SMB2F2 3

MBA-0000
Strategic Financial Management
Block
3
STRATEGIC ENVIRONMENT ANALYSIS
UNIT 9
Industry Analysis, Financial Policies and Strategies
05
UNIT 10
Information Asymmetry and the Markets
for Corporate Securities
16
UNIT 11
Managerial Incentives
43
UNIT 12
Decision Support Models
74
Expert Committee
Dr. J. Mahender Reddy
Vice Chancellor
IFHE (Deemed University), Hyderabad
Prof. P. A. Kulkarni
Vice Chancellor
Icfai University, Dehradun
Prof. Y. K. Bhushan
Vice Chancellor
Icfai University, Meghalaya
Dr. O. P. Gupta
Vice Chancellor
Icfai University, Nagaland
Dr. Lata Chakravorty

Director
IBS Bangalore
Prof. D. S. Rao
Director
IBS Hyderabad
Prof. P. Bala Bhaskaran

Director
IBS Ahmedabad
Dr. Dhananjay Keskar

Director
IBS Pune
Prof. P. Ramnath
Director
IBS Chennai
Course Preparation Team

Shri T. S. Rama Krishna Rao
Icfai University
Prof. Hilda Amalraj

IBS Hyderabad
Dr. M. Syambabu
Icfai University
Prof. Bratati Ray

IBS Kolkata
Ms. C. Padmavathi
Icfai University
Dr. Vijaya Lakshmi S

IBS Hyderabad
Ms. Sudha
Icfai University
Dr. Vunyale Narender

IBS Hyderabad
Ms. Sunitha Suresh

Icfai University
Prof. Arup Chowdhury

IBS Kolkata
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BLOCK 3
STRATEGIC ENVIRONMENT
ANALYSIS
This block extensively covers strategic environment analysis. It briefly discusses

industry analysis and analysis of strategic environment of a firm. This unit also covers
information asymmetry and managerial incentives. There are various decision support
models to take timely decisions. All these are covered in this block. This block consists
of four units.
Unit 9 deals with the dynamics of Asset-Liquidity, Leverage Styles, Managerial Agency
Cost and strategic points in fixing managerial compensation. An industry may have an
optimal debt capacity even though individual firms within the industry do not. This
happens as a result of bankruptcies and liquidations within the industry, when it is
depressed. Hence, the assets are sold at fire sale prices. The future expected cost of
financial distress and bankruptcy increases thereby limiting the composite debt capacity
in the industry.
Unit 10 covers issues relating to information asymmetry and the problem of
simultaneous information which have always been influencing factors in a firms debt
as well as equity markets, its ownership structure, capital structure and dividend
policies.
Unit 11 covers the insides of managerial incentives. The degree to which the managerial
incentives match with that of the shareholders depends upon the time the managers
spend on the job and the number of shares they own. Firms with concentrated
ownership are likely to be better monitored and are hence better managed. However, the
cost of having a less diversified portfolio is borne only by the large shareholder.
Unit 12 titled Decision Support Models covers the Modelling Process, Financial
Modelling, Marakon Model, Alcar Model, and McKinsey Model. Corporate decisions
are affected by a large number of variables. Many-a-times, the interlinkages between
these variables, and their resultant effect on the decision are extremely complex.
Decision-support models are tools used to spell out the relationships clearly in order to
help the management arrive at the optimal decision.
UNIT 9 INDUSTRY ANALYSIS,

FINANCIAL POLICIES AND
STRATEGIES
Structure
9.1
Introduction
9.2
Objectives
9.3
Principal Agent Conflicts in Industry Setting
9.4
Designing Executive Compensation as a Competitive Strategy
9.5
Joint Ventures and Strategic Alliances
9.6
Summary
9.7
Glossary
9.8
Suggested Readings/Reference Material
9.9
Suggested Answers
9.10
Terminal Questions
9.1 INTRODUCTION
Keeping in mind the framework within which a firm operates, there are certain factors
that affect a firms profitability and risk, and in turn the financial policies and strategies.
The decisions that are taken in the organization reflect the features and dynamics of the
industry as a whole rather than the company as such. In this unit, dynamics of
Asset-Liquidity, leverage styles, Managerial Agency Cost and strategic points in fixing
managerial compensation, and joint ventures are discussed.
9.2 OBJECTIVES
After going through the unit, you should be able to:
Understand the dynamics of Asset-Liquidity and Financial Strategy;
Realize the implications of Managerial Agency Cost;
Know the Competitive Strategy in Designing Executive Compensation; and
Analyze Joint Ventures and Strategic Alliances.
9.3 PRINCIPAL AGENT CONFLICTS IN INDUSTRY SETTING

Studies in corporate agency have yielded certain new dimensions. Say for example, a
manager reduces his personal welfare, and then based on his firms capital structure, he
may go on picking some excessively risky projects thus sacrificing profitable projects
and consuming dissipative perks. Apart from a few stray cases, normally results have
been derived by viewing a firm in isolation rather than considering the industry as a
whole in the equilibrium state. Further, it has been seen that if the firms within the
industry operate and compete in a product market, then the very nature of the
equilibrium may be different. This is a clear suggestion of the fact that these standard
predictions lack the well defined empirical content. Thus, it can be safely said that there
is yet much to be seen on how the theoretical concept can explain the limited evidence
on the financial and industrial structure. These evidences may include the correlations
between the profitability of the firm, its physical capital as well as the book value of the
debt. Williams had formulated a model relating to industry equilibrium that takes into
account the agency costs due to both the shareholder management as well as the
shareholder creditor conflict. William had earlier postulated that the equilibrium in an
industry shows the effect of agency cost of managerial discretion on capital investment.
There will always be certain firms that possess the potential to raise external capital so
as to carry on the profitable capital investments, whereas there will also be the existence
of firms which cannot avoid their dissipative perks and so cannot pursuit such ventures.
Thus while, on one hand, the resulting industry will be characterized by the firms that
are large in size, highly levered and capital intensive, as well as having high profitability
on the other hand, there will be firms that are smaller in size, more labor intensive in
nature, relatively unprofitable with almost very less degree of leverage. In the model
propounded by Williams, the following consequences can be observed. The model
states that each of the firms within the industry can produce a homogeneous product
with the help of either of the two available technologies, one being the labor intensive
that involves zero initial investment but carries a higher variable cost of production and
the other being the more capital intensive technology. The capital intensive firm raises
capital by means of selling bonds and stocks in a perfectly competitive capital market.
With the existence of these two critical parameters some of the firms get into the
equilibrium by way of foregoing the investments with their net present values. It is to be
remembered that more and more managers would like their firms to invest, but they are
unable to raise the required capital from outside investors due to their lack of
creditworthiness. Now these foregone investments having positive net present values,
the capital-intensive firms earn positive profits in equilibrium. But on the other hand,
the more labor intensive firms can have negative NPVs after taking into account their
cost of entry. This foregone investment is the result of the competition existing within
the industry and not a case of isolated investment. The capital-intensive firms are
characterized by larger size and less of risk involvement as compared to the labor
intensive investments. At the same time there will always be some optimal debt for the
capital-intensive firms though this level of optimal debt may vary from one firm to the
other. Though it is known that the cost of entry converges to zero, there will be certain
capital-intensive firms that will continue earning extraordinary profits and at the same
time there will be labor intensive firms, which may fail to earn profits and thus make an
exit. Thus it can be said that one can find concentration of firms even with marginally
small cost of entry. The main reason that can be attributed to this is the access to capital,
which is another form of entry barrier.
6
Industry Analysis,
Financial Policies and Strategies
DYNAMICS OF ASSET-LIQUIDITY AND FINANCIAL STRATEGY

Sheifer and Vishy in their theoretical paper focuses on the problem of liquidating the
assets of a firm that are under distress as well as a firm that has gone bankrupt.
The paper is built on the premise that the distress and failure are more likely to occur
where the entire industry within which the firm operates is in distress. The analysis of
the paper is more closely related to the tradeoff theory from the point of view of an
industry. Let us here probe into what actually determines the liquidation value of the
assets with a stronger focus on the potential buyers of the assets. A firm which is
undergoing financial distress has the need to sell off its assets, its industry peers also
might undergo similar problems. This leads to the fact that the assets are forced to be
sold at a price that is much below its price when it was best in use. This makes the value
of the assets much cheaper in bad times, which ex ante signifies a private cost of
leverage. In the following sections, the example of asset buyers is taken in order to explain
the variation in debt capacity across the industries as well as over the business cycle, further
the discussion concerns the rise in the US corporate leverage in the 1980s. One of the
integral components that determine the cost of financial distress is asset liquidity. The
theoretical paper as stated earlier focuses on economy and industry wide determinants of
asset liquidity. The following conclusions could be drawn from the paper:
i.
It is not always necessary that the asset liquidation process, be it through an

auction or any other form of sale, allocates the asset to the users of highest value.
This may result in those assets that have no alternative use fetching prices below
the value in best use, when they go out in times of industry wide recession or in
times the industry buyers cannot bid for the assets due to industry set guidelines.
Such a situation can involve substantial private as well as social costs.
ii.
The asset liquidity limits the optimal debt levels. If the cash flow volatility is held
constant, the cyclical as well as the growth assets have a lower level of debt finance,
following on the same line, the multi decimation firms and the conglomerate firms
have a higher optimal debt level at the same level of cash flow volatility.
iii.
The paper further concludes that the optimal level of debt or rather leverage of
any firm is dependent on the leverage of other firms in the industry within
which it operates. It is to be noted that the industry itself might have an
optimal debt capacity even when the individual firms might not.
iv.
As a result, the asset liquidity and in true the optimal debt levels change over
time.
v.
As per the statistical evidences, there has been a consistent increase in the
leverage of companies during the 80s both by firms involved in corporate control
transactions and by other firms too. The major reason that can be cited for this is
the liquid market for corporate divisions. The liquid market for division was a
result of certain exogenous factors. These factors include antitrust enforcement
and the influx of foreign buyers as well as of an important self reinforcement
component. The positive prediction made on account of liquidity and debt
capacity resulted in the same.
Let us now shift our focus towards the several theoretical and empirical studies that
consider the firms financial decisions as an integral part of its overall competitive
strategy.
LEVERAGE AGGRESSIVENESS VS POSSESSING A LONG PURSE
The theoretical research paper that has come of late focuses on the effect of product
market competition on a firms capital structure.
These research works have thus resulted in two principle hypothesis. The first can be
referred to as leverage aggressiveness hypothesis or strategic commitment, and the
other is the long purse hypothesis, the former was developed by Brander and Lewis
(1986) and Maksimovic (1988). This particular hypothesis postulates that the
component of leverage in a firm helps it in boosting the firms growth
vis--vis to that of its industry competitors. The main reason being, the firm, via its
leverage, goes for aggressive competition in the product markets. This results in the
less aggressiveness of the shares yield in their market. Let us come to the other
hypothesis, better known as long purse hypothesis, developed by Fester (1966), which
states that the firm might deliberately go for low leverage so as to be able to pursuit
major market share by adopting predatory market strategies and thereby put a major
levered rival in the back seat, even to the extent of going bankrupt. Compello, in the
year 2002, comes with another hypothesis that is consistent with both the above stated
strategies. This hypothesis finds consistency with the leverage hypothesis by stating
that the growth of a firm is positively related to its leverage. Further the hypothesis
speaks of a relationship that is consistent only in industries where the leverage varies
widely across the firms. This hypothesis also states that the relationship between the
leverage of the firm and the growth tends to get reversed in times of recession that
speaks of the fact that in difficult times the levered firm may be prone to predatory
market strategies of the less levered rivals. Here, the ten levered rivals refer to those
firms that have long purses.
Self-Assessment Questions 1
a.
What will be depicting of equilibrium in an industry accounting to William?

..
..
..
b.
What is the hypothesis postulated in leverage aggressiveness hypothesis?

..
..
..
Industry Analysis,
MANAGERIAL AGENCY COST COST OF COMPETITIONS

AGGRESSIVENESS STRIKING A BALANCE
Boltom and Scharfsteen in 1990, in their theoretical model of industry equilibrium, have
raised the argument that an individual firm, operating in a competitive industry is
required to tailor its financial policies as per its desired competitive position in the
product market, keeping in mind the firms capital structure decisions. The papers
remind us of Jensens free cash flow argument as stated in 1986. This argument states
that the firms board should compel the issue of debt so as to soak up free cash flow and
thereby frustrate the managements incentives to overinvest. But it is also to be kept in
mind, that within the context of competitive industry, a firm becomes more vulnerable
towards those market strategies that are aggressive in nature. This vulnerability may
be the result of the increase in leverage. The ultimate result of this leads to the
increase of the firms risk towards failure. So, one has to remember that the firm
should increase leverage till the time where the marginal benefits accrued due to the
reduction in managerial agency cost and the marginal costs of competitors
aggressiveness strikes a balance.
RETAINING THE OPTION TO INCREASE IN LEVERAGE
Another model relating to the equilibrium in a competitive industry was developed in
1997 by Fries, Miller and Perraudin. This model has its implications for a firms
optimal capital structure. The model developed by these lets the firm enter into, as well
as exit, from the industry. But at the same time it is seen that the firms initial capital
investment is irreversible. The model is based on the assumption that the net fax
advantage of debt is more than the bankruptcy costs, so that the debt has a net advantage
over the equity capital.
But due to the existence of the free rider problem, it is not possible for the firms to
decrease the amount of debt in their capital structure in periods of time though it is
possible for them to increase it. This model gives several interesting insights relating
to the capital structure of the firm in the industry, more than that, the author shows
that the optimal initial capital structure for a firm is depended on the demand
elasticity for industry output. But at the same time, the firms maintain various options
to increase the leverage in an opportunistic way. In a similar discussion, Maksimovic
in 1990, stated the importance of the type of loan contract that the firm may receive
from a bank, based on the premise that the firm operates in a competitive industry.
The commercial loan contracts are basically of two types, one being a simple loan and
the other being a commitment contract. The former carries no commitment on the part
of the bank to lend any additional loan amount to the firm in future. In the former type
of loan, the firm can borrow immediately and even has the option to borrow any
further amount in the future at a predetermined interest rate. The commitment contract
provides a valuable option to the firm. Here, the firm is required to pay a substantial
fee to a bank so as to secure a loan commitment. Now, an obvious question that
comes into the forefront is that, why at all a firm should pay any fee to secure a
commitment contract rather than go for a security with simple loans with the banks
over a period of time when the firm would require the funds. The author of the paper
(Maksimovic) puts forth the argument that, a firm can take help of a loan commitment
as a strategic tool, in order to compete more effectively against industry rivals. Let us
now see how at all this issue can be explained.
9
Let us consider here the case of a firm A, that is competing with its rivals in an
industry, where the future market demand for the industry output is not certain, now,
say all the firms within the industry produce their initial composite output capacity as
per the current market demand. It may happen later that this market demand fluctuates
in either direction. Now, say the market demand rises, those firms that are in a position
to increase their output quickly will gain the market share, whereas the other firms stand
to lose. On the other hand, if the market demand falls, any firms that have earlier
promised to outsize their output capacity may have to suffer substantial losses and may
even turn out to be a failure. So, in brief, it can be said that the loan commitment allows
a firm to be more flexible in terms of its financials, thus letting it, to compete
strategically in a competitive and uncertain product market.
USING THE DEBT TO PROHIBIT ENTRY
As propounded by Jensen (1993) and supported by Kaplan et al, the leveraged takeovers
and buyouts result in an increased profitability, there are other models that give the
same results even though their profoundness has not considered the element of tax
incentive for debit. Thus it can be said that an incumbent firm may prevent itself an
entry into the industry by the increase in its leverage.
RELATIONSHIP BETWEEN FINANCIAL DECISIONS AND PRODUCTION
AND PRODUCT MARKET DECISIONS
Several research papers have stated that there exists a clear level of interaction between
the firms production and product market decision with that of its financial decisions.
Say for example, many of them have come out with the fact that the firms product
quality, pricing and warranties is depended on the firms risk of bankruptcy. If there is a
substantial bankruptcy for a firm because of increased leverage, it may opt for cutting
costs. This it will do, at the cost of its product quality, as a result its product warranties
may be of little value to its purchasing consumers. If viewed from another angle, the
firm may intentionally increase its leverage, and in turn its bankruptcy risks, and it may
use this as a means of securing concessions from its employees, suppliers or customers.
There has been enough evidence of the existence of the effect of financial decision on
the production and product market decision of a firm. In a particular study mode by
Phillips (1995), the pricing and productions decisions of four industries have been done.
These industries have recently increased their financial leverage to a considerable
degree. In three out of these four industries, it was found that the industry output was
negatively related with the average debit ratio of the industry. Further it was seen that,
with these leverage increasing recaps, the incentives to the managers in order to
maximize shareholders wealth had increased substantially. The firms were found to
increase their profit margins and decrease outputs, which reflected that the increase in
leverage decreased the agency cost and also inefficient investment. At the same time it
was seen that, the firms within each of these industries increased their leverage
simultaneously. Thus it can be safely said that the rival firms operating in a particular
industry should respond as a coherent unit as far as financial decisions are concerned.
This will ultimately result in greater efficiency to the firms.
9.4 DESIGNING EXECUTIVE COMPENSATION AS A

COMPETITIVE STRATEGY
10
Industry Analysis,
It is to be remembered that the component of incentives in an executive compensation

contract helps in bringing together the interest of the executive with that of the firms
shareholders. In normal cases, the executives compensation contracts include incentive
tools that motivate the management to either increase the firms earnings or its share
price. If the Reitmans (1993) model is taken into account, it is seen that the optimal
compensation plan not only includes the profit incentives and grants of stock, but also
stock options. These stock options act as a deterrent to the overly aggressive behavior of
the management. If not, the aggressive behavior might merge from the firms
competitors by competing in difficult situations. The main reason that can be attributed
to the stock options in acting as a barrier towards the aggressive behavior of the
management is due to its non-linearity. The value of the stock option is nothing once the
stocks price falls below its strike price. Thus it can be judged by intuition that, the
option of a particular firm will only be in the money if the competitor firm abstains
from producing too much. This lets the owners of the firm to allow their managers in
playing more aggressively if the competitor firm behaves similarly, but to counteract
with maximizing its sales if it is faced by overly aggressive behavior.
In other words it can be said that, if the managers in two different firms that are
competing with each other are given stock options, there will be at least some chances
that both of them will opt for competing less aggressively, instead of violently engaging
themselves in mutually destructive research paper. Agarwal and Samwick have found
an appropriate answer to the question as to why it is always found that the compensation
contracts tend to blind the managers compensation to the firms absolute performance
rather than focusing on other performance that is relative to its industry competitors. It
seems strange in explaining the fact that the manager of high profit earning industry gets
considerable amount of bonus, whereas the manager in an industry that makes lower
profits gets lower performance bonuses even when such lower profit making industry
outperforms its competitors. The answer that the authors of the paper give is that, the
relative performance incentives affect the firms competitive strategy in a way that
lessens the returns to the shareholders. The very fact that there is absence of relative
performance based incentives where the compensation decreases with rival firms
performance can be explained from the existence of the strategic interaction within the
firms. The very fact that there is a need to soften the product market competition gives
rise to an optimal compensation contract that gives rise to a positive effect on both the
firms own as well as its rival performance. At the same time, those firms that are in a
more competitive industry puts a much greater weight on its competitive firms
performance roped to its own performance. The paper thoroughly examined the actual
executive compensation contract, and found out evidences that were in line with their
arguments.
9.5 JOINT VENTURES AND STRATEGIC ALLIANCES
11
As we were almost close to our discussion on the financial strategies and policies in the
contract of an industry, let us speak about two types of co-operative relationships that
have been quite often seen among two firms in a given industry.
The first being joint venture, and the other being strategic alliance. Both of these
relationships take into account the sharing of some of the resources of both the
interacting firms for a certain temporary span of time. Further, the cohesion is formed so
that both the units can take advantage of competing in a more effective way in the
common industry within which they operate. They can even find solutions to the interfirm contracting problems; go on for reducing the trade risk at key stages of the
industry. They can reap the advantages of developing a new market; start the
distribution network for the new product or service. Ultimately, they can represent a
partial combination of corporate resources. In a way they can be distinguished from a
merger or acquisition, where one finds a complete and permanent combination of the
two firms. The joint ventures in fact involve a more systematically drawn arrangement
that involves the creation of a jointly owned private firm.
a.
Illustrate the relationship between Financial Decisions and Production and

Product Market Decisions.
.
.
..
b.
Explain the advantages of Joint Ventures.

