Transcript Shearman & Sterling - NYU Stern School of Business

Corporate Finance
Prof. Ian Giddy
New York University
What the Module is About...

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 4
The Decisions
that Create Shareholder Value
CORPORATE
INVESTMENT
DECISIONS
Copyright ©1998 Ian H. Giddy
CORPORATE
FINANCING
CHOICES
CORPORATE
PAYOUT
POLICIES
CORPORATE
RISK
MANAGEMENT
CREATING
CORPORATE
ECONOMIC
VALUE
Corporate Finance 8
The Goal of Financial Management

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


Possible goals: Size, market share, profits
Three equivalent goals of financial
management:
 Maximize
shareholder wealth
 Maximize share price
 Maximize firm value
Copyright ©1998 Ian H. Giddy
Corporate Finance 9
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.
Copyright ©1998 Ian H. Giddy
One
company’s
statement
Corporate Finance 10
First Principles

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.


Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
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
Minimize unnecessary financial risks.
Objective: Maximize the Value of the Firm
Copyright ©1998 Ian H. Giddy
Corporate Finance 11
The Objective in Decision Making



In traditional corporate finance, the objective
in decision making is to maximize the value of
the firm.
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.
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 12
The Criticism of Firm Value
Maximization

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.
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.
Maximizing stock price does not imply that a
company has to be a social outlaw.
Copyright ©1998 Ian H. Giddy
Corporate Finance 13
Why Maximize Stockholder Wealth?



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).
If investors are rational (are they?), stock prices
reflect the wisdom of decisions, short term and long
term, instantaneously.
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 14
The Classical Objective Function
STOCKHOLDERS
Hire & fire managers
Maximize
- Board
stockholder
- Annual Meeting
wealth
Lend
No Social
Money
Costs
BONDHOLDERS
SOCIETY
Managers
Protect
Costs can be
bondholder
traced to firm
Interests
Reveal information
honestly and on time
Markets are efficient and assess
effect on value
FINANCIAL MARKETS
Copyright ©1998 Ian H. Giddy
Corporate Finance 15
The Agency Problem



The agency relationship
Will managers work in the
shareholders’ best interests?
Agency costs
Corporate governance
Incentive issues
Control of the firm -- there is a
market for corporate control
Copyright ©1998 Ian H. Giddy
Shareholders
Board of
Directors
Managers
Allocation
of Resources
Corporate Finance 16
What Can Go Wrong?
STOCKHOLDERS
Have little control
over managers
Managers put
their interests over
shareholders’
Lend
Significant
Money
Social Costs
BONDHOLDERS
SOCIETY
Managers
Some costs
Bondholders
cannot be
can get
traced to firm
ripped off
Delay bad news or Markets make
provide misleading mistakes and can
information
overreact
FINANCIAL MARKETS
Copyright ©1998 Ian H. Giddy
Corporate Finance 17
I. Stockholder Interests vs.
Management Interests
Theory: The stockholders have
significant control over management.
The mechanisms for disciplining
management are the annual meeting
and the board of directors.
 Practice: Neither mechanism is as
effective in disciplining management as
theory posits.

Copyright ©1998 Ian H. Giddy
Corporate Finance 18
The Best Boards ...
Copyright ©1998 Ian H. Giddy
Corporate Finance 19
And the Worst...
Copyright ©1998 Ian H. Giddy
Corporate Finance 20
Illustration:
Overpaying on Takeovers



The quickest and perhaps the most decisive way to
impoverish stockholders is to overpay on a takeover.
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.
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 21
II. Stockholders' Objectives vs.
Lenders' Objectives
In theory: there is no conflict of interests
between stockholders and lenders,
including bondholders.
 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 22
1. Increasing leverage dramatically and
making existing bonds less valuable
Copyright ©1998 Ian H. Giddy
Corporate Finance 23
2. Increasing Dividends Significantly
EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES
0.5
0
t:- -12
-0.5 15
-9
-6
-3
0
3
6
9
12
15
CAR (Div Up)
CAR
CAR (Div down)
-1
-1.5
-2
Day (0: Announcement date)
Copyright ©1998 Ian H. Giddy
Corporate Finance 24
The Modified Objective Function

For publicly traded firms in reasonably efficient
markets, where bondholders (lenders) are protected:


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
For publicly traded firms in inefficient markets, where
bondholders are not fully protected


Maximize Stock Price: This will also maximize firm value
Maximize firm value, though stockholder wealth and stock
prices may not be maximized at the same point.
For private firms, maximize stockholder wealth (if
lenders are protected) or firm value (if they are not)
Copyright ©1998 Ian H. Giddy
Corporate Finance 25
Finance in the Corporation
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operations Officer (COO)
Vice President
Finance (CFO)
Vice President
Marketing
Controller
Treasurer
Cash Manager
Capital
Expenditures
Copyright ©1998 Ian H. Giddy
Vice President
Production
Credit Manager
Financial
Planning
Tax Manager
Cost Accounting
Manager
Financial
Accounting
Manager
Data Processing
Manager
Corporate Finance 26
“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?
 As a rule, it is more costly to build than to
buy—markets make better decisions than
bureaucrats
 Hence there must be some good reason,
some synergy, that makes an activity better if
done within a firm
 Eg: the production of proprietary information
 Often, these synergies are illusory
Copyright ©1998 Ian H. Giddy
Corporate Finance 27
Takeovers as a Solution to “Agency
Problems”




