Corporate Governance

Part II

Presented by:

Moksh Walia

Takeovers Capital Structure of firms Market systems

Flow of the Presentation

Corporate Governance - Takeover

“ Differences in information and expectations between raider and shareholders may permit profits to be achieved by the entrepreneur “

“ Takeover can be a vehicle of efficiency or rent seeking”

Why do Takeovers happen?

When the management of a dispersed corporation is judged by an outside entrepreneur to be inefficient, the advantages of establishing a controlling interest arises.

However, where information is publicly available scope of entrepreneurial action is limited.

Entrepreneur & Takeover

Small shareholders may want to free ride by not selling their stocks for potential gains if the deal goes through.

They think that their refusal will not affect the chances of deal going through

A solution to the free-rider problem could be exclusion of minority stake holders from the benefits brought by takeover. However, this may increase the cost of pursuing the takeover.

Takeover & free rider problem

Bidders have to share a lot of gains through takeover with shareholders of the target firm

The challenge lies in finding an optimal bid. The probability that a bid will succeed rises with the size of the initial holding.

Minority stake holders should provide monitoring services up to the point at which the marginal private benefits equal the marginal private costs.

Takeover & Minority Stake Holders

Rent Seeking Contract renegotiation Social losses In future reduces the scope of beneficial

and efficiency enhancing contracts

Takeover & Hold up/Breach of faith

Outside shareholders may not know true internal state of the firm (Information Asymmetry)

Signaling (Dividend payments) Market perceptions Existence of takeover threat combined with

information asymmetry can result in wasteful signaling and short-termism.

Existence of informed raiders and fear of job loss both push managers in the direction of greater market signaling

Adverse selection, Short-Termism & Takeover

Dividends can be considered as a way of reducing information and monitoring costs to shareholders.

The truly good firm would always signal in ways bad ones could not match.

Moral Hazard, Monitoring Costs & Takeover

Adverse Selection Problem High take over cost discouraged signaling &

permitted resources to be devoted to long-term investment

Low takeover cost led to wasteful signaling and short-termism.

Moral Hazard Problem High takeover costs implied that a reputation for

payment of regular dividends was necessary Low costs of asserting control and enforcing distribution when managers misuse funds would make such a reputation less necessary.

Low takeover cost produce dividends as commitment to minimum performance

Either way, asymmetric information has consequences for long-term investment

Capital markets make symmetric mistakes in valuing assets.

Capital-market pressures lead managers to act myopically

Stock prices will not reflect ‘inside’ information and pressures from takeover might result in managers acting in a short-termist way.

Capital Market Efficiency & Takeover

Supermajority Amendments Dual-Recapitalizations Poison Pills Greenmail Golden Parachutes

Defences Against Hostile Takeovers

Takeover wave of the 1980s (takeover, divestment, MBO)

Moral hazard & Fee Cash-Flow Theory Junk bonds – In a study the proportion of

equity held by managers was found to be main determinant of performance

Gains in Target and Bidding Companies

Takeover & Economic Efficiency

Corporate Governance - Capital Structure

In costless & perfect market conditions, the means of finance is irrelevant to the firm’s valuation and there is no particular ‘optimal’ financial structure.

The market prices of stocks and bonds will so adjust that firms with the same risk and return characteristics will have the same total market valuation, irrespective of their financial structure.

Similarly, it can be shown that firm’s policy on distribution will not affect its value.

Critics say, theory on financial structure cannot be based upon assumptions of costless and frictionless markets with full information. Moral hazard, adverse selection & bounded rationality problems play an important role.

Modigliani-Miller Theorem

Outside equity reduces the value of the firm and results in ‘Agency Cost’.

Agency costs are associated with the use of debt as well. Mangers tend to take more risks.

The benefit of equity is a more widely diversified portfolio. The optimal amount of outside financing will be reached when the marginal benefits from increased diversification equal the marginal agency costs incurred.

Agency Cost Theory

P

E’

T

D’

D

T’

EA

gency

Cost

D*/(D*+E*)

D/(D+E)

Non-Contractibility Short-term debt & project liquidation Long-term debt & new investment Bounded rationality

Agency Problem, Debt & Hart-Moore Theory

Corporate Governance – Market System

US & UK (Market Oriented) Relationship between shareholder & firm is

very impersonal & distant. Low incidence of direct monitoring Control rights and residual right are seldom

separated Effectiveness of control mechanism is

questionable if flow of information reaching auditors & outside directors is controlled by management

Bank Oriented Vs Market Oriented

Japan (Bank Oriented) Shareholders are ‘insiders’ Investing institutions are not independent Banks which give loan will also have stake in the

firm Implicit agreements to hold shares as friendly

and passive ‘insiders’ are widespreadGermany Continuity of control is greater than market

oriented system. Public companies can issue non-voting shares Two tier board structure for worker representationThere is a split of control and residual rights

Bank Oriented Vs Market Oriented

Thank you!