.
.
..
On the other hand, in a strategic alliance there is simply the pooling of specific
resources between the firms. There have been several studies done on this which found
out that the market generally reacts in a positive way to the announcement of a strategic
alliance. Further, it was also seen that with the announcement of horizontal alliances,
there had been greater transfer or pooling of technical knowledge which tends to
produce larger wealth effects than marketing alliances. These results are suggestive of
the fact that alliances add the maximum value by allowing the firms to maintain the
focus of their businessmen by the use of complimentary technical skills of the similar
partner firms.
9.6 SUMMARY
12
Industry Analysis,
Agency theory suggests that firms in an industry shall be grouped into two. One would
consist of large, capital intensive, levered and highly profitable firms and the other
group shall consist of small, labor intensive, less levered and less profitable firms.
As a result of the asset substitution problem associated with debt, the firms would come
under two major segments one would consist of highly levered firms who would
pursue more profitable projects and the other group shall consist of firms with low
leverage and will pursue less risky projects.
An industry may have an optimal debt capacity even though individual firms within the
industry do not. This happens as a result of bankruptcies and liquidations within the
industry, when it is depressed. Hence the assets are sold at fire sale prices. Hence the
future expected cost of financial distress and bankruptcy increases thereby limiting the
composite debt capacity in the industry.
A firms leverage should be set to balance the managerial agency costs (which
decreases as the firms leverage decreases) with the costs associated with competition in
terms of product market strategy (which increases with the firms leverage).
The executive compensation contracts should reflect the firms industry relative
performance as well as absolute performance, depending upon the level of competition
in an industry.
A firm in a competitive industry should maintain excess debt capacity as a matter of
competitive strategy.
Leverage can be used to create a barrier to the entry of rival firms in an industry.
Co-operative relationship among firms, like joint ventures and strategic alliances are
becoming means to compete effectively in an industry.
9.7 GLOSSARY
Absorption is a type of merger that involves fusion of a small company with a large
company. After the merger, the smaller company ceases to exist.
Asset Acquisition involves buying of assets of another company. The assets may be
tangible assets like a manufacturing unit or intangible assets like brands.
Asset Sales involves the sale of tangible or intangible assets of a company to generate
cash.
A Joint Venture involves two companies coming together and forming a new company
whose ownership is shared. Usually MNCs use this strategy to enter into a foreign
market.
A Leveraged Buyout happens when a buyer lacks the requisite cash to finance the
acquisition. The buyer, therefore, borrows money against the target companys assets or
cash flows to fund the acquisition.
9.8 SUGGESTED READINGS/REFERENCE MATERIAL

13
Brealey Myers. Principles of Corporate Finance. 6th ed. US: Mcgraw-Hill

Companies Inc., 2000.
James C. Van Horne. Financial Management and Policy. 11th ed.

US: Prentice-Hall, 1998.
Eugene F. Brigham, and Michael C. Ehrhardt. Financial Management Theory

and Practice. 12th ed. US: South-Western College Publishers, 2007.
Prasanna Chandra. Financial Management Theory and Practice. 6th ed.

New Delhi: Tata Mcgraw-Hill, 2004.
9.9 SUGGESTED ANSWERS

a.
William had postulated that the equilibrium in an industry shows the effect of
agency cost of managerial discretion on capital investment. There will always be
certain firms that possess the potential to raise external capital so as to carry on the
profitable capital investments, whereas there will also be the existence of firms
which cannot avoid their dissipative perks and so cannot pursuit such ventures.
b.
This particular hypothesis postulates that the component of leverage in a firm

helps it in boosting the firms growth vis--vis to that of its industry competitors.
The main reason being, the firm, via its leverage, goes for aggressive
competition in the product markets. This results in the less aggressiveness of the
shares yield in their market.
a.
The firms product quality, pricing and warranties is depended on the firms risk of
bankruptcy. If there is a substantial bankruptcy for a firm because of increased
leverage, it may opt for cutting costs. This it will do, at the cost of its product quality,
as a result its product warranties may be of little value to its purchasing consumers.
b.
Joint ventures helps to share some of the resources of both the interacting firms
for a certain temporary span of time. Further, the cohesion is formed so that both
the units can take advantage of competing in a more effective way in the
common industry within which they operate. They can even find solutions to the
inter-firm contracting problems; go on for reducing the trade risk at key stages of
the industry. They can reap the advantages of developing a new market; start the
distribution network for the new product or service.
9.10 TERMINAL QUESTIONS

A. Multiple Choice
1.
2.
14
Separation of ownership and control is a problem especially common for

____________.
a.
Small, privately held corporations
b.
Non-profit businesses
c.
Large, publicly held corporations
d.
Proprietorships
e.
Limited partnerships.
In terms of increasing risk to the investor, the proper ranking would be _______.
Industry Analysis,
3.
4.
a.
Common stock, preferred stock, secured debt
b.
Long-term government debt, subordinated debt, common stock
c.
Long-term government debt, secured debt, preferred stock
d.
Secured debt, common stock, preferred stock
e.
Subordinated debt, preferred stock and common stock.
In terms of decreasing return to the investor, the proper ranking would be _____.
a.
Common stock, long-term government debt, preferred stock
b.
Long-term government debt, common stock, preferred stock
c.
Preferred stock, common stock, secured debt
d.
Common stock, secured debt, treasury bills
e.
Common stock, long-term government debt, preferred stock.
A _________ is a merger between firms operating at different but related levels

in the production and marketing of a product.
5.
a.
Conglomerate merger
b.
Cooperative
c.
Joint venture
d.
Vertical merger
e.
Horizontal merger.
The person who assumes full co-ownership of a business, including unlimited

liability is a __________.
a.
Sole proprietor
b.
Stockholder
c.
Shareholder
d.
Limited partner
e.
General partner.
B. Descriptive
1.
What are the determinants of asset liquidity?
2.
How does designing Executive Compensation will become Competitive

Strategy?
3.
How does Joint ventures and strategic alliances reduce the risk?
These questions will help you to understand the unit better. These are for your
practice only.
15
UNIT 10 INFORMATION ASYMMETRY

AND THE MARKETS FOR
CORPORATE SECURITIES
Structure
10.1
Introduction
10.2
Objectives
10.3
Management Incentives for holding Information
10.4
Economic Theories of the Effects of Information Asymmetry
10.5
Basic Cause of Information Asymmetry
10.6
Measurement of Quality of a Trading Stock
10.7
Pecking Order Hypothesis
10.8
Summary
10.9
Glossary
10.10 Suggested Readings/Reference Material

10.11 Suggested Answers
10.12 Terminal Questions
10.1 INTRODUCTION
Issues relating to information asymmetry have always been an influencing factor in the
firms debt as well as equity markets, its ownership structure, capital structure, and
dividend policies. The information relating to debt equity ratio, financial results,
financial planning etc., show an effect on information asymmetry. Generally the
managers act to maximize their firms share price. However, if there is a difference
between what managers believe their firms shares are worth and the market price of
those shares, then the appropriate goal of the managers needs further elaboration. By the
corporate actions, the quality of trading shares can alter. In this unit, the basic causes of
information asymmetry and the problem of simultaneous information are covered.
10.2 OBJECTIVES
Know Management Incentives for holding information;
Find the reasons for Earnings Manipulation;
Understand Economic Theories of the Effects of Information Asymmetry;
Identify the basic causes of Information Asymmetry;
Measure the Quality of a Trading Stock; and
Define Agency Cost of Debt.
Information Asymmetry and

the Markets for Corporate Securities
10.3 MANAGEMENT INCENTIVES FOR HOLDING

INFORMATION
It is a known fact that the management of a firm has better information regarding the
firms value than its creditors and shareholders. The primary reason that can be
attributed for this is that, the management of the firms must keep itself away from
percolating any information about its strategic plans to either of its shareholders or
creditors. This is so because, any information so leaked may be taken up by its
competitors who in turn might use them for better competing against its rivals. This in
turn would have a negative value creation activity of the original firm. Thus, the firm
finds itself in a serious dilemma. On one hand, it cannot pursue profitable investment
projects without funds, and at the same time it might be difficult or impossible to sell
the securities to ill informed public investors.
It is a matter of common discussion that managers act to maximize their firms share
price. However, if there is a difference between what managers believe their firms
shares are worth and the market price of those shares, then the appropriate goal of the
managers needs further elaboration. Should managers act to maximize the current
market price of the firms shares, which reflects only public information or should they
act to maximize what they believe is the present value of the firms future cash flows,
which reflects the managers private information?
In some cases, there is no conflict between these two objectives, even when there is a
difference between the firms full information values, which we refer to as the intrinsic
value, and its current market value. However, as shown later in this chapter, when a
decision conveys information that analysts use to value a firms stock, decisions that
maximize the firms current stock price may not be in the best long-term interests of
shareholders. When this is the case, different shareholders will not necessarily agree on
how managers should choose between these conflicting objectives.
Shareholders who plan to hold onto their shares for a long time will capture the intrinsic
value, even if they eventually sell their shares, because the share price at the time of the
sale will reflect the managers private information about future cash flows that the
investor has not yet directly captured. Hence, long-term shareholders prefer managers to
make decisions that maximize the intrinsic value of the shares.
This of course assumes that managers correctly assess the firms intrinsic value and are
not, for example, overly optimistic. However, shareholders who plan to sell their shares
in the near future prefer managers to take actions that improve the firms current or
short-term share price irrespective of how this affects the firms intrinsic or long run
value. Thus, there is an inherent conflict between the interests of long-term and shortterm shareholders.
As in many of the previous chapters, our examples here are simplified by assuming that
investors are risk neutral and the discount rate is zero. In this case, current share prices
17
are equal to expected share prices at any near-term horizon where the cash flow
implications of the managers actions are not yet fully known to investors. However,
even with the risk aversion and positive discount rates, short-term share prices tend to
be higher when current share prices are higher. Hence, short-term shareholders prefer
that the managers take actions that immediately or shortly signal good information and
conceal bad information about the firms cash flows, even if the manager privately
known that those actions are detrimental to the firms long-term future cash flows.
CONFLICT BETWEEN SHORT-TERM AND LONG-TERM SHARE PRICE
MAXIMIZATION
The exhibit given on the next page illustrates that managers have a number of
competing pressures that determine how a firms current share price and its intrinsic value
enter the decision criteria. If a manager expects to be a long-term player at the firm and
intends to continue to hold stock and options in the firm, then he or she is likely to want to
maximize the firms intrinsic value. However, most managers are also concerned about
the firms current stock price. The concern for this arises due to several reasons:
Managers may plan to issue additional equity to sell some of their own stock in
the near future.
Managers may be concerned about the acquisition of the firm by an outsider at a

price that is less than the firms intrinsic value.
Managerial compensation may be directly or indirectly tied to the current stock

price of the firm.
The ability to attract customers and other outside stakeholders may be related to
outsiders perception of the firms value.
Management
Decisions
Incentive to
Incentive to
increase current
increase the
stock prices
intrinsic value of
the firm
Compensation
considerations
Concern about
short-term
unwanted
long-term
stockholders
takeover bids
stockholders
Figure 1
18
Pressure from
Pressure from

Although managers usually have an incentive to increase the firms current stock price,
the degree to which they are willing to sacrifice intrinsic value varies. Given these
inevitable conflicting incentives, one might best view a managers objective function as
one of maximizing a weighted average of the firms current stock price and intrinsic
value.
Thus, we can now safely summarize that the management incentives are influenced by a
desire to increase both the firms current share price and its intrinsic value. The weight
that managers place on these potentially conflicting incentives is determined by, among
other things, the managers compensation and the security of the managers job.
Illustration 1
The Trade-off Between Value and Intrinsic Value
John Jones, CEO of Tremont Corporation, has just exercised 10,000 stock options and
now owns 20,000 shares of Tremont stock. He plans to sell 10,000 shares within the
next month and will hold the remaining 10,000 shares indefinitely. Assuming that his
salary is fixed and that Mr. Jones is entrenched in his job and is unconcerned about
outside takeover threats, describe how Joness objective function would weight current
value and intrinsic value.
Jones would weight current value and intrinsic value equally. In other words, he would
be willing to make a decision that reduces Tremonts intrinsic stock price by $1 per
share if it increased its current stock price by more than $1 per share.
If Mr. Jones, was concerned about takeover threats or losing his job for other reasons,
his decision would be further biased towards those choices that enhance the current
value of his firms shares. As we illustrate in the following case, the weight that
managers place on current share prices versus the firms intrinsic value can have an
important effect on the decisions that they make.
The Joint Venture of IBM, Motorola, and Apple Computer
The joint venture between IBM, Motorola, and Apple Computer to collaborate on
personal computers and workstations (the power PC chip) provides an example of how
corporate decisions can provide information that is potentially relevant for pricing a
firms stock. On the announcement of such a venture, analysts and investors attempt to
assess whether the joint venture is a good decision and whether it will be successful. For
example, if they believe the decision is good for IBM, there will be upward pressure on
the price of IBM stock. On the other hand, if they believe it is a bad decision, there will
be downward pressure on the price of IBM stock. In addition, the market reaction to the
announcement will reflect new information about IBM that is signaled indirectly by the
announcement.
This new information may have almost nothing to do with the merits of the particular
transaction. For example, the joint venture could have been viewed as a favorable signal
about IBMs future prospects because it shows that IBM is confident about its ability to
19
fund a major new investment. Alternatively, such an investment might be viewed as a

negative signal if the analysts interpretation is that IBM has unfavorable prospects in
the mainframe business and the company is not confident about its ability to develop
new personal computers and workstations on its own. If this negative information is
sufficiently important, then IBMs stock price will drop on the announcement of joint
venture even if the venture is believed to be a good decision.
IBMs managers are thus faced with a dilemma in making such a choice. If IBMs
managers are concerned about the firms current share price and they anticipate an
unfavorable stock price reaction, then they may choose to pass up the joint venture even
if the project itself makes economic sense.
So it can be summarized that good decisions can reveal unfavorable information and
bad decisions, favorable information. This means that, stock price reactions are
sometimes poor indicators of whether a decision has a positive or a negative effect on a
firms intrinsic value. Managers who are concerned about the current or short-term
share price of their firms may bias their decisions in ways that reduce the intrinsic
values of their firms.
EARNINGS MANIPULATION
Let us now see how information considerations affect financing and investing choices.
However, it is important to first see how these considerations affect the earnings
reported by firms. Recent accounting research suggests that managers sometimes
manipulate the earnings number of their firms in ways that increase reported income in
the current year at the expense of reporting lower earnings in the future. Managers have
some discretion over the firms accounting methods, which allow them to shift reported
income from the future to the current year and vice versa. For example, if the firm elects
to use straight-line depreciation, reported earnings are initially higher since the initial
depreciation expenses are lower than they would be with accelerated depreciation.
However, the opposite is true in later years. Accelerated depreciation methods cause
reported earnings in the years to be higher than they would be with straight-line
depreciation. Similarly, the choice of inventory valuation methods that is, LIFO (LastIn, First-Out) or FIFO (First-In-First Out) affects current year and future earnings,
depending on whether input prices are rising or falling. These accounting methods are
typically disclosed in a companys public financial statements. However, other
undisclosed accounting decisions also affect earnings. For example, managers have
discretion in coming up with a number of estimates, including the service lives and
salvage values of depreciable assets, the lives of intangibles, the uncollectible rate on
accounts receivable, the cost of warranty plans, the degree of completion when the
percentage-of-completion method is used for certain assets, the actuarial cost basis for a
pension plan, and the interest for capitalized leases and pension accounting.
As illustrated below, accounting changes can have dramatic effects on reported
earnings.
20

