaranteed. We can only hope they’re met,
and empirical studies must convince us this is so
X. Signaling Equilibrium - Summary
• Investors must apply same s to all firms
• Firms have different levels of ε, so can’t get all of
them to invest optimally
• s will be set so that, given the distribution of ε
across firms, the dividend surprise (γ) will order
firms by their level of ε (fundamentals)
• Firms with larger ε will have a better surprise γ
• In this equilibrium, any dividend surprise will,
justifiably, result in increased stock value, but the
increases will, in general, not accurately reflect
fundamentals
• In general, firms will under-invest. This can be
mitigated by better fundamental analysis!!

Class Notes Week Ix: Reading Assignment GT Ch.19

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CLASS NOTES

• It’s difficult to interpret stock price reactions to

Exhibit 19.1: Conflicting Incentives That Motivate Management

1.16 1.15 This price is explained in

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