There is a conflict of interest between
shareholders and managers of a target
company—Eg poison pill defenses
Individual owners do not have suffcient
incentive to monitor managers
Corporate takeover specialists, Eg KKR,
monitor the firm's environment and keep
themselves aware of the potential value of the
firm under efficient management
The threat of a takeover helps to keep
managers on their toes—often precipitates
restructuring.
Copyright ©1998 Ian H. Giddy
Corporate Finance 28
Who Gains What?
Target firm shareholders?
 Bidding firm shareholders?
 Lawyers and bankers?
 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 29
The Price: Who Gets What?
Market value before deal
leaked
Value added by merger
Daimler
Chrysler
Combined
$52.8
$29.4
$82.2
$18.0
Merged Value
$100.2
Shareholders get
57.2%
42.8%
100%
Which is now worth
$57.3
$42.9
$100.2
Shareholders' shares of
the gain
Premium, as %
$4.5
$13.5
$18
9%
46%
Copyright ©1998 Ian H. Giddy
Corporate Finance 30
A Case Study: Kodak - Sterling Drugs

Eastman Kodak’s Great Victory
Copyright ©1998 Ian H. Giddy
Corporate Finance 31
Earnings and Revenues at Sterling
Drugs
Sterling Drug under Eastman Kodak: Where is the synergy?
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
1988
1989
Revenue
Copyright ©1998 Ian H. Giddy
1990
1991
1992
Operating Earnings
Corporate Finance 32
Kodak Says Drug Unit Is Not for Sale
(NYTimes, 8/93)
Eastman Kodak officials say they have
no plans to sell Kodak’s Sterling
Winthrop drug unit.
 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 33
Sanofi to Get Part of Kodak Drug Unit (6/94)

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 34
Smithkline to Buy Kodak’s Drug
Business for $2.9 Billion
Smithkline Beecham agreed to buy
Eastman Kodak’s Sterling Winthrop Inc.
for $2.9 billion.
 For Kodak, the sale almost completes a
restructuring intended to refocus the
company on its photography business.
 Kodak’s stock price rose $1.25 to
$50.625, the highest price since
December.

Copyright ©1998 Ian H. Giddy
Corporate Finance 35
Goals of Acquisitions
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost
of transaction]
 Synergy
 Gain market power
 Discipline
Example:
 Taxes
Ciba-Geigy/
 Financing
Sandoz
Copyright ©1998 Ian H. Giddy
Corporate Finance 36
Most Value is Created on the Asset
Side (Operational Restructuring)
Discounted Cash Flow (DCF) analysis
for project evaluation
 Value-Based Management for
performance evaluation

Wärtsilä NSD
(from Wärtsilä Diesel & New Sulzer Diesel
?
Copyright ©1998 Ian H. Giddy
Corporate Finance 37
Wärtsilä NSD: Consolidating
Production and Distribution
Wärtsilä NSD now has the
world’s most extensive portfolio
of heavy duty engines. Its 4stroke engines are mainly
Wärtsilä design, while the 2stroke 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.
Copyright ©1998 Ian H. Giddy
Corporate Finance 38
Wärtsilä NSD: Gains Market Power
Copyright ©1998 Ian H. Giddy
Corporate Finance 39
Sometimes, Too Late is Too Little
30
Peruvian Banks: Market Share by Deposits, %
25
BBV ACQUISITION
20
SANTANDER
ACQUISITION
15
10
Copyright ©1998 Ian H. Giddy
Nuevo
Mundo
Santander
Lima
Del Sur
Latino
Interbanc
Continental
Wiese
Credito
0
Banco de la
Nacion
5
Corporate Finance 40
Framework for Assessing
Restructuring Opportunities
Current market
overpricing or
underpricng
Current
Market
Value
1
Company’s
DCF value 2
5
Restructuring
Framework
Operating
improvements
Total
restructured
value
Financial
structure
improvements
(Eg Increase D/E)
4
3
Potential
value with
internal
improvements
Copyright ©1998 Ian H. Giddy
Maximum
restructuring
opportunity
Disposal/
Acquisition
opportunities
Potential
value with
internal
+ external
improvements
Corporate Finance 41
Using The Restructuring Framework
($ Millions of Value)
$1,000
$ 25
Current
perceptions
Gap: “Premium”
$ 975
$ 300
Company
value as is
Current
Market
Price
1
2
$ 635
Maximum
restructuring
opportunity
5
Restructuring
Framework
Strategic
and operating
opportunities
Potential
value with
internal
improvements
Financial
engineering
opportunities
4
3
Disposal/
Acquisition
opportunities
$ 1,275
Optimal
restructured
value
$ 1,635
$ 10
Eg Increase D/E
Potential
value with
internal
and external
improvements
$ 1,625
$ 350
Copyright ©1998 Ian H. Giddy
Corporate Finance 42
First Principles of Corporate Finance

Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.




Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
If there are not enough investments that earn the hurdle rate,
return the cash to stockholders.


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.
The form of returns - dividends and stock buybacks - will depend
upon the stockholders’ characteristics.
Manage financial risk
Copyright ©1998 Ian H. Giddy
Corporate Finance 43
www.giddy.org
Ian Giddy
NYU Stern School of Business
Tel 212-998-0332; Fax 212-995-4233
[email protected]
http://www.giddy.org
Copyright ©1998 Ian H. Giddy
Corporate Finance 47