The Management of Reported Earnings by General Motors

Between 1985 and 1989, General Motors reported slightly rising earnings despite the
decline in its car and truck sales. Although the efforts of General Motors to streamline
its operations may have contributed to this earnings increase, accounting changes also
affected its reported earnings.
In 1986, General Motors raised the expected rate of return on its existing pension assets,
which allowed it to reduce the amount that was required to add to the fund in the current
and subsequent years. This increased reported profits in 1986 by about $195 million. In
1987, General Motors increased the estimated useful life of its plant and equipment,
which reduced depreciation and amortization charges in that year, thereby increasing its
reported earnings by about $1.2 billion.
Incentives to Increase or Decrease Accounting Earnings
Firms show the greatest tendency to artificially inflate accounting earnings when
managers have the most to gain from increasing share prices. For example, Teoh, Welch,
and Wong (1998a, b) found that firms make discretionary accounting choices that
temporarily increase reported earnings before both initial and seasoned public offerings of
equity. In these cases, managers are especially interested in improving the firms current
stock price because they want to maximize the proceeds from the equity issues.
Occasionally, managers also manipulate their earnings downward when they want their
firms to appear weaker than they really are. For example, Liberty and Zimmerman
(1986) found that some firms manipulated their earnings downward before union
negotiations, and Jones (1991) found strong evidence of managers manipulating their
companys earnings downward prior to appealing to the government for help against
foreign competitors.
10.4 ECONOMIC THEORIES OF THE EFFECTS OF

INFORMATION ASYMMETRY
Various theories that dealt with the information asymmetry problem for a publicly
traded firm, initially gained its recognition in the discipline of economics. Once this
happened, the financial markets were very quick to recognize the same. Thus, the
discussions carried out in the following section deals with the analysis of information
asymmetry carried out in the economics literature. Here we speak of the works of
Akerlof (1970) and Spence (1973). These papers actually provide a deep insight to the
alternative issues pertaining to the problems of information asymmetry and also bring
into the picture certain new and basic concepts of the subject.
INFORMATION ASYMMETRY OF THE MARKET FOR LEMMONS
Akerlof (1970)
The first theoretical analysis of the implication of information asymmetry for the market
for an asset that is traded in a public market was carried out by Akerlof (1970).
His study dealt with the market for used automobiles. Let us summarize his analysis in
the following way:
Say a large number of units of an automobile model are manufactured and sold in a
given year, and the quality of these products varies from excellent to lemmons.
21
Lemmons are in fact referred to those automobiles that face chronic mechanical
problems. At some point of time, the owners of many of these units wish to sell their
units for some reason that the prospective buyer is aware of.
Moral Hazard
It is to be noted here that some of the units in the secondary markets are lemmons,
whereas some are not. Sellers who have lemmons, of course know that they have
lemmons. But their tendency is to speak better about the quality of the lemmons,
because telling the truth about the products condition may limit the proceeds of the sale
and thereby making it difficult to sell the unit. Instead, for the period that is involved in
short selling, the seller of a lemon can put his unit in a condition that imitates the
condition of a better quality unit, and can then claim that the unit is of good quality. As
a result of this, the potential buyers of this unit will not be able to differentiate the good
quality units from the lemmons that are for sale in the secondary market. All the
potential buyers face the hazard that they will unintentionally purchase a lemon rather
than a good quality unit. This is in fact referred to as the moral hazard.
Pooling Equilibrium
If the sellers of the lemmon are successful in initiating the strategy, the equilibrium
price will be the same for all the units. This common price is actually the reflection of
the average quality of all the units in the market, which all the potential buyers are
assumed to be aware of. This, in the finance perspective, is termed as pooling
equilibrium. This is because, all the units in the markets are pooled in order to
determine the common price. This equilibrium is not a stable one. Sellers who know
that they possess units of high quality know that the value of their units is higher than
the current market price. Thus, many of the owners of the non-lemmons units will
withdraw their units from the markets, resulting in the average quality of the lemmons
that are remaining in the markets to fall. If one continues with the assumption that the
potential buyers are always aware of the average quality of the units that are available in
the market, a resulting pooling equilibrium price will emerge that is lower than the
initial price. This process might continue until only the lower quality units of the
lemmons remain in the market.
Adverse Selection
Akerlof has provided further illustration of the lemmon problems, and also discussed
the mechanisms that are used to reduce the problems. He discusses the problems of
adverse selection in health insurance market. As a general case, the health insurers
attempt to estimate, for each individual insurance applicant, the probability that he or
she will file an insurance claim and the insurance premiums are priced accordingly. But
this process is costly and imperfect. This is so because each of the individuals is aware
of his or her own health better than the insurer. Thus one can have the case of
information asymmetry. Eventually, an insurer must offer a common premium to a
specified group of individuals that is reflective of the average health of the individuals
in the group, even though the individuals in the group differ in terms of their health and
thus the probability of the claim. This leads to the inevitable result that those members
22

of the group who are less healthy will be more likely to purchase an insurance policy.
Thus, a policy that is originally priced to reflect the average health of an identified
group will be inadequate to compensate the insurer for the ex post subgroup of
individuals that actually purchase a policy.
Screening
Health insurers attempt to reduce these adverse selection problems by effectively
screening the potential customers to create a more uniform group to which a specific
insurance policy and premium can successfully apply. Akerlof illustrates this screening
effect by referring to the case of group insurance, in which all the employees of a given
organization are offered a common insurance policy and premium. Though, the
individual employees widely vary in terms of their health, and thus the probability of
their claim, the identification of the group represents an effective screening from the
population at large. The insurer also benefits from economies of scale in screening costs
per individual relative to the costs of screening all individual applicants in a population.
Certification, Costly Signaling, Separation Equilibrium
In this research paper, Akerlof also introduces the concept of certification as a means of
mitigating the problems of lemmons. Here his focus is on the jobs market, where he
considers the role of education as a means by which the prospective employees can
certify their qualifications, and thereby separate themselves from other prospective
employees who are less qualified.
Reputation
The author also stresses on the importance of reputation as a means of reducing the
problems with lemmons. Here, he uses the credit markets to illustrate his argument. He
puts forth the argument that potential borrowers sometimes can be effectively screened
by examining their past repayments, records or reputation.
Contract Enforcement
Lenders can take action ex post in order to attempt to enforce repayment from a default.
It is to be remembered that the effectiveness of the contract enforcement mechanism
depends largely on the following factors:
Specifications in the loan contract that allows the lender to take enforcement
actions.
Ability of the lender to monitor the borrowers behavior, especially to the use of
borrowed funds.
The effectiveness of the legal system to which the lender appeals to enforce
repayment in the event of default.
23
Guarantees
The final discussion of Akerlof centers around the importance of the role of guarantees
in the lemmons problems. Here he refers to a market for goods that is potentially dealt
with variations in quality that are unnoticed by consumers. Those firms that produce a
particular type of high quality product finds an incentive to provide a costly signal of
the quality of the product that becomes an impossibility for other firms to initiate. The
cost incurred in imitating the product is higher for the producers of the low quality
products.
JOB MARKET SIGNALING SPENCE (1973)
An extension of Akerlofs theoretical analysis of problems relating to information
asymmetry can be seen in the study conducted by Spence (1973). He introduced the
concepts of information transfer mechanisms which lead to information equilibria.
Spences labor market model can be summarized in the following way. Say in the
process of evaluating a job applicant, an employer has access to a couple of observable
attributes, one being unalterable attributes such as age, race and sex, and the other being
signals, which may be altered by the applicant. The influencing power of the signal
depends critically on two closely related conditions:
The signal must be effective in revealing the applicants inherent productive

capabilities.
A signal of a more productive applicant finds difficulty in imitating by the ten

productive applicants.
Spence describes the concept of separating equilibrium as one of the costly signals of
the job market in education. An equilibrium can be explained from the viewpoint of a
feedback loop in which the expectations of the employers lead to offered wages at
various levels of education, which in turn lead to investment in education by
individuals. His equilibrium structure includes those feedbacks that the employers
receive after hiring the employees over time. It is only after hiring that the revised
expectation in the minds of the employer creeps in and the cycle starts once again.
10.5 BASIC CAUSE OF INFORMATION ASYMMETRY

The asymmetry between a firms management and financial markets is created as a
result of the conspiracy of product market competition and the separation of ownership
and control. In order to explain this, let us assume that the common interest of the
shareholders of a publicity traded firm is to maximize the market value of the firms
equity and the shareholders are able to frame a perfect contract with the firms
management so as to ensure that the management will act strictly in their interest. Keeping
in mind the competition that exists in the market, the shareholders and management must
develop strategic plans and operations that will not only create value but also garner
profits as the firm operates in its product and service markets. It is also to be remembered
that as an inherent in the strategic plans and operations must not be divulged to the firms
competitors. So is the fact that management cannot divulge the strategic plans of the firm
even to its shareholders. The reason being that if they had a policy of doing so, the
24

competitors of the firm can opt for purchasing the firms shares and thus become its
shareholders. In doing so, they may gain access to this strategic information. So one can
safely say that the management will be unwilling to provide strategic information to the
creditors of the firm, at least to that extent that the debt is publicly traded. For all these
reasons, the management of the firm is better equipped with information relating to the
operation of the firm, also about the true value of the firms share.
VALUATION OF PUBLICLY TRADED EQUITY UNDER ASYMMETRIC
INFORMATION
As it has been stated earlier, the market value of a publicly traded firm may not reflect
its true value because it may not reflect the information that is known only to the
insiders of the firm. The market value can reflect its true value only in conditions when
the firm can successfully signal its true value. Thus a number of outcomes can be seen
due to the difference existing between the two values.
The following table illustrates several possible outcomes of a set of hypothetical firms
named A, B, C, D, & E. The figures in the first column of the table reflect the true value
of each firm. The average value is 300. But in case, the market is unable to differentiate
between the firms, the market values of all five firms will reflect a pooling equilibrium.
In other words, the market values of all the firms will be equal to the average values of
the firm. The equilibrium results in mispricing of four among the five firms.
Firm
True
Value
Pooling Equilibrium
Partially Separating
Equilibrium
Fully
Separating
Equilibrium
500
300
400
500
400
300
400
400
300
300
400
300
200
300
150
200
100
300
150
100
Average
300
300
300
300
Table 1: Theoretical Consequence of a Firms Equity

Let us also consider an alternative situation where the market is partially able to
separate these firms into two groups. The first group includes A, B, and C, that
possesses a higher true value than firms in the second group, D and E. The market
values of the firms A, B and C reflect the average of their true value; D and E reflects
the average of their true values, or 150. A partially separating equilibrium of this nature
may take place when the firms A, B and C manage to send a powerful signal to the
market that concerns their true value and the firms D and E are unable to imitate them.
In such conditions, the mispricing is reduced relative to the case of a pooling
equilibrium, though it is not totally got rid of. Let us also consider the possibility of a
fully separating equilibrium. A feature of a fully separating equilibrium is that, in such
conditions the market values of the individual firms reflect its true value. This state can
be achieved only if each of the firms is able to send a unique and powerful signal of its
true value to the market, the signal that other firms are not able to copy.
25
INFORMATION ASYMMETRY AND THE QUALITY OF THE MARKET FOR A

FIRMS EQUITY
As it has been already discussed, information asymmetry is an influencing effect on the
quality of the market for a firms securities. It is to be remembered that the quality of
the market with respect to a stock has a close relationship with its information
efficiency. If all the information is freely available to all the investors, it is expected that
the market for corporate securities will be highly efficient. But one should remember
that in situations of information asymmetry, getting provisions of such high level of
information efficiency may lead to further problems. The core of the problem is that,
some of the traders, may have accent to private information that is not available to other
traders. If at any particular point of time, the market price does not reflect private
information, the informed traders can profit from their trades with the relatively
uninformed traders. If such situation turns out to be on a regular basis, the uninformed
traders may find it very difficult to earn normal returns on their stocks. In cases that are
very extreme, the market for a corporate security may even fail.
a.
How do the managers manipulate the earnings?
b.
What is basic cause of information asymmetry?
10.6 MEASUREMENT OF QUALITY OF A TRADING STOCK

Information asymmetry is among the many factors that contribute to the quality of a
trading stock. Let us try to explain three common measures of quality in brief:
a.
Floats,
b.
Turnover, and
c.
Bid-ask spread.
Floats: The term float for a stock is referred to the number of shares that are actively
traded in the exchange. The measure of float is the number of shares outstanding for the
total number of shares held by the insiders and those other investors who are in
possession of at least 5 percent of the outstanding shares. The importance of float lies in
providing the investors enough potential to purchase the firms shares, and also in the
potential interest of the investing community. Added to this, if the insiders or other
investors who are well informed hold a major proportion of a given firms shares, it
26

may be perceived by the investors that they are facing a considerable information
disadvantage in trading the firms shares.
Turnover: The turnover of a stock is defined as the ratio of the number of shares traded
over a specific period of time to the total number of shares outstanding. With all the
discussion made so far, it can be safely said that the presence of information asymmetry
may result in seriously hampering the trading activities. In addition to this, the turnover
of the stock is directly related to the volatility of the stock price of the firm.
Bid-ask spread: The bid-ask spread factor also provides valuable insight to the markets
quality for a given share. The bid price for a stock is the price at which the dealer is
willing
to
purchase
specific
number
of
firms
shares,
and
the
ask-price is the price at which the dealer is willing to sell a specified number of shares.
A dealer makes a market by offering to buy or sell a firms shares at any time.
The difference between the dealers bid and ask price is termed as spread. The bid-ask
spread is generally expressed as a percentage of stock price. The stocks bid-ask spread
exerts a great deal of influence on the quality of the market for stocks. The spread is in
fact one of the integral components of the overall cost of trading a stock. The other two
being, the brokerage commissions and the price impact. The price impact is the
behavior of the investors trading activity to the price of the stock.
Say for example, a purchase of stock raises the price and the selling activities pulls
down its values. Another reason for the bid-ask spread to influence the markets quality
for a stock is that the bid-ask spread consists of three components. All of these represent
the costs that are incurred by the dealer, and later on they are passed on to the trader
through the medium of spread. These three costs are:
Adverse Selection Cost,
Inventory Cost, and
Order Processing Cost.
In the context of theoretical models, there are two distinct types of investors:
a.
Liquidity traders.
b.
Informed traders.
The former type of trader carries on the buying and selling activities to adjust the
composition of their portfolios. The latter type takes advantage of the private
information that they possess which others are not aware of and trades their stocks on
their basis. But, in reality the dealer cannot differentiate between the two kinds of
traders. Thus, the dealer has to set the spread in such a way so that he can at least, offset
his losses incurred while trading with the informed traders and with the profits made in
trading with the liquidity traders. Things might turn out to be problematic in case the
informed traders are more frequent. In such situation, the dealer must set a relatively
widespread. In case where a dealer may not be able to set a spread that results in an
unexpected profit, the market for the stock may fail.
27
INFORMATION ASYMMETRY AND EXTERNAL FINANCING

Let us here try to take a glance at some of the theoretical perspectives concerning the
effects of information asymmetry on the firms optimal policies regarding leverage,
terms in its contracts, and external financing in general.
Risk of a Firm and Optimal Leverage
Under the conditions of information asymmetry, the leverage of a firm may prove to be
a strong and powerful signal of the firms true value. In his study Ross (1977) has
argued that managers do possess private information about the future cash flows.
The management of a firm can distinguish itself as a high quality firm by the issue of
debt. The management shows its confidence in the future cash flows of the firm, by
committing itself to make the future payments of interest and principal. His model takes
into account a positive but limited amount of debit, relative to that of equity.
Role of Collateral in Loans
It has been stated by Besanko and Thakor (1987) that the presence of collateral in loans
can act as an effective shielding device to impact on the problems of information
asymmetry in the corporate debt market. There is a greater change of default in cases of
a risky borrower, and as a consequence they have a greater chance of loosing their
collateral, and thus they tend to choose an unsecured loan contract with a higher interest
charges attached to it. Borrowers who tend to be risky opt for a secured loan contract
having a lower interest rate. Thus the theory is suggestive of the fact that collateral can
serve as a powerful signal of the firms values.
10.7 PECKING ORDER HYPOTHESIS

Stewart Myers (1984) observes three aspects of corporate financial behavior that is seen
to be exhibited by managers.
His observations are,
Managers give preference to internal finances than external financing.
Managers try to maintain a stable dividend even in adverse situations.
In cases of external financing, managers always prefer to issue the least risky of
all the securities.
The securities can be listed in order of increasing riskiness; it ranges from straight debts
to common stocks. The pecking order of corporate financing ranges from internal equity
to common stock. In a later article, Myers and Majluf (1984) formulated the above
stated findings into a theoretical model and tried to correlate the same with information
asymmetry. Their theory states that the market is chronically underinformed about the
relative values of various projects that the firms bring to the market, and as a result the
market tends to undervalue these projects. This in turn undervalues the securities that
are issued to finance them. This results in some sort of pooling equilibrium so that on an
average, the uninformed investors tend to break even on the securities they purchase.
This in turn puts the managers in such conditions that they find the effective cost of
external financing higher than it should be. This is mainly due to the fact that the firm
tends to give up a major portion of the firms NPV to the investors who purchase the
issued securities. This surrender in the value to the new investors can be particularly
28

detrimental if the firm issues equity stock, this is so because the difference between the
valuation of the firm by its management and the market is fully reflected in the price
that the market is willing to pay for the issued security. In extreme cases, the manager
may even go in for rejecting a profitable project if it is to be financed with external
equity, because the surrender costs more than the NPV of the project. Issuing debt may
also be a matter of concern. But it is to be remembered that debt enjoys a priority, and
so the difference that exists in the valuation is also to a smaller extent. Thus if external
financing is to be considered, debt is to be preferred to equity. Well one of the ways to
avoid the surrender in values is to avoid the external financing, in other words to go for
internal financing. So in order to be in a position that can enable a firm to carry out any
project without the aid of external financing, firms tend to maintain financial slack.
This includes the cash and marketable securities in a broader sense, the unused debt
capacity.
Well there is also an exception to the above condition. In case, where the management
believes that their firm is overvalued mainly due to the possession of inside information.
In such a case the management is motivated by the issue of external equity. But the
market is fully aware of this adverse selection problem and thus ultimately the stocks
price, instead of rising, falls.
DIVIDEND POLICY
In this study, Bhattacharya developed one of the pioneering models that employs
dividends as a signal of managements private information about the future cash flows
of the firm. The model incorporates certain intuitive factors. It says that there exists two
kinds of firms good and bad, where the expected net cash flow is higher for a
good firm than for a bad firm. Though the managers are aware of the expected net cash
flow of their own firm, it is not possible for the markets to distinguish between a good
firm and a bad one. Further, the model also takes into consideration the following
assumptions:
The cost of external financing is more than the cost of internal financing.
The firms will always pay the dividends they have promised to the full.
A positive correlation exists between the firms managers individual wealth and
the stock price of the firm.
Keeping in mind these considerations, Bhattacharya (1979) has shown that, it is only the
managers of good firms who pay out the promised dividends, and their amount of
dividend will be just sufficient enough to deter the manager of the bad firm from paying
or initiating dividends. The major finding of the model is that, while the advantage of
paying dividends is the same for each firm, the cost of doing so is higher for the bad
firm. In other words, one can say that bad firms have greater chance of not possessing
enough cash so as to pay the promised dividend and as a consequence a greater chance
of heeding costlier external financing to protect this shortfall. As a result of this, a bad
29
firm is unwilling to promise a dividend because of which the market is able to make out
the true value of the firm from its dividend policy, and so we have a separating
equilibrium.
The Signaling Power of Cash Payouts
In the signaling model developed by Miller and Rock (1985), the cash payouts that
include the dividends, share repurchases, or debt retirements, serve the similar roles as
powerful signals on the earning capacity of the firm and thus its value. Any such cash
payout reveals that the firm is generating and also has a strong potential in generating
high level of net cash flows. On the other hand, the issue of securities, particularly the
equity securities, reflects negative information about the ability of the firm to generate
earnings.
Principal-Agent Problem
Much of the research papers have dealt with the management shareholder or the
shareholder-creditor conflicts in separation. Few have actually tried to address these
issues together. This is understandable to a certain extent, because these issues involve
so many complexities that examining them simultaneously becomes a Herculean task.
But, in essence, these problems in general cannot be separated. In certain contexts of
information asymmetry, the firms management enjoys both the opportunity as well as
the incentive to show a better picture of their products quality that they develop over
time. As far as the incentives are concerned, the managers may inflate the quality of the
new projects primarily due to a couple of reasons. One may be the fact that the
managers have a tendency of enhancing the quality of the new projects, so as to like the
price of the firms stock. The other reason being, if the compensation of the manager is
the function of the price performance of its stock, he may be having a self serving
incentive to type the firms stock price, especially in the short-term.
Noe and Rebellos (1996) theoretical model simultaneously discusses the effects of
asymmetric information and managerial self interest on the financing and dividend
policies of a firm. Let us take the case where the firm is looking for an investment
opportunity, the details of which are known only to the managers of the firm, and the
insider shareholders. The budget constraints of the firm are such that if it goes on
paying more dividends, then it has to resort to external financing. So, this brings us to
two important questions:
Should the firm pay high or low dividends?
When the requirement of external financing arises, should the firm issue debt or
equity?
The shareholders can limit the ability of the management to pursue their self interest by
putting a restriction on the free cash flow available to them. Thus, one can safely say that
dividends help in reducing the agency costs of managerial discretion by ejecting the excess
cash. One can also say that dividends may be necessary as a signal of value in an asymmetric
information world. But also on the other hand, more dividends tend to increase the need for
30

external financing, and given the conditions of adverse selection, this tends to be costlier.
With regard to external financing, the manager tries to minimize the component of debt, but
at the same time the cost of the adverse selection that is associated with the equity financing
may lead on to increase the reliance upon more debt funds.
AGENCY COST OF DEBT
Harris and Ravice (1990) formulated a theoretical model of optimal structure.
The model is based on the setting where the debt component serves as a means to
provide investors with information about the firm, and also as a device to restrict the
managements engagement is self serving activities. They say that the mere ability of
the firm to make its contractual payments to its debt holders provides information,
and in times of default the management must placate the creditors to avoid
liquidation. This can be done either through informal negotiations or through the
formal bankruptcy proceedings.
ADVERSE INCENTIVES, AND CREDIT RATIONING
There are many firms that obtain private debt financing from commercial banks.
In dealing with a corporate borrower, the banks may often limit the amount of debt
financing that they will provide. If one thinks from an economics standpoint, it is
surprising why the banks ration their credits instead of simply raising the interest rates,
by offering a schedule that involves higher interest rates. Well some researchers suggest
that banks activity of rationing the credit among their pool of borrowers instead of
varying interest rate is because the latter policy has certain interest problems.
INFORMATION ASYMMETRY AND THE LIMITATIONS ON THE MARKET
EFFICIENCY
As it has been repeatedly discussed in various sections, there is an existence of
information asymmetry between the management of the firm and the outside investors.
When such a situation arises the outside investors find themselves at an information
disadvantage as they try hard in order to determine the true and fair value of the firm.
Well under such conditions, how can one expect the market to remain efficient? Let us
now probe into this matter and try to find some suitable answers.
Well, it is a known fact that the scope of the problems related to information asymmetry
is limited. The reason being the investors of the firm does not have any reliable
information about the workings of the firm and as a result its value. As far as the US
market is concerned, the regulations imposed by the Securities and Exchange
Commission make it a compulsion for the firms to disclose its information for the
interest of the shareholders. Similar is the case with the Indian counterpart where the
Securities Exchange Board of India (SEBI) lays down similar guidelines for the
disclosure of information by the firms. This helps in reducing the problems of
information asymmetry to certain extent thus making the market price of the firms
securities somewhat efficient. Though the information is limited, the investors can
augment their information by engaging a security analyst. One can safely say that the
31
price of a security will be fair only if the market is efficient. The process of gathering
and processing information is a costly affair. At the same time, trading of securities is
also by no means cheap. The benefit that the investor may reap by engaging a security
analyst is being able to differentiate the properly priced securities from the mispriced
ones. But if the market is already efficient with respect to the gathered information, the
investors would not find any incentive to engage an analyst to determine the markets
efficiency. At the same time one can argue that how can the market be efficient if no
such information is gathered? This is termed as the paradox of market efficiency
(Grossman and Stiglitz).
Several studies and empirical evidences have suggested that the markets cannot be truly
efficient. Rather, the price of the securities always tends to oscillate from their true
values. Such deviations provide the analysts with an added energy to carry on their
analysis and to keep the prices of the securities close to their fair price. Thus it is
important to judge the efficiency of the market on a scale, which ranges from small to
larger deviations. At the same time it is also to be remembered that market for the
security analysts is itself a very competitive one. The price value deviations will always
be very small and only the superior analysts will be able to realize the profits arising
from such deviations.
There are certain factors that determine the efficiency of the securities market. Some of
these factors are:
a.
The characteristics of the security as well as the issuer.
b.
The characteristics of the market in which the security trades.
c.
The availability of technology to facilitate the process of information gathering

and processing.
Efficiency of the market also depends on the trading costs, that include commissions
and the bid-ask spread. Finally one can conclude that in order to determine the minute
and fleeting deviations in the true value of the stock price, a trader must be equipped
with efficient technologies for both information processing as well as trading.
INFORMATION CONTENT OF THE DEBT-EQUITY CHOICE
Let us now discuss the type of information conveyed to investors by a firms
debt-equity choice. The debt-equity choice conveys information to investors for two
reasons. First, because of financial distress costs, managers will avoid increasing a
firms leverage ratio if they have information indicating that the firm could have future
financial difficulties. Hence, a debt issue can be viewed as a signal that managers are
confident about the firms ability to repay the debt. The second reason has to do with
the reluctance of managers to issue what they believe are underpriced shares. Hence, an
equity issue might be viewed as a signal that the firms shares are not underpriced and
therefore may be overpriced.
32

A SIGNALING MODEL BASED ON THE TAX GAIN/FINANCIAL DISTRESS

COST TRADE-OFF
To understand why the debt-equity choice conveys information, assume, as a first
approximation, that firms select their capital structures by trading off the tax benefits of
debt financing against the various costs of financial distress. In this setting, firms desire
higher debt levels when expected cash flows are higher because they can better utilize
the tax benefits of debt. In addition, for any given debt level, the probability of incurring
the costs of financing distress is lower if expected cash flows are higher.
Because expected future cash flows determine the firms optimal capital structure, the
capital structure choice of better informed managers is likely to convey information to
shareholders, while the information content of the capital structure decision would not
affect the decisions of managers who also are concerned about the current share prices
of their firms. Indeed, managers whose objectives are heavily weighted towards the
maximization of current share price are likely to avoid reducing leverage even when
doing so improves the intrinsic value of their shares but conveys information that
reduces their current value. They may similarly choose to increase leverage beyond the
point that maximizes intrinsic value.
So we can say that an increase in a firms debt ratio is considered a favorable signal
because it indicates that managers believe the firm will be generating taxable earnings
in the future and that they are not overly concerned about incurring financial distress
costs. Managers understand that their firms stock price is likely to respond favorably to
higher leverage ratios and may thus have an incentive to select higher leverage ratios
than they would otherwise prefer.
a.
Define Bid-ask spread.
b.
Present the assumptions under Bhattacharyas dividend policy model.
PROBLEM OF SIMULTANEOUS INFORMATION

As far as this problem is concerned, the researchers use a two-step procedure so as to
adjust for the valuation effects of other influencing information so as to isolate the
valuation effect of specific events. These adjustments then combine to form the event
study methodology, the standard means by which the researchers measure the impact of
an announcement, (which is called an event) on the value of the firms stock price.
The method involves a two-step procedure, which is explained as follows.
33
Step 1: Adjusting the Contemporaneous Returns on the Market Portfolio

As a first step, the researchers adjust the event period raw return on the stock price of
the focal firm, for the contemporaneous returns on the stock market, thus yielding the
stocks event period abnormal return. This adjustment helps in the elimination of that
portion of the return of the stock that is caused by the effects of the information that
actually affected the entire market structure.
Using the Market Model to Adjust for Contemporaneous Market Returns:
Researchers generally make a more sensitive adjustment for contemporaneous market
returns by using the market model. The market model involves a regression of returns
on the focal firms stock against contemporaneous returns on a proxy for the market
portfolio:
Ri, t = i + i Rm,t + i,t
(1)
Where,
Ri,t and Rm,t are the day t returns on stock I, and
the market portfolio respectively,
i and i are the intercept and slope coefficients of the regression for stock I,
respectively, and i, t is the regression residual.
The market model provides a more sensitive adjustment of the return on a stock for
contemporaneous market returns for two reasons. First, the intercept of the regression,
i, captures the average return on stock i given that the market return is zero. Second,
the term i Rm, t captures the sensitivity of returns on stock i to contemporaneous market
returns.
The regression residual, i, t, captures the deviation of the return on stock i on day t from
its normal relationship to the market, and is therefore called stock is abnormal return on
day t. In an event study, we focus on the abnormal return on a stock because, according
to theory, it captures the effect of new firm-specific information on the stocks price.
To estimate regression equation 1, researchers typically use daily returns on the stock
and the market over a period of time that excludes the focal event period, obtaining
estimates of the intercept and slope coefficients, denoted as i and i. With these
estimates,
the
researcher
then
calculates
the
abnormal
return
on
stock
i on the event date, designed as day 0. The event-day abnormal return, denoted as i,0, is
calculated using Equation 2:
i, 0 = Ri, 0 ( i + I Rm, 0)
(2)
Pursuing again the case of Sears 1994 dividend announcement, we estimated regression
Equation 1 using percentage daily returns on Sears stock and the S&P 500 index for
two calendar years prior to the announcement (i.e., 1982 to 1983). The results were:
RSears,t = 0.12% + 1.46RS&P,t+ Sears,t
34

The t-statistics for the intercept and slope coefficients were 1.91 and 23.73, respectively,
and the adjusted R2 was 52.7 percent. We then inserted the estimates of the values for
the intercept and slope coefficients into Equation 2 to obtain Sears abnormal return on
the dividend announcement date:
Sears0 = 0.35% {0.12% + 1.46 (0.85%) = 1.47%.
Step 2: Washing Out the Effects of Other Information Released
Simultaneously
The purpose of the second step in event study methodology is to wash out the valuation
effects of other firm-specific factors that may have affected a stocks price on the event
day to isolate the valuation effect of the focal event more precisely. This is done by (a)
collecting a sample of firms, all of which have made a similar type of announcement
(though on different calendar dates), (b) calculating the event-day abnormal return on
each firms stock, and (c) calculating the average:
0 =
1 N
i,0
N i=1
(3)
Where,
N is the number of events in the sample.
The need to average abnormal returns across similar events exposes another limitation
of event study methodology. The methodology cannot be used to accurately gauge the
valuation effect of a single event for a single firm.
Using a Two-Day Event-Period Window: Researchers generally use an event-period
window of two days, rather than one day, to calculate abnormal returns. These two days
include the announcement day and the following trading day. This is done in part
because many announcements are made after the close of trading on the announcement
day, so it is necessary to include the stocks abnormal return on the following trading
day, denoted as day + 1, to adequately capture the markets reaction to the new
information. We denote the two-day abnormal return for firm I as Ri,
(0 + 1).
For an
individual firm, i, (0 + 1) is calculated using equation 4:

i,(0, +1) = R i,(0+1) [2 i i R m,(0, +1) ]
(4)
Returning to Sears dividend announcement, the returns on Sears stock and the S&P
500 index on day+1 (i.e., February 14, 1984) were 4.23 percent and 1.07 percent,
respectively. Hence, the (compounded) two-day returns were 4.59 percent and 0.20
percent, respectively. To calculate Sears market-model based abnormal return over two
days, we must double the intercept of the estimated market model regression, because
we are working with two-day returns rather than one-day returns. That is, the intercept
must be 0.24 percent rather than 0.12 percent. With this adjustment, the two-day
abnormal return on Sears stock is
Sears (0,+1) = 4.59% [0.24% + 1.46% (0.20%)] = 4.06%
35
Finally, we can calculate the average two-day abnormal return across a sample of firms
(or events) using equation 5:
(0,+1) =
1 N
i(0,+1)
N i=1
(5)
Results of Selected Event Studies

Let us now focus our discussion on the event studies done on the following firms
announcements:
a.
Capital expenditure plans
b.
Earnings
c.
Changes in the leverage
d.
Seasoned equity offering
e.
Change in the quarterly dividend
f.
Merger activity.
Let us now try to discuss each of these in brief.

Announcement of Capital Expenditure Plans: Studies conducted by McConnell and
Muscarella (1985) have examined the effects of the announcement of the firm regarding
capital expenditure plans on the valuation of the firm. They predicted that a firm that
announces an increase in the capital expenditure tries to reveal that it somewhat enjoys a
more profitable investment opportunity and as a result the stock price of the firm is
expected to go up upon such an announcement. On the other hand, a firm that is
announcing a decrease in its capital expenditure plans is a reflection of the fact that its
capital investment opportunities are limited and so the price of its stock is expected to
fall on such an announcement. Let us now put forth the following hypothesis in order to
see the possible effect of the value of the firm to the firms announcements. If the
managers tend to engage in unprofitable capital expenditure for the vested interests of
building up their own empire, then an announcement of increased capital expenditure
may be thought of as a bad news, and a decrease in capital expenditure may be
thought of as good news. The studies conducted by the authors on the announcement
of the expenditure decisions focused on two types of firms. The industrials and the
public utilities. The industrial sample consisted of 547 announcements made by 285
different firms, and the public utility sample consisted of 111 announcements made
by 72 different firms.
The empirical results seem to be consistent with the predictions that the authors have
made. On an average it was seen that those industrial firms that announced an increase
in capital expenditure decisions realized a positive event period abnormal return of
1.12%, while those that announced a decrease showed a negative return of 1.93%.
The corresponding results for the public utility firms were weaker by 0.03% and
1.06% respectively. The results of the public utility firms are explained by the authors
saying that these firms are regulated to the extent that they are unable to earn a return on
the capital investments that is more than their cost of capital as a result of which the
capital budgeting decisions of the utility firm should have smaller impact on its share
36

price. However, it is observed that even for the industrial firms the magnitude of the
reported average abnormal returns seem rather small given the importance of the capital
expenditure decisions. So one can say that for some firms that announced an increase in
capital expenditure, the reaction of the market may have been adverse because the
information implies that the management intends to intensify its self serving empire
building. In contrast, some of the firms that announced a reduction in the capital
expenditure, the markets positive reaction might be due to some mechanism that has
been brought to bear in order to discipline the tendency of the management to engage in
empire building. Another explanation may be that the market may have anticipated
much of these informations.
Earnings Announcements: Studies conducted by Joy, Litzenberger and McEnally
(1977) concentrated on the earnings announcement of the firm and its impact on the
value. The earnings announcement was taken to be a quarterly one. Whenever such a
study is conducted, it is important to take into account of the expectation of the market
to the earnings announcement so that later on it is possible to sort out the firms by the
deviation of their actual earnings from the markets expected earnings. While carrying
out their studies, the authors established several alternative methods of earnings
expectations, that includes a nave and no change model that forecasts the earnings by
extrapolating the past earnings trends. Having done this they have sorted the firms into
three categories in accordance with the reaction of the market to the earnings resulting
in a positive surprise or no surprise. The authors have found out that:
a.
Firms that have positive earnings surprises, realized a substantial positive

abnormal return of 6.71%.
b.
Firms that provide earnings close to the expectations realized a small negative
abnormal return of 0.45%.
c.
Firms with negative earnings surprises, realized substantial negative abnormal

return of 8.16%.
These results are indicative of the fact that the earnings announcements convey
considerable information to the market. So it is also not surprising that the earnings
expectation and the announcement generate the attention of the financial press to a
considerable extent.
Exchange Offer Announcements: Masulis (1980) has examined the reaction of the
market to the firms announcement of a change in its capital structure. His study
focused on two contradictory capital structure changes. A firm can be viewed as an
exchange of equity for debt that results in the decrease in the leverage of the firm. It can
also be viewed as an exchange of debt for equity which results in the increase in the
leverage. The authors study revealed that the former incident generates a negative
abnormal return of 5.37% on an average. On the other hand, in cases of the latter one
gets a positive abnormal return of 7.63%. Among the several explanations that have
37
been provided for such kind of market behavior, two of them are worth mentioning.
The first says that the increase in leverage increases the tax shield of the firm and thus
increases the value of the firms equity, whereas the leverage decrease results in an
opposite reaction. The second explanation states that an increase in the debt capacity of
the firm through an exchange results in the expropriation of wealth from the existing
creditors, while extinguishing debt accomplishes the opposite.
Announcement of a Seasoned Equity Offering: Masulis and Korwar (1986) examined
the valuation effect of a publicly traded firms announcement of an equity offering,
known as Seasoned Equity Offering (SEO). For the industrial firms they found out that
there was a substantial negative average abnormal return of 3.25%. For the public
utility return firms then was of the magnitude of 0.68%. There have been several
explanations that have been provided for such reactions of the market. One such can be
summarized as follows. Due to the existence of information asymmetry, the
management of the firm has better information about the true value of the firm than the
market. Thus it might sometimes happen that the market price of the firm deviates
substantially from the value of the firm that is assessed by the firms management. If it
is further assumed that the management of the firm acts in the interest of its current
shareholders, the management will find an incentive to issue new shares when the
market price of the shares exceed the value of the shares as assessed by the firm. But
actually, the market becomes aware of the firms tendency to offer new shares when the
management of the firm believes that their shares are overpriced. As a result of which
the market reacts adversely to the announcement of a SEO.
Dividend Announcement: Studies on the reaction of the market to the announcements
regarding changes in the firms dividends were carried on by Pettit (1972). His
hypothesis can be summarized as follows. Firms go for increase in their dividends only
when there is a high degree of certainty that the increase in the dividend would be
supported by the future positive cash flows and firms go for decrease in the dividend
only when they are not sure of positive future cash flows. This is indicative of the fact
that the changes in the dividend announcement reflect the firms assessment over the
future cash flow generation of the firm. The sample of the study composed of the
following structure:
i.
52 firms announced an increase in dividend by more than 10%.
ii.
39 firms announced an increase in dividend ranging from 1% to 10%.
iii.
44 firms announced elimination or cut in their dividend.
The following were the findings of the study:
38
a.
Firms that announced a substantial increase in their dividends realized a

considerable positive abnormal return of 1.48%.
b.
Firms that announced a minor increase in their dividends realized a somewhat

positive abnormal return of 0.88%.
c.
Firms that announced elimination or cut in their dividend realized a substantial

negative abnormal return of 4.32%.

Thus keeping in mind the earlier hypothesis it is safe to conclude that decisions to the
changes in the dividends convey considerable information to the market.
Merger Announcements: Dodd (1980) studies the effects of valuation of a merger
announcement of the prices of the stocks of both the bidding firm as well as the target
firm. He observed that on an announcement of a merger activity, the bidding firm
experiences
slightly
negative
abnormal
return
of
the
magnitude
of
1.16%, whereas the target firm experiences a substantial positive abnormal return of
13.4% on an average.
10.8 SUMMARY
The problem of information asymmetry pertains to the dilemma that the corporates face
of whether to release information of strategic importance to the investors or not. If it
releases such information, it can be leaked out to the competitors, yet it is difficult to see
securities to ill-informed investors or to procure more funds.
There are various mechanisms used to mitigate this problems. These are: (a) the use of
screening devices, (b) costly signals that are difficult or impossible to mimic, (c) the
sellers reputation, (d) ex post contract enforcement, and (e) guarantees.
Managers can distinguish their firm as a better one by issuing debt.
In general, in the presence of information asymmetry between market and managers,
external financing is costlier than interval financing.
There is a preference structure or the pecking order regaining financing alternatives
when in need of funds, firms must first use retained earnings, debt, external equities in
that order.
Low cost borrowers choose secured debt with a low interest rate. In contrast, riskier
borrowers have a high credit risk, having a higher probability of defaulting and losing
the security, hence choose unsecured loan with high interest rate.
Dividends represent a costly signal of managements strategic information about future
cash flows. Share repurchase and debt retirements can serve as effective signals of the
firms value.
10.9 GLOSSARY
A Float for a stock is referred to the number of shares that are actively traded in the
exchange.
Turnover is the ratio of the number of shares traded over a specific period of time to
the total number of shares outstanding.
Bid price is the price at which the dealer is willing to purchase a specific number of
shares.
Ask-price is the price at which the dealer is willing to sell a specified number of shares.
Dividend is a part of earnings of a firm distributed to shareholders.
39
Aswath Damodaran. Investment Valuation. John Wiley & Sons, Inc., 2002.
Donald De Pamphillis. Mergers, Acquisitions and other Restructuring Activities.

Academic Press, 2001.
Frank C. Evans, and David M. Bishop. Valuation for M&A Building Value in
Private Companies. John Wiley and Sons, Inc., 2001.

a.
Recent accounting research suggests that managers sometimes manipulate the

earnings number of their firms in ways that increase reported income in the
current year at the expense of reporting lower earnings in the future. Managers
have some discretion over the firms accounting methods, which allow them to
shift reported income from the future to the current year and vice versa. For
example, if the firm elects to use straight-line depreciation, reported earnings are
initially higher since the initial depreciation expenses are lower than they would
be with accelerated depreciation. However, the opposite is true in later years.
Accelerated depreciation methods cause reported earnings in the years to be
higher than they would be with straight-line depreciation. Similarly, the choice
of inventory valuation methods that is, LIFO (Last-In, First-Out) or FIFO
(First-In-First Out) affects current year and future earnings, depending on
whether input prices are rising or falling. These accounting methods are typically
disclosed in a companys public financial statements.
b.
The asymmetry between a firms management and financial markets is created as

a result of the conspiracy of product market competition and the separation of
ownership and control.
a.
Bid-ask spread: The bid-ask spread factor also provides valuable insight to the
markets quality for a given share. The bid price for a stock is the price at which
the dealer is willing to purchase a specific number of firms shares, and the
ask-price is the price at which the dealer is willing to sell a specified number of
shares. A dealer makes a market by offering to buy or sell a firms shares at any
time. The difference between the dealers bid and ask price is termed as spread.
The bid-ask spread is generally expressed as a percentage of stock price.
The stocks bid-ask spread exerts a great deal of influence on the quality of the
market for stocks. The spread is in fact one of the integral components of the
overall cost of trading a stock. The other two being, the brokerage commissions
and the price impact. The price impact is the behavior of the investors trading
activity to the price of the stock.
40

b.
The assumptions under Bhattacharyas dividend policy model are:

i.
The cost of external financing is more than the cost of internal financing.
ii.
The firms will always pay the dividends they have promised to the full.
A positive correlation exists between the firms managers individual wealth and
the stock price of the firm.

A. Multiple Choice
1.
2.
3.
Asymmetric information refers to the fact ___________.

a.
That borrowers typically have more information than lenders
b.
That lenders typically have more information than borrowers
c.
That banks wont give depositors all the information about their accounts
d.
That lenders have an incentive to withhold information from borrowers
e.
That buyers typically have more information than sellers.
Financial Intermediaries _________.

a.
Reduce diversification available to individuals
b.
Transform long-term debt into short-term assets
c.
Provide a way for investors to share risk
d.
Increase the riskiness of investments for depositors
e.
Transform short-term assets into long-term debt.
The higher returns associated with trading based on inside information is an

example of a more general market problem identified as ___________.
4.
a.
A market for lemons
b.
Informational asymmetry
c.
Moral hazard
d.
Adverse selection
e.
Market inefficiency.
The problem of managers making huge profits from insider trading would not
exist if there were no _________.
a.
Information asymmetry
b.
Riskless investments
c.
Government regulations
d.
Project cash flows
e.
Stock exchanges.
41
5.
In the studies demonstrating that the risk-adjusted returns on small firms

equities are significantly higher than those on large firms equities, the definition
of size is indexed by ___________.
a.
Asset base
b.
Market capitalization
c.
Number of employees
d.
Sales
e.
Employee productivity.
B. Descriptive
1.
What are the Conflicts between Short-term and Long-term Share Price
Maximization goals?
2.
What are the factors that contribute to the quality of a trading stock?
3.
Explain the relationship between information asymmetry and the market

efficiency theory.
practice only.
42
UNIT 11 MANAGERIAL INCENTIVES

Structure
11.1
Introduction
11.2
Objectives
11.3
Separation of Ownership and Control
11.4
Factors Influencing Managerial Incentives
11.5
Executive Compensation
11.6
Value-Based Management
11.7
Summary
11.8
Glossary
11.9
Suggested Readings/Reference Material

11.1 INTRODUCTION
It is very unpleasing for the managers to lay-off its employees; rather, they find it more
rewarding to provide them with better career opportunities. As a matter of fact, many
corporate houses firmly believe that, one of the primary objectives of the concern
should be taking care of their employees and not shareholders wealth maximizing.
There is also another school of thought that holds a more cynical point of view. They
opine that, most managers take advantage of their positions and indulge in actions that
personally benefit them at the cost of the shareholders. Thus, taking into account both
the points of view, the managers sometimes resort to taking investment and financing
strategies that do not direct towards maximizing the value of the firm. The managers of
the firm may take investment and financing decisions in such ways that might reduce
risk and increase the firms growth rate. This is actually done by the managers to
increase their own opportunities as well as those of their employees. As it is known that
the managers and the shareholders do not always have the same level of interest, the
financial decisions can be viewed from a number of perspectives. In this unit, the realworld factors influence on financial policies and factors influencing the managerial
incentives are covered.
11.2 OBJECTIVES
Understand separation of ownership and control;
Know real-world factors and their potential effects on a firms financial policies;
Identify opportunities for the management to alter their compensation; [v1]
Understand executive compensation;
Analyze Stock-Based versus Earnings-Based Performance Pay; and
Define Value-Based Management.
11.3 SEPARATION OF OWNERSHIP AND CONTROL

It has been observed that in many big corporations the effective control is held by the
companys managers, who hold a relatively small portion of the companys share.
Further it has also been seen that there is a distinct separation of ownership and control
in these houses. Such a separation may lead to problems, as the interest on the part of
the managers may not be in alignment with that of its shareholders. The equity holders
are interested in maximizing the value of their shares. On the other hand, the managers
consider these shareholders to be just another constituent of the stakeholders family. It
has been often quoted that the management and the top executives of the firm consider
themselves as the representatives of the three different constituencies, including both the
financial as well as the non-financial stakeholders. They are the investors, customers,
suppliers and employees of the firm. While making any important decision, the manager
tries to make a trade off all of the three groups rather than simply maximizing the value
of the shareholders. When the stakeholders of the firm remain unaffected by the
managers decision, there is absolutely no question of a conflict. But in reality, this is
not the case.
Real-World Factors: Violations of Ideal Capital Market Assumptions
The following discusses in brief several real-world factors and their potential effects on
a firms financial policies. These factors are cast in terms of violations of one or more of
the assumptions that define the ideal capital market.
VIOLATIONS OF ASSUMPTION 1
Frictionless Markets
The first assumption of the ideal capital market is that capital markets are frictionless;
that is, they are devoid of transaction costs and taxes. There are at least five potentially
important consequences of violations of this assumption.
First, transaction costs and personal taxes may affect investors ability to undertake
arbitrage, which is critical to the development of the M&M Propositions, the Capital
Asset Pricing Model (CAPM), the Binomial Pricing Model, and the Black-Scholes
Option Pricing Model (BSOPM),
Second, variation in personal tax rates and transaction costs across both investors and
securities may differentially affect the values of corporate securities (e.g., debt versus
equity), and ultimately a firms preference for issuing one type of security versus
another.
Third, if the firms earnings are taxed, and interest payments are deductible while
dividends are not (as the US corporate tax code specifies), a firms preference for debt
versus equity financing may be determined in part by the effect of taxes on the market
value of the firm.
Fourth, if a firm faces substantial transaction costs in issuing securities, such frictions
may inhibit its ability to undertake otherwise profitable investment opportunities, and
may also affect its choice of debt versus equity financing. Suppose the cost of issuing
either debt or equity is substantial, and the cost of issuing equity is substantially higher
than the cost of issuing debt. The firm may find it optimal to issue debt rather than
equity, which would lead to high leverage. Alternatively, the firm may find that the
lowest-cost financing is internal equity financing (i.e., funding projects via retained
earnings). This policy would impart a bias toward equity financing, and therefore low
leverage, and may also require the firm to reduce or eliminate dividends to shareholders.
44
Fifth, costs of financial distress and bankruptcy, which are basically transaction costs
associated with the presence of debt in a firms capital structure, may inhibit the firms
issuance of debt securities.
All Market Participants Share Homogeneous Expectations
Assumption 2 states that all market participants have the same information regarding
value-relevant information concerning a firm. This assumption disallows several realworld problems that may affect a firms financial decisions and, more fundamentally,
the quality of the market for the firms securities. Chief among these is information
asymmetry between investors and the firms management. Owing to their position as
insiders, a firms management has more information about the value of the firm than
investors. As we will see, this circumstance can affect a firms financial decisions and
market value.
Atomistic Competition
Assumption 3 states that all investors are atomistic; that is, their wealth, or at least the
wealth that they are willing to bring to purchase a given firms securities is small
relative to the total value of given firms securities. Here, two real-world factors that
constitute violations of this assumption are important, first, if an individual investor has
either sufficient wealth or sufficient borrowing capacity to purchase or sell a substantial
proportion of an individual firms securities, the investors trades may affect the market
value of these securities. Consequently, the value of the firms securities, and thus the
firms financial decisions, may reflect the personal preferences and value assessments of
such a dominant investor. Second, the firm itself can issue substantial quantities of
securities, and may have sufficient cash to engage in substantial repurchases of
outstanding securities. Transactions of either type may affect the market value of the
firms securities.
The Shareholder-Management Principal-Agent Problem
On the other hand, the satisfaction of assumption 3 also can be problematic. Closely
related to the concept of atomistic competition is the stipulation that the ownership of a
firms securities is diffused. The problem here is that, if no single investor has a
substantial portion of his or her wealth invested in a given firm, no investor has an
incentive to monitor the firms management to ensure that they are acting in the
shareholders interest.
Under these circumstances, it is difficult to imagine that management would make
decisions that are strictly in the shareholders interest (i.e., in the absence of an effective
incentive device). Instead, managers will tend to manage the firm in a manner that
maximizes their own utility rather than shareholders wealth. We describe this situation
as a principal-agent conflict, where the shareholders are the principals and managers are
the shareholders agents.
In the classic contracting paradigm, an agent is hired by a principal to perform duties
that serve the principals interests. (For example, you are the principal when you hire a
taxicab driver, the agent, to take you to the airport.) The problem is that the agent also
has an incentive to serve his or her own interests, which may conflict with the interests
of the principal. There is the existence of several contracting devices that can be used to
mitigate conflicts of interest between shareholders and managers. One such device is the
45
requirement that managers hold the firms equity shares (or options on the firms
shares) in their personal portfolios. Devices such as this though imperfect, serve to align
the interests of shareholders and management. However, such devices are often costly.
In the present case, depending on the size of managers holding of their firms shares
relative to the aggregate number of shares outstanding, the above requirement may
result in the firms shares being closely held by the firms managers. If so, the
requirement results in a substantial violation of the assumption of atomistic competition.
Moreover, the liquidity of the firms shares may be compromised. In any event, it is
ironic that an assumption of the ideal capital market must be violated to mitigate the
adverse effects of a particular real-world problem!
The Firms Capital Investment Program is Fixed and Known
Relaxing the assumption that the firms capital investment program is fixed engenders a
number of possible interactions between the firms investment and financing decisions.
For example, suppose a firm initially engages a capital investment program that is
financed with both debt and equity. As we will show in this chapter, if the debt is
default-risky, the firms management, acting in the shareholders interest, has an
invention of wealth from the debt holders to the equity shareholders.
Violation of the assumption that all market participants know the details of the firms
capital investment program also presents problems. Theory posits that a firms
management must keep strategic information regarding its operations private (i.e.,
known confidentially by insiders only). As such, we have the information asymmetry
problem noted earlier. Information asymmetry can have a deleterious effect on the
quality of the market for a firms securities. Briefly, one resolution to this problem is for
management to signal the firms value via their willingness to invest a substantial
portion of their personal wealth in the firms shares. By doing so, however, the firms
managers may own a substantial proportion of the firms shares, and therefore would
not be atomistic competitors; so again, we have the ironic situation that an assumption
of the ideal capital market must be violated to resolve a particular real-world problem.
Once Chosen, the Firms Financing is Fixed
Suppose a firm initially finances its assets with specified proportions of debt and equity,
and then later issues additional debt, using the proceeds to pay a dividend to
shareholders. If the new debt has the same priority as the original debt, the value of the
original debt will probably fall, an effect called claim dilution. Moreover, the firms
shareholders have an incentive to take such an action, because shareholders wealth
likely increases by the amount of the original debt holders loss (i.e., the sum of the
dividend and the market value of the remaining equity will be greater than the total
value of the equity prior to the issuance of the new debt). The shareholders will have
thereby expropriated wealth from the original debt holders.
This is an example of the second of the two principal-agent conflicts that we discuss. In
this case, the principals are debt holders and the agents are shareholders. The possibility
that management would take expropriator actions against debt holders on shareholders
behalf has potentially serious consequences for the firms ability to raise funds by
issuing debt securities (i.e., debt versus equity financing of a firm may no longer be a
matter of indifference).
46
SUMMARY AND PERSPECTIVE

This section emphasizes the point that much of what is interesting, important, and
challenging about corporate financial policies and strategies relates to real-world
factors, which represent violations of the assumptions of an ideal capital market. First,
even if one or more of the ideal capital market assumptions is violated, the fundamental
conclusions drawn from these theoretical models may yet hold, at least in
approximation. To the extent that this is so, they provide insights of the first order with
respect to the effects of corporate financial decisions on both risk and value.
Second, a variety of legal structures (e.g., corporate law and the US Securities and
Exchange Commission), institutions (e.g., commercial banks, investment banks and
securities exchanges), and contracting devices (e.g., provisions in bond contracts and
executive compensation contracts) exist that serve, at least in part, to mitigate either the
extent of the violations themselves or their adverse effects. As such, they serve to
establish capital markets that, as closely as practicable, approximate the ideal.
Third, as we will see, analyses of the effects of these real-world factors often rely on
predictions that emerge from the valuation models.
LIMITED LIABILITY AND THE SEPARATION OF OWNERSHIP AND
CONTROL
The corporation is a distinct legal entity, tethered to its owners with equity shares. Two
of the most important features of the corporate form of business organization are limited
liability and the separation of ownership and control.
Limited Liability
Under the limited liability provision, shareholders financial responsibility for any and
all liabilities that the corporation incurs is limited to the assets of the corporation, and
does not extend to shareholders personal assets (whether the shareholder is an
individual, a financial institution, another corporation, or any other entity). If the
corporation defaults on its liabilities, creditors may force the firm into bankruptcy
proceedings, but their claims are limited to corporate assets. Alternatively, if the firms
liabilities become onerous, the firm can voluntarily enter bankruptcy proceedings as a
means of protecting shareholders financial interest in the firm.
Separation of Ownership and Control
In an influential book, Berle and Means (1932) were first to formally discuss issues
associated with the separation of ownership and control in the modern corporation. In
most large firms, ownership is vested in one group, the shareholders, whereas control of
the firms operations is vested in a separate group, management, who are hired by the
shareholder, though we hasten to note the important and common circumstance in
which management holds some of the firms shares, or conversely, some shareholders
are part of the management team.
To a certain extent, the separation of ownership and control simply reflects a common
dichotomy in virtually and economy. Some individuals have capital, but lack the time
and/or expertise to undertake profitable real investments; other individuals have the
expertise to undertake profitable real investments, but lack capital. The corporation
brings together these two factors of production, capital and labor, under a formal,
efficient structure.
47
Both Limited Liability and Separation Reflect Investors Risk Aversion

Both limited liability and the separation of ownership and control reflect investors risk
aversion, regarding limited liability; each shareholder is concerned about the
preservation, as well as the growth, of his or her personal wealth. The limited liability
feature of the corporation allows an investor to make an equity investment in a firm
without risking his or her personal wealth beyond the amount invested in the firm. This
is particularly important because shareholders relinquish control of the corporation, and
therefore their equity investment, to management. Moreover, as Jensen and Meckling
(1976) point out, if shareholders liability were unlimited, individual shareholders
would wish to monitor each others wealth so as to estimate their own liability, which
would be very costly if shares were widely held.
The separation of ownership and control also allows shareholders to reduce the risk of
their private portfolios by diversifying their equity investments across firms. This would
be difficult if they also had to exercise control over each firms operations. Indeed, the
value to shareholders of diversification is so great that the separation of ownership and
control is a virtual necessity for the successful financing of large corporations. The
separation is necessary in part because diversification generally implies that none of the
equity holders of a given corporation will have a sufficient proportional stake in the
firm, nor will they have a sufficient portion of their personal wealth invested in a single
firm, to warrant the effort required to actively manage, or perhaps even to monitor, the
firms operations. Consequently, shareholders must hire managers and delegate control
of each firms operations to them.
Reaping the Benefits of Diversification
Diversification not only reduces the risk of investors personal portfolios, but also
indirectly increases the liquidity of their equity investments. The liquidity of a security is
defined in terms of an investors ability to buy or sell the security quickly, at a low
transaction cost, and at a price that reflects its fair market value. Liquidity is important to
investors because the ultimate purpose of investment is to provide for future consumption,
which the investor may desire either sooner or later.
Diversification increases the liquidity of equity shares via the following sequence of
events, first, en masse diversification among shareholders leads to a wide dispersion of
each firms shares among investors, second, ownership diffusion fosters the
development of a secondary market for a firms shares, wherein investors can buy or
sell a security according to their need for an investment versus liquidity. Third, as a
positive feedback effect, the development of liquid secondary markets for the shares of
many firms further facilitates investors ability to diversify.
This chain of development is illustrated in the following Figure:
Equity holders Motivation to diversify leads to Diffused Ownership, Increased Value,
and Enhanced Liquidity.
Moreover, ownership diffusion and attendant diversification have at least three positive
effects on the value of a firms shares: First, based on the analysis of portfolio theory
and the CAPM, well-diversified investors demand an expected return premium only for
the systematic risk of a firms shares, because firm-specific risk is eliminated through
diversification. If instead investors were not diversified, they may well demand
48
compensation for the firms total risk, and as a result the value of each firms shares
would likely be lower (and their cost of equity capital would be higher, which would
limit capital investment).
Figure: Diversification's Positive Feedback Loop

Second, the value of any security is positively related to its liquidity, and the natural
development of secondary markets among diversified investors increases the liquidity of
each firms securities.
Third, both shareholders diversification and the existence of a liquid secondary market
for a firms shares improves the firms ability to generate new equity funds to pursue
profitable capital investment projects over time, whether these funds are generated
internally via retained earnings or externally through the issuance of stock.
Regarding internal equity, if shareholders were not diversified and/or a liquid secondary
market did not exist for a firms equity, shareholders would likely require the firm to
pay higher dividends (which constitute a periodic, partial liquidation of the firms
assets) as a substitute for the illiquidity of the firms shares. Dividends reduce the pool
of internally generated funds available to the firm to pursue profitable investment
projects. Regarding new external equity, the firm is in a better position to attract new
equity funds if shareholders are diversified and a liquid secondary market for the firms
shares exists.
49
EXTENDED STAKEHOLDERS, CONFLICT OF INTERESTS, CONTRACTS,

AND REVISED DIRECTIVE: MAXIMIZE THE MARKET VALUE OF EQUITY
Some researchers, managers, and social scientists have argued that, in making decisions
managers should consider the interests of other parties (i.e., in addition to the firms
shareholders) who have direct or indirect interests, or stakes, in the firm. Such extended
stakeholders include,
a.
Governments, which may impose taxes on the firms profits and constraints on
the firms operations (such as operational and product safety regulations);
b.
Creditors, who have a claim on the firms future cash flows and its assets;
c.
The firms general employees, who depend on the firm for their personal
income, and medical and retirement benefits;
d.
The firms suppliers, whose operations and profits are tied to those of the firm;
e.
The firms customers, who purchase and use the products and services that the
firm provides;
f.
Society at large, which may either benefit from, or be harmed by, various
activities of the firm; and Finally managers themselves, who ultimately are
interested in maximizing their own personal utility.
How should the firms management deal with the interest of these extended
stakeholders?
The answer is provided in two parts:
The Firm as a Nexus of Contracts: Management must appreciate the critical role that
each extended stakeholder plays in the firms operations or financing, as the case may
be. However, as all of the extended stakeholders are ultimately pursuing their own
interests, conflicts of interest are bound to occur frequently. Dealing effectively with
these conflicts is one of the most important challenges that managers face. Contracts are
the primary means by which management deals with these conflicts. Indeed, a firm may
be described as a nexus of contracts between the firm and each of its stakeholders
(Jensen and Meckling 1976). Each contract is partially under managements control and
simultaneously constrains management. Moreover, each contract affects the firms risk
and profitability, and thus the market value of the firms equity. After all, equity holders
have a residual claim to the firms future cash flows, where residual means after
contracts with all other stakeholders have been settled.
A Revised Directive: Maximize (E): In the light of the stakeholder view of the
corporation, we might rephrase our question as, Should shareholders adopt the classic
directive, or adopt an alternative directive?
The short answer is that management should be given the following revised directive:
Revised Directive: Maximize the Market Value of the Firms Equity (E):
Management should adhere to this directive even if at times their decisions do not
simultaneously maximize the market value of the firm, and even though it does not
result in the maximization of other stakeholders utilities (even their own). In other
words, this revised directive is a mandate to management to resolve conflicts with other
stakeholders (through contracting) in a manner that is consistent with shareholders
interest, as expressed. After all, shareholders are the principals in their relationship with
management, while managers are the shareholders agents.
50
Given this revised directive, all extended stakeholders must realize that management
will tend to minimize the value of their claims in order to maximize the market value of
the firms equity, E. For instance, the firms employees should understand that
management would tend to provide the lowest possible wages and salaries, subject to
the dictates of a competitive labor market. Likewise, the firms suppliers and customers
should understand that the firm is continuously attempting to maximize profits in its
dealings with them, subject to the competitive dictates of these respective markets.
THREE IMPORTANT EXTENDED STAKEHOLDERS
Working under the revised directive, the firms dealings with three particular groups of
extended stakeholders occupy a disproportionate amount of four attentions in the
corporate finance literature. The first group includes governments. According to the
revised directive, management should take full advantage of all legal means to minimize
the present value of government tax claims against the firm. One such legal means is to
simply take advantage of the deductibility of interest payments on debt by employing
more debt in the firms capital structure. In addition management can choose, or switch
to, a depreciation schedule that is more tax favored.
Creditors constitute a second important group of extended stakeholders, if the firm has
debt outstanding, management, acting in the shareholders interest, has a derived
incentive to take actions to reduce the market value of the debt, if such actions serve
simultaneously to increase the market value of the firms equity. Management would
thereby expropriate wealth from the creditors to the shareholders. We provide examples
of such expropriation later in this chapter.
Creditors protect their interest in the firm by three primary means. First, promised
payments to creditors have a priority status within the law. If the firm fails to make
timely payments of interest and/or principal, creditors can force the firm into
bankruptcy proceedings, wherein they have a priority claim. Second, creditors generally
place various restrictive covenants and other provisions in the debt contract that serve to
protect their interests. Third, creditors can monitor the firms activities for compliance
with stipulations in the debt contract. The third group of extended stakeholders consists
of managers themselves. Managers have a personal interest in controlling the firm in a
manner that serves to maximize their utility rather than shareholders wealth. Such selfserving behavior is obviously costly to shareholders, and these costs are referred as
agency costs of managerial discretion.
OPPORTUNITIES FOR MANAGEMENT TO INCREASE THEIR
COMPENSATION
Managers may employ any of several schemes to increase their compensation from the
firm, including those discussed below:
Excessive Consumption of Perquisites
Managers have an incentive to take additional compensation in the form of perquisites.
That is, they can use the firms money to make expenditures that provide them with
personal benefits. For instance, a manager may purchase a Learjet to make his overseas
trips more pleasant, or hold meetings in exotic resort doubling as vacation sports.
Manipulating Earnings and Dividends
Suppose managements annual bonuses are based on the firms performance for the
year, where performance is measured by Return on common Equity (ROE).
51
Management then has an incentive to distort earnings upward to receive a larger bonus.
Alternatively, management may lower (or fail to increase) dividends over time as a
means of retaining more cash within the firm, which they can use to draw additional
compensation.
Maximizing the Size of the Firm, rather than its Value
In the (labor) market for corporate managers, compensation is highly correlated with the
size of the firm. Thus, left unchecked, management has an incentive to maximize the
size of the firm, rather than the market value of the firms equity. They can do this
through excessive internal expansion, acquisitions, or reducing dividends, even if these
actions are not in the shareholders interest. This is known as the over investment
problem. Managers who over invest are said to be engaging in empire building.
Siphoning Corporate Assets
A particularly brazen example of managerial self-interest involves siphoning corporate
assets. For example, a firms executives may establish a separate "shell" firm, which
they own, and then direct cash flow from the focal firm to the shell. This could be done
under the guise of (very favorable) payments for goods or services that the shell firm
provides to the focal firm.
OPPORTUNITIES FOR MANAGEMENT TO DECREASE THE RISKINESS OF
THEIR EMPLOYMENT INCOME
It is important to recognize that managers and shareholders are likely to have different
views on the riskiness of the firm. Assuming that shareholders are diversifie their risk
with respect to the firms limited to the stocks systematic risk. In contrast assuming
that the bulk of a managers wealth consists of compensation from the firm that he or
she manages, the manager is exposed to the firms total risk. Therefore, management
may tend to take actions to reduce the firms total risk even if such actions may not be
in the shareholders interest. Management may use any of the following schemes to
decrease the firms risk, and thus the risk of their personal portfolios.
Excessive Diversification
Management may pursue pure conglomerate mergers, which had no value to
shareholders, not only to increase the size of the firm but also to reduce firm-specific
risk (e.g., by diversifying the firms operations across industries, which is of no value to
already diversified shareholders). Reducing the probability of the firms failure reduces
the probability that the manager would be out of a job.
Bias toward Investment with Near-Term Pay-offs
If management compensation is tied to the firms earnings, management has an
incentive to bias their selection of capital investment projects toward investments that
pay-off well in a short period of time, even if these investments may not maximize
shareholder value in the long run. This bias may be particularly severe if top managers
have only a short period of time before they retire.
Underemployment of Debt
Under-employment: Suppose there is a particular optimal (i.e., E maximizing) amount
of leverage that a firm should employ. Management may choose a lower level of
leverage than is optimal in this sense, because the probability of bankruptcy, and thus
the loss of their jobs, increases with leverage.
52
Management Entrenchment
A firms CEO will naturally tend to steer the firm toward investments that reflect his or
her unique talents. Over time, this policy will make it difficult for the shareholders to
remove the CEO even if he is not performing adequately. That is, a CEO has become
entrenched. An alternative ploy is the inclusion of poison pills in the firms charter, in
an executive compensation contract, or in a bond contract. For instance, a poison put
provision in a bond contract makes the firms debt due immediately if the firm is the
target of a successful hostile takeover, after which the firms incumbent management is
fired. The poison pill increases the cash cost, and thus reduces the probability of a
takeover.
Yet another tactic management may use to keep their jobs involves the payment of
greenmail. Suppose an arbitrageur who has substantial capital believes that the
management of a given firm is failing to maximize the market value of the firms
equity, perhaps because management is relatively incompetent or is making self-serving
decisions. In the arbitrageurs opinion, the firms shares are undervalued relative to their
potential under better management. The arbitrageur has an incentive to purchase the
undervalued shares until their accumulated shares, perhaps in combination with those of
other shareholders who have been persuaded by the arbitrageurs argument, is sufficient
to vote out incumbent management. As this process is unfolding, the firms current
management realizes the threat to their positions and may offer to purchase the
arbitrageurs shares, using company funds, at a substantial premium to the current
market price if the arbitrageur promises to cease and desist. Such a payment is called
greenmail.
In a similar vein, a firms management can reduce the risk of losing their positions by
thwarting the attempts of activist investors to purchase the firms shares. Activist
investors purchase the shares of underperforming firms and then attempt to either oust
the firms incumbent management or force reform.
Management can limit the number of activist investors by systematically limiting
activists access to the firms shares. They can do this by any of several means. First,
they could include stock options in their compensation contracts that allow themselves
to purchase a substantial number of the firms shares over time. Second, they could
encourage individual investors with relatively little wealth (who may be more passive
than a wealthy investor, a mutual fund, or a pension fund) to purchase shares. Many
firms have dividend reinvestment plans that allow eligible individual investors to
automatically reinvest their dividends into shares of the firm. Generally, the firm
purchases the requisite shares in the secondary market, but gives the participating
shareholder a discount to the price actually paid, and also waives commission costs.
Third, management could use the firms cash to repurchase shares.
Packing the Board
Management may be able to garner the appointment of individuals to the firms board of
directors who have a favorable bias toward management. This policy is referred to as
packing the board.
REINVESTING THE ISSUE OF SEPARATION OF OWNERSHIP AND
CONTROL
At this point you may be wondering (a) whether agency costs of managerial discretion
are sufficiently large as to exceed the cited benefits of separation of ownership and
53
control, and (b) whether a firm should ever use debt in its capital structure, given that,
(1) debt engenders an additional principal-agent conflict between shareholders and debt
holders, and (2) debt can cause distortions in the firms capital investment program.
These are important issues that we will address in detail in later chapters. Here we will
make only some preliminary comments on both issues.
A Trade-off between Agency Costs of Managerial Discretion and Benefits
of the Separation of Ownership Control
In practice, it is difficult to quantify the benefits of separation of ownership and control
or the agency costs of managerial discretion, so it is difficult to know whether the
benefits exceed the costs. However, it seems likely that, for some firms, agency costs of
managerial discretion can be quite large relative to the benefits of separation. For
instance, in some firms it may be difficult to monitor (a) managements consumptions
of perquisites, (b) managements possible manipulation of earnings and/or dividends to
their own advantage, and (c) the efficacy of managements capital investment program.
For such firms, separation of ownership and control may lead to excessive agency costs
of managerial discretion, and the firm can be viable only if the firms managers are also
its owners, at least to some extent. This may explain why hundreds of successful firms
are privately and/or closely held.
a.
What is the responsibility of shareholders under limited liability provision?
b.
Define greenmail.
11.4 FACTORS INFLUENCING THE MANAGERIAL

INCENTIVES
A number of factors can be cited in relation to the managers of the firm acting in the
interest of the shareholders. The span of work in the firm increases the loyalty of the
manager to the various classes of stakeholders whom he meets on a day to day basis.
This makes it more difficult for him to take tough decisions that might improve the
stock price of the firm at the expense of the customers and the employees.
The proportion of the companys stock that is owned by the managers is also a
determining factor in the managements interest getting deviated from the interest of the
equity holders. It has been found out that as a group, the shareholders are not able to
force the managers to maximize the share prices. This is because their ownership is
totally diffused. Those shareholders who want to challenge the policies of the
management must stage proxy fights, which calls for the shareholders to organise among
themselves to oust the incumbent board of directors by electing a new board that supports
an alternative policy. These proxy fights come for a cost and it has been seen that the
54
outsiders that engage the outside share holders to vote against the incumbent
shareholders often do not win them in the process. While the aggregate benefits
available to all the shareholders who are involved in the process may be much more
than their costs, the individuals who bear those costs may only receive a fraction of the
total benefits. The remaining shareholders are the free riders. So it can be safely said
that these types of proxy fights are rarely in practice.
IS THE OWNERSHIP ACTUALLY SO DIFFUSED?
For any individual share holder, who wishes to have that number of shares that can give
him considerable control over the companys management will generally have to hold
an undiversified portfolio. The investor would reap the benefits of getting the
management make value maximizing decisions; he, at the same time would have to bear
the costs of holding an undiversified portfolio. So the investors are left with choice
between diversification and control. The undiversified investors, of course, share the
benefits of control along with the other shareholders. But, at the same time, they alone
must bear the cost of holding the undiversified portfolio. The significance of holding an
undiversified portfolio perhaps explains the reason of the investors rarely choosing to
take a position that is large enough to provide them the opportunity to adequately
monitor and even control the management. But this motive for diversification fails to
explain why the institutions do not arise to provide such monitoring services.
MANAGEMENT SHAREHOLDING AND MARKET VALUE
Despite having the awareness and motives of having a portfolio that is diversified, it has
been found that the ownership of the shares in many corporations is actually quite
concentrated. Many of these large shareholders are actually the founders of the firm. As
an example, records have revealed that at the end of the year 2000, Michael Dell owned
about 12% of Dell computers, and Jerry Young owned 10% of Yahoo. By selling the
shares of his company, the founder may himself throw wrong signals to the
shareholders of the firm regarding the value of the shares. When the founder holds a
considerable portion of the firms shares, he actually reflects his confidence about the
future prospects of the company and that he has further plans on implementing a
strategy that can maximize the value of the companys share. It has been suggested in
one of the studies conducted by Demsetz and Lehn that the executives in the industries
that have the greatest potential for incentive problem, tend to retain the largest share of
ownership in their firm.
AN EMPIRICAL EVIDENCE OF MANAGEMENT SHAREHOLDING AND THE
FIRM VALUE
Morck, Shleifer, and Vishny (1988) examined the relation between market values and
management shareholdings in a sample of Fortune 500 firms. They found that, for
relatively small shareholdings, firms with higher concentrations of management
ownership have higher market values relative to their book values. However, as
managements holdings rise above 5 percent, the firms become less valuable. This
suggests that as the managers holdings become too large, managers become
entrenched, allowing them more freedom to pursue their own agendas in lieu of valuemaximizing policies.
Unfortunately, it is difficult to interpret the evidence on the relation between value
creation and ownership concentration because the ratio of a firms market value to its
book value, which is used in these studies as a measure of value creation, measures
55
more than how well the firm is managed. For example, firms with substantial intangible
assets, such as patents and brand names, may have high market-to-book ratios even if
they are poorly managed. Similarly, well-managed firms may have relatively low
market-to-book ratios because they own few intangible assets. Perhaps management
ownership is related to market-to-book ratios because there are more benefits attached
to the control of intangible assets. We would expect, for instance, that it would be a
great deal more fun to own a controlling interest in a baseball team or a movie studio,
where most assets are intangible, than a copper mine, where most assets are tangible.
Measuring the value created by managers is much easier in the case of closed-end
mutual funds, which are publicly traded mutual funds with a fixed number of shares that
can be bought and sold on the open market rather than bought and redeemed directly
from the fund at their net asset values, as is the case for open-end mutual funds. The
ratio of the share price of the closed-end mutual fund to the net asset value per share of
the portfolio it holds provides an excellent measure of the value created by the funds
managers, since the net asset value of the fund provides a good measure of the market
value that could be achieved without the manager (for example, if the fund were
liquidated). If investors believe a fund is badly managed or that it generates excessive
expenses, they will not be willing to pay the full net asset value of the shares. Indeed,
there have been many cases of closed-end funds selling at more than a 25 percent
discount.
Barclay, Holderness, and Pontiff (1993) found that the average discount was 14.2
percent for closed-end funds with a large shareholder but only 4.1 percent for funds
without large shareholders. This evidence indicates that large shareholders tend to
depress values, suggesting that the negative effects of management ownership in this
case outweighed the positive benefits.
MANAGEMENT CONTROL DISTORTING THE INVESTMENT DECISIONS
There are several benefits that are associated with controlling a large corporation. And it
has been found that the top executives of the firm enhance and preserve those benefits.
The following section discusses on how the firms investment choices can influence the
controlling benefits in a number of ways.
MAKING THE INVESTMENTS THAT FIT THE MANAGERS EXPERTISE
If the benefits that are derived from controlling the corporation are sufficiently large, the
desire of the CEO to remain in the job for a longer period of time will also be more. In
order to become well established, the managers may resort to investing in irreversible
projects in which they have a strong expertise so that in the near future they will not
become dispensable. This may be one of the reasons why the oil firms have continued
to carry on the process of oil explorations even though the price of oil was continuously
falling during the period of the early 1980s. Apart from this, there is also the reliance of
the managers on personal relationships and implicit contracts which later on make it
very difficult for their potential replacement once they are initiated. There is also the
possibility of managers preferring for investment in variable and fun industries. They
also go for that investment that pays off early. This is an additional consideration in
which the managers want to make investments that help the current stock price of the
firm even when they are hurt in the long run. Thus, having a favorable financial result in
the short run may allow the firm to raise capital at a more favorable rate. This is coupled
56
with the fact that it increases his compensation and at the same time it reduces his
chances of losing his job.
MAKING INVESTMENTS THAT MINIMIZE THE RISK OF THE MANAGER
AND INCREASE THE SCOPE OF THE FIRM
The high degree of personal cost that is associated with the firms bankruptcy provides a
further bias to the investment and the financing choices of the managers of the firm. It is
observed by Gilson (1990) that only 43% of the CEOs and 46% of the directors of the
firm retain their jobs subsequent to the bankruptcy of the firm. One of the reasons that
can be attributed to the fact that the managers prefer the smaller sized empires to the
larger ones is because of the fear of bankruptcy. As a result, the managers tend to
expand their companies in a much faster way than they should. They do this by
investing more of the companys earnings and distributing less in dividends that is
optimal for value maximization. It is also a common tendency on the part of the
managers to be more risk averse in situations of making an investment than they are
supposed to be, especially in case of the treatment of the risk that the shareholders can
avoid through the process of diversification. For the shareholders it is only the
systematic risk that actually matters. But if seen from the perspective of the manager,
both the systematic as well as the unsystematic risk are of significance to him. The
reason being, both these forms of risk actually influence the chances of the firm in
getting into financial trouble. This may be the same reason of why the managers may
also prefer less than the value maximizing level of debt in their capital structure. But,
one must remember that the reduction in the level of risk may not be the only reason
why the managers may go for increasing the size of their companies. This may be the
prestige associated of being the CEO of the company. At the same time it becomes easy
to justify the high level of salaries for those individuals who are managing the larger
sized organization.
OUTSIDE SHAREHOLDERS AND MANAGERIAL DISCRETION
Up to this point, it has been assumed that managers control the investment choice.
However, large outside shareholders, knowing that managers have a tendency to skew
decisions in directions that benefit them personally, have an incentive to reduce
managements discretion. These outside shareholders may favor investments in fixed
assets and other technologies that limit the managers future discretion.
ALLIED INDUSTRIES
Consider the hypothetical example of Allied Industries, a conglomerate with business
units in a number of industries. The companys CEO and major shareholder, Kiran
Kashyap, has appointed Kunal Roy to run its farm machinery division. Mr. Roy is a
good choice for this position because he understands farm machinery better than anyone
in the world. As a champion of quality, he represents a commitment to customers that
Allieds farm machinery will be the best on the market.
Unfortunately, Roys commitment to quality is also his biggest weakness. Kashyap is
worried that Roy will spend too much money to produce the perfect tractor when an
almost perfect tractor would still be the best on the market.
Before completely turning over the division to Roy, Kashyap must decide between two
production processes: a labor-intensive process and a capital-intensive process. The
labor-intensive process requires more upfront training costs, but the yearly cost of the
capital-intensive process is actually the higher of the two processes given the high
maintenance costs of the machinery. Kashyap would certainly prefer the labor-intensive
57
process if he were running the farm equipment division himself. In addition to its lower
costs, the labor-intensive process provides the flexibility to improve the quality of the
product by increasing costs. However, since he wishes to delegate all future decisions to
Brandon, he believes that the capital-intensive technology will be the better alternative
because he does not wish to give Roy too much discretion in choosing the quality of the
product.
Trading Off the Benefits and Costs of Discretion
The Allied Industries example illustrated a negative aspect of flexibility. However,
under uncertainty, flexible investment designs can add value to a firm since flexibility
increases a firms operating options. If the value of flexibility is greater, greater is the
uncertainty. Hence, the costs associated with having to limit flexibility because of
incentive problems is greater, the greater the level of uncertainty. With sufficient
uncertainty, it is better for the outside shareholders to expend more effort monitoring
management but also to allow managers greater flexibility and discretion. However,
when there is very little uncertainty, the outside shareholders may want to limit the
managers flexibility. Thus, we can say that allowing management discretion has both
benefits as well as costs. The benefits of discretion are greater in more uncertain
environments. The costs of discretion are greater when the interests of managers and
shareholders do not coincide. Therefore, one might expect to find more concentrated
ownership and more managerial discretion in firms facing more uncertain environments.
Capital Structure and Managerial Control
A manager may prefer for a below optimal level of debt because of the fact that an
additional amount of debt increases the risk of bankruptcy and limits a managers
discretion. In certain situations the outside shareholders of the firm may view these as
advantageous. The added debt may prevent the manager from expanding the firm more
rapidly than would be optimal. Further, as the higher debt ratio increases the threat of
bankruptcy, which the managers always would want to avoid, the increased debt may
induce the management to avoid the policies they might personally prefer but which
reduce the value of the firm. From the above discussion, one can safely draw the
conclusion that those shareholders of a firm that is run by self interested management
gives preference to a higher leverage ratio, than one would be able to find in firms that
are managed in the interest of the shareholders.
Relation between the Shareholders Control and Leverage: The evidence of the fact
that financing choices of the firms are influenced by the outside shareholders of the firm
was provided by Mehran (1992). In his sample of 124 manufacturing firms, he observed
that a positive relationship exists between the firms leverage ratio and
Percentage of the total executive compensation that is tied to the performance.
Percentage of equity owned by the managers.
Percentage of investment banker in the board of directors.
Percentage of equity owned by large individual investors.
Thus, it can be said that the firms tend to be more highly leveraged if they are managed
by the individuals who have a strong sense of interest in increasing the stock price of
the firm or if they are monitored by the board members or large shareholders whose
shares have same level of interest.
58
Leverage Affecting the Level of Investment

Tom and Charleys Victorian Rehab: Using Debt to Limit Future Investments:
To understand why an investor might want to use debt to limit a firms investment
opportunities, consider the case of Tom and Charley, former college roommates. One
afternoon Tom, who had become an architect, called Charley, an investment banker,
with a proposal to buy an old Victorian house to convert into apartment units. Tom
estimated that the total cost of the house and the rehabilitation would be about
Rs.200,000. As the projects architect, Tom would receive a small fee from the profits,
and he would have complete control over the project once it was financed. Charley was
asked to come up with the best financing alternatives.
Charley carefully calculated the projects net present value. After considering several
possible scenarios, he concluded that Toms assessment of the projects potential was
reasonably accurate. Charley then considered financing alternatives and settled on a
fixed-rate mortgage as the best alternative. The next question was to determine how
much to borrow and how much of their own money to invest in the project.
Both Tom and Charley have Rs.25,000 to invest in the project. Tom would prefer to
invest his entire Rs.25,000 since his alternative is to put the money in a bank CD paying
5.5 percent interest and the mortgage rate would be 7 percent. Charley has no good
alternatives for his Rs.25,000, but he has one reservation about putting up such a large
down payment on the house. With a large down payment, the monthly payments would
be much lower, so Tom would face much less pressure to cut costs and increase cash
flows. With a large equity investment, Charley also could easily secure an additional
loan to make further renovations. Although Charley trusts Tom completely, he realizes
that Tom has the tendency to make his projects perfect, regardless of costs. For this
reason, Charley believes that the project should have a smaller down payment and a
larger loan.
This example illustrates one very important point:
A large debt obligation limits managements ability to use corporate resources in ways
that do not benefit investors.
Selecting a Debt Ratio that Allows a Firm to Invest Optimally
It may happen that too much of debt may force a firm to pass up some positive net
present value projects. The debt overhang problem is suggestive of the fact that a firm
that chooses a high debt ratio will find the cost of obtaining an additional fund relatively
high, thereby reducing the amount of that the equity holders will want the firm to invest.
It can be shown that the outside shareholders of the firm may be able to use the debt
overhang problem to their advantage. When ever the managers have a tendency to over
invest, the debt financing can be used to reduce the intensity of the problem. The
following example illustrates this particular point.
Selecting the Debt Ratio That Leads to the Optimal Investment Strategy
Consider a firm that is financed with an initial investment of Rs.100 million. In exactly
one year, it must decide whether to go ahead with a project that requires an additional
Rs.100 million investment. The present values (at the end of the first year) of the
payoffs from taking or not taking the additional investment in three future states of the
economy are given in the following table:
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Value with investment

Value without investment
Good
Medium
Bad
Rs.250
Rs.175
Rs.125
50
50
50
Table 1: Value (in Rs. millions) When State of the Economy

One year from now, if in either the good or medium states, the additional investment
has a positive NPV; that is, it creates more than Rs.100 million in value in the good and
medium states. In the bad state, however, where only Rs.75 million (Rs.125 million
Rs.50 million) is created by taking the investment, the additional investment has a
negative NPV.
Assume that when financing the investment at the beginning of year 1, the original
entrepreneurs understand that the manager they hire will want to fund the new
investment at the end of year 1, even if it has a negative NPV. How should they finance
the original investment to ensure that the firm can raise sufficient funds only when the
additional investment has a positive NPV at the end of year 1? Let us we find an answer
to this.
If the original Rs.100 million investments are financed completely with equity, the
additional investment can be funded by issuing debt even in the bad state of the
economy. To keep the managers from funding the additional investment in the bad state
of the economy, the firm can finance part of the original investment with senior debt
that requires additional debt to be of lower priority. Note that if the original investment
at the beginning of the year is Rs.100 million dollar investment in the medium state of
the economy. (Since, the original Rs.100 million investment must be paid first in the
medium state of the economy, only Rs.75 million is left to pay the new investors.) In
this case, a positive NPV project is passed up. However, if the firm issues more than
Rs.25 million in senior debt but less than Rs.75 million, it will be able to finance the
project in the good and medium states of the economy but not in the bad state of the
economy.
The outside shareholders in the above example were able to induce the firms managers
to invest exactly the right amount by selecting the appropriate debt ratio. In reality,
however, things may not work out as nicely. For one thing, the above example ignores
the possibility that the firm also has internally generated funds to invest in the project.
This does not necessarily cause a problem if the firm generates cash in those states of
the economy in which it has positive NPV investments. However, as the following
example illustrates, if the firm generates a substantial amount of cash when its
investments have negative NPVs, it may not be possible to induce managers to invest
the optimal amount in every state of the economy by simply selecting the appropriate
capital structure.
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CAN FINANCING CHOICES ALWAYS BE USED TO ACHIEVE THE

OPTIMAL INVESTMENT STRATEGY?
Consider, again, the previous example with a further assumption that the firm also
generates funds internally. The cash flows and payoffs in the different states of the
economy are described below:
It is possible for the firm to select a debt ratio that allows the firm to fund the
investment in the medium and good state of the economy but not in the bad state of the
economy? Let us see.
(Rs. in millions)
Value When State of the Economy is
Good
Medium
Bad
Rs.250
Rs.175
Rs.125
Value without investment
50
50
50
Internal cash flow
100
25
100
Value with investment
Table 2
It is not possible. The firm can be kept from financing what would be a negative NPV
project in the bad state of the economy by taking on:
a.
A Rs.100 million short-term debt obligation due when the initial cash flows are
realized, and
b.
An additional Rs.26 million in senior debt (or any amount above Rs.25 million)
due in the following year.
These debt obligations, which prevent the firm from borrowing additional amounts in
the bad state of the economy, also prevent the firm from investing in the medium state
of the economy even though doing so is a positive NPV investment. If the debt
obligations are lowered to allow the firm to finance its investments in the medium state
of the economy, then the firm also will be able to finance its operations in the bad state
of the economy.
11.5 EXECUTIVE COMPENSATION

The relationship between the owners and the management of a company is described as
a principal-agent relationship by the economists. In such a relationship the stockholders
are considered to be the principals and the management as the agents who are hired by
the principals to take actions on their behalf. In order to solve the problems that arise
because of the principal-agent conflicts, the economists have resorted to various ways to
compensate the agents in order to motivate them to work for the benefit of the
principals.
Major Components of the Agency Problem
The two essential components of the agency problem are the element of uncertainty that
the agent cannot control and the lack of information on the part of the principal. If the
principal was in a position to monitor the actions that are carried out by the agent, and
there was or free rider problem, there would not have been the existence of the incentive
problem. The principal is in a position to simply force the agent to work in his interest.
The agent who refuses to do so can be fired. Further, if the agent is not in a position to
bear the risk of a particular project or in other words if there was no risk that the agent
61
could not control, the principal could motivate the agent to make value maximizing
choices by having the agent to bear all the risks that are associated with his or her
actions. In brief, it can be said that if the manager is not averse to the risk and he had the
capital, the best situation would be the case in which the manager owned all of the
firms stock.
Measuring Inputs Versus Outputs
It is to be noted that the agency problem can be reduced to a great extent if the principal
can carefully monitor the actions of the agent. This can be done by the principal in
either of the two ways:
a.
Closely monitoring the input of the labor.
b.
Observing keenly on the agents output.
Designing the Optimal Incentive Contracts

The profits of a firm are determined by a number of factors some of which are under the
control of the manager, whereas others are not. On the whole, a well designed
compensation contract minimizes the extent to which the managers can be penalized by
factors that are outside their control. Keeping certain things in mind, it can be said that
the managers compensation should not be tied just to the stock price of the firm or the
firms earnings performance. Rather, it is more logical to be tied with the amount of the
return and the earnings of the firms stock exceed that of the return of the market in
general or to the performance of the other firms in the industry.
EXECUTIVE PAY CLOSELY TIED TO PERFORMANCE?
Executives receive compensation from a number of sources. A portion of their pay is
fixed, and some part is contingent on corporate profits, where as some part on
improvements in the stock price of their companies. It has been observed that executive
pay became much more tied to firm performance during the 1980s and 1990s. However,
there is still some level of ambiguity regarding how sensitive CEO compensation is tied
to performance. Let us look at some of the studies that have been conducted in this area.
The Jensen and Murphy Evidence
In their Harvard Business Review article, Michael Jensen and Kevin Murphy (1990)
had put forth the argument that executive compensation is not nearly as sensitive to the
performance as it should be. Their examination included the compensation and share
ownership of 2,505 CEOs from 1974 to 1988 and calculated how much the
compensation of the CEOs increased with each $1,000 increase in the value of their
companies. They came to the conclusion that the pay-for-performance sensitivity of
most CEOs compensation is surprisingly low and that most CEOs are not given
sufficient monetary incentives to cut costs and create value for their shareholders. Say
for example, the Jensen and Murphy estimates suggest that if an executive at a large US
corporation purchased an extra $10 million jet for his or her personal use, he or she
would be penalized for about $30,000 in lost compensation.
Examples of Some More Recent Evidence
Subsequent evidence by Boschen and Smith (1995), and Hall and Liebman (1998)
suggest that Jensen and Murphy may have underestimated average
pay-for-performance sensitivities and that these sensitivities have been increasing over
time.
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Boschen and Smith (1995) examined how the stock returns of a company affect the
future as well as the current compensation of its CEO. This study concluded that the
Jensen and Murphy evidence substantially underestimates the sensitivity of CEO pay to
performance.
In order to understand the importance of considering the CEOs future compensation,
let us consider a CEO who was promised a bonus in each of the next five years equal to
30 percent of the amount by which the companys earnings exceeded a certain level. If
the CEO took actions that doubled earnings in his or her first year, the stock price would
probably increase substantially upon the announcement of the higher earnings,
reflecting not only this years earnings but also the higher earnings predicted in the
future. In this case, one would observe only a weak relation between the CEOs
compensation in a given year and the firms stock return in that year. In the first year of
the contract, the firms stock price would increase substantially and the CEO would
receive a bonus reflecting the higher earnings in that year. In subsequent years,
however, one would not expect the firms stock price to respond to favorable earnings
since the expectation of good earnings was already reflected in the stock price at the end
of the first year. However, the CEO would continue to receive the same bonus he or she
received in the first year. Hence, the correlation between the firms stock returns in a
given year and the CEOs compensation in that year would not be particularly strong.
However, if one looked across firms, one might find a relation between stock returns
and compensation levels cumulated over many years. Boschen and Smith found that the
cumulative response of pay to performance is about 10 times as large as the pay-toperformance sensitivity found by comparing stock returns and compensation levels in
individual years.
CROSS-SECTIONAL DIFFERENCES IN PAY-FOR-PERFORMANCE
SENSITIVITIES
The Jensen and Murphy study along with the new evidence in Murphy (1999) reveal
that the pay-for-performance sensitivities differ substantially across firms. For example,
the CEOs of media companies generally have compensation contracts with substantial
pay-for-performance sensitivities, while the compensation contracts of regulated utility
company CEOs exhibit very little pay-for-performance sensitivities. This difference
probably reflects the fact that the CEOs of media companies have many more
opportunities to consume on the job and are more difficult to monitor than an
executive at a regulated utility. It is also the case that CEOs of small firms have much
higher pay-for-performance sensitivities than the CEOs of large firms. This is not
particularly surprising given the way Jensen and Murphy calculate pay-for-performance
sensitivities. For example, suppose that the CEO of a $100 billion company such as IBM
had a pay-for-performance sensitivity of 1 percent, meaning that he or she would receive an
extra $10 in compensation for every $1,000 in value improvement. With such a
compensation contract the CEO would give a bonus of more than $100 million for
increasing the value of the firm by just 10 percent. While a 1 percent pay-for-performance
sensitivity is probably not feasible at a company as large as IBM, far larger sensitivities are
often observed at much smaller companies. In addition, because the CEOs of growth
companies generally have more discretion than the CEOs of more mature companies, a
number of authors have argued that the compensation of growth company CEOs should be
more closely tied to their companies performance. However, the empirical evidence on this
is somewhat mixed.
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One reason why growth firm executives may not have higher pay-for-performance
sensitivity is that these firms tend to be very risky. Recall that the most important cost
of increasing performance-based pay is the added risk that must be borne by managers.
This implies that holding all else equal, we expect more risky firms to employ less
performance base compensation. A recent study by Aggarwal and Samwick (1999) of
the pay-for-performance sensitivities of the top executives of large US firms finds that
this is indeed true. In general, executives working for companies with less volatile stock
prices have higher pay-for-performance sensitivity than executives that work for
companies with more volatile stock prices.
IS PAY-FOR-PERFORMANCE SENSITIVITY INCREASING?
Hall and Liebman (1998) and Murphy (1999) report that over the past 20 years
executive compensation in the United States has become much more sensitive to
performance. The observed increases in pay-for-performance sensitivities have been
driven almost exclusively by the increased use of stock option grants.
HOW DOES FIRM VALUE RELATE TO THE USE OF PERFORMANCEBASED PAY?
If performance-based compensation improves incentives, then firms that implement
incentive-compensation programs should realize higher values. Empirical studies, which
have revealed the positive reaction of stock prices to the adoption of performance-based
executive compensation plans, tend to support this hypothesis. For example, Tehranian
and Waegelein (1985) examined stock returns at the time of the adoption of 42
performance-based compensation plans during the 1970s. They found that stock prices
increased about 20 percent, on average, from seven months before the announcement of
the adoption of the plans until the adoption date. A more recent study by Mehran (1995)
looked cross-sectionally at the relationship between the ratio of the market-to-book
value of a firms shares and the extent of performance-based compensation for top
management. He found that these two variables are positively correlated, indicating that,
on average, firms using more performance-based compensation have higher stock
prices.
Unfortunately, it is difficulty to infer causality from these studies. Performance-based
compensation is associated with higher stock prices; however, it is difficult to tell
whether this compensation causes stock prices to be higher or, alternatively, whether
managers are more willing to adopt performance contracts after observing increases in
their stock prices. Perhaps it would be easier to sell managers on the idea of adopting
performance-based compensation if the managers would have made more money in the
recent past had the plan been adopted earlier. In addition, managers are more willing to
adopt performance-based compensation plans when they have special information
suggesting that the firm may be undervalued. The following example illustrates the
reason behind the adoption of a performance-based compensation plan conveying
information to investors.
The Information Conveyed from Adopting a performance-based compensation Plan.
An Illustration
Consider the CEOs of two firms, A and B. The two firms currently have stocks priced at
Rs.20 per share. LEO of firm A has favorable proprietary information that leads him to
believe that his firms stock is really worth Rs.30 per share. CEO of firm B has
unfavorable proprietary information that leads her to believe that her firms stock is
worth only Rs.15 per share. Both CEOs are considering proposals that would lower
64
their fixed salary in exchange for stock options exercisable in one year at Rs.20 per
share. Which manager would be more inclined to accept such an offer? How would
agreeing to a performance-based incentive plan affect the companys stock price? Let us
find an answer to this.
Firm A is more willing than firm B to adopt the performance plan because its
proprietary information implies that the expected value of the options on this firm is
higher. If investors understand these incentives, they will view firm As acceptance of
the performance plan as good news and bid up the price of the firms stock.
As this example illustrates, stock prices may react positively to the adoption of a
performance-based compensation plan even if the plan has no effect on the managers
productivity.
IS EXECUTIVE COMPENSATION TIED TO RELATIVE PERFORMANCE?
Compensation contracts should be designed in such a way that it helps to eliminate as
much extraneous risk as possible. One way to eliminate extraneous risk is with a
relative performance contract, which determines executive compensation according to
how well the executives firm performs relative to some benchmark such as the
performance of the firms competitors. The relative performance contract would thus
have the desired feature of reducing the effect of risk elements that affect all industry
participants, which probably are not within the CEOs control, while rewarding the
executive only when he or she beats the relevant competition.
By far, the largest fraction of performance based pay comes from stock options.
Although these options could, in theory, be indexed to industry stock price movements,
in practice they are not, implying that relative performance does not have a major effect
on pay. For some firms, however, annual bonuses are tied to relative performance.
Murphy (1999) reports that in a 1997 survey of 177 large US firms by the consulting
firm Towers Perrin, 21 percent of the 125 industrial companies tie their annual bonuses
to their firms performance relative to their industry peers. The survey indicates that the
percentage of financial firms that do this is 57 percent, and the percentage of utilities
that base their executives bonuses on relative performance is 42 percent.
The fact that few industrial firms have embraced relative performance-based pay may
reflect the fact that these contracts can adversely affect the competitive environment
within an industry. The disadvantage of this type of contract is its undesirable side
effect of providing the CEO with an incentive to take actions that reduce its
competitors profits, even if doing so does not help his or her own firm. For example, a
firm that utilizes a relative performance contract may compete more aggressively for
market share since the costs imposed on competitors from being aggressive improves
the CEOs compensation, even if the gain in market share does not improve profits. The
consequences are that if all industry participants instituted relative performance
contracts of this type, industry competition would be more aggressive and profits would
likely be lower for all firms in the industry. Perhaps this is one reason we do not
observe explicit relative performance compensation contracts. Thus, we can now safely
conclude that relative performance contracts, which reward managers for performing
better than either the entire market or, alternatively, the firms in their industry, have an
advantage and a disadvantage:
The advantage is that the contracts eliminate the effect of some of the risks that
are beyond the managers control.
65
The disadvantage is that the contracts may cause firms to compete too
aggressively, which would reduce industry profits.
STOCK-BASED VERSUS EARNINGS-BASED PERFORMANCE PAY

Performance-based compensation contracts come in two distinct forms:
Stock-based compensation contracts, which include executive stock options and other
contracts that provide an executive with a pay-off tied directly to the firms share price,
and earnings or cash flow-based compensation contracts, based on non-market variables
like earnings, cash flow, and adjusted cash flow numbers such as Stern Stewarts
Economic Value Added. Let us understand each of these in brief.
Stock-Based Compensation
The advantage of stock-based compensation is that it motivates the manager to improve
stock prices, which is exactly what shareholders would like the manager to do.
However, there also are disadvantages associated with stock-based compensation which
lead us to believe that earnings or cash flow-based compensation might be referred in
many cases. There are also a couple of disadvantages that are associated with the stock
based compensation contracts. They are:
The stock prices change from day to day for reasons outside the control of top
managers (for example, changes in interest rates).
The stock prices move because of changes in expectations as well as realizations.
The latter disadvantage is illustrated in the following example:
Using Stock Returns to Evaluate Management Quality

Consider two CEOs, Ben and Alex, who are hired at the same time to manage
competing toy companies. Investors initially have an extremely favorable opinion of
Ben and expect his company, the Coy Toy Company, to do well. However, investors
initially are extremely skeptical about Alexs qualifications and the prospects of his
company, Toyco. How will the stock market react over the next few years if the two toy
companies do equally well?
Let us find an answer to this question.
If both companies do equally well, Coy Toy will have performed worse than expected
and Toyco will have performed better than expected. Hence, Toycos stock price will
perform much better, merely due to the improved opinion of Toycos future.
In general, companies would like to compensate managers based on how much they
contribute to shareholder value. As illustrated in the above example, however, stock
prices reflect how well the managers did relative to expectations. Hence, with stockbased compensation plans, managers are penalized when investors have favorable
expectations and are helped when investors have unfavorable expectations.
Earnings-Based Compensation
The principal advantage of compensating managers on the basis of earnings and cash
flows is that the numbers are generally available for the individual business units of a
firm as well as for nontraded companies that cannot easily base compensation on an
observable stock price. However, compensating managers based on earnings and cash
flows also has its drawbacks. First, it is difficult to calculate the cash flow number that
would be appropriate to use for evaluating performance. For example, one cannot
simply base the executives compensation on total earnings or cash flows because this
will provide an incentive to increase the scale of the corporations operations, even if
66
doing so requires the firm to take on negative net present value projects. Hence, there is
a need to adjust the cash flows for the amount of capital employed, which is likely to
change from period to period. In addition, both cash flow and earnings numbers that can
be pulled easily from a firms income statements are accounting numbers which include
various adjustments for inventory valuation methods, pension fund liabilities, and so
forth, and might not provide a very reliable measure of a firms performance.
a.
Explain the relationship between Management Shareholding and Market

Value.
b.
What are the observations made by Mehran (1992)?
11.6 VALUE-BASED MANAGEMENT

The idea that managers in individual business units should be compensated according to
the contribution of their units to overall firm value attracted substantial attention in the
1990s and has generated large revenues for consultants. Consultants like Marakon
Associates, Stern Stewart, McKinsey, and Boston Consulting Group/Holt have
developed what they call value-based management methods to transform accounting
cash flows to economic cash flows so that they more accurately measure the economic
cash flows that are most useful in compensating managers. Each of the preceding
methods share the insight that managers create value by making positive net present
value choices and reward managers for making such choices. These methods calculate
the value created by a particular business unit by subtracting a charge for the amount of
capital employed from the cash flows of each unit. The methods can differ in the way
that cash flows and the cost of capital are calculated.
The advantage of a value-based management compensation method over stock based
compensation methods is summarized below:
Stock-based compensation has the advantage that it motivates managers to improve
share prices. However, stock prices change for reasons outside of a managers control
and only partially reflect the efforts of a manager who heads an individual business
unit in a diversified corporation. A cash flow-based compensation plan that
appropriately adjusts for capital costs may provide the best method for motivating
managers in these cases.
COMPENSATION ISSUES, MERGERS, AND DIVESTITURES
It is to be noted here that although stock-based compensation contracts might prove
useful for motivating top management, they are less useful as a device for motivating
the head of a business unit who has little influence on the firms overall profitability.
For example, the efforts of Compaqs CEO are better reflected in the price of the
companys stock than the efforts of his counterpart in the personal computer division of
67
a multidivisional firm such as IBM. This puts IBM at a comparative disadvantage to

Compaq in motivating the managers in its PC group because their compensation cannot
be structured as easily to reflect the results of their efforts. This is especially true when
the economic cash flows of the individual business units are hard to measure.
SPIN-OFFS AND CARVE OUTS
Schipper and Smith (1986) and Aron (1991), among others, have argued that
motivational issues in an organization are one reason firms sometimes choose to spin
off a division, transforming the division into a new company by distributing shares of
the new company to the firms existing shareholders, carve out a division, that is, do an
IPO of the division, making it an independent operating firm. Announcements of spinoffs and carve outs usually lead to a favorable reaction in stock prices. In a sample of 93
spin-off announcements between 1963 and 1981 Schipper and Smith found that stock
price increased 2.84 percent, on average, when the spin-offs were announced.
Cusatis, Miles, and Woolridge (1994) described the case of Quaker Oats
spinning off Fisher Price, its toy subsidiary in 1991. Fisher Price reported losses of
$37.3 million and $33.6 million in the two years before the spin-off, but in its first two
years as a public company, Fisher Price showed profits of $17.3 million and $41.3
million, respectively. The authors attributed at least part of the strong operating
performance of the new company to the financial incentives of the officers and
directors, 14 of whom held 6.2 percent of the outstanding shares as of March 23, 1993.
While these individuals might have held stock in Quaker Oats prior to the spin-off, the
connection between their efforts and the resulting pay-off would have been much less
direct, so the incentive effects would have been substantially reduced.
The Indian Perspective
The basic elements of executive compensation in India are salary, benefits and the
incentive compensation. The first component, salary, was traditionally subject to certain
restrictions that were imposed by the government which are no longer in practice. The
benefits actually comprise of elements of furnished accommodations, pension and
gratuity benefits, chauffer driven cars, medical reimbursement, club membership, leave
travel allowance and others. The incentive compensation is in the form of an annual
bonus. Of late the very topic of executive compensation has become an issue of
controversy. It has given rise to a lot of debate among various classes of people, such as
legislators, corporate observers, economists, journalists, and even management experts.
Some of the recent sayings are summarized as follows. In a world that is assume to be
totally rational, the top executives would get a handsome payment for first class
performance, and would lose out when they are unable to deliver that. But never the less
such an inability goes unnoticed in many of the situations and they are still paid
handsomely.
The board of directors, individual shareholders and the large institutions are required to
rectify their own acts with respect to corporations that have poor performance and make
that performance even poorer by offering volumes of compensation to totally
incompetent employees.
Conflict of Interests
As it has been discussed earlier, due to the existence of the separation of ownership and
control in many public corporations, the very concept of agency theory has come into
68
being. In such companies, the interest of the managers tends to conflict with the interest
of the shareholders. The primary sources of these conflicts (according to Lambert and
Lacker) are:
a.
Excessive perquisites.
b.
Differential risk attitudes.
c.
Varying time horizons.
The very use of the executive compensation system can act as a means of aligning the
interest of the managers and the shareholders and thus bring in more shared interest on
the part of both the shareholders and the managers.
Why do Executive Compensation Plans Fail to Deliver the Results?
The basic reasons for the failure of the executive compensation plan can be enumerated
as follows:
Correlation between the size of the company and its payment structure. Because
of the existence of the strong correlation between the size of the company based
on its asset value and sales and the payment structure, companies sometimes tend
to strive for a bigger size irrespective of the fact that it adds to the value of the
concern.
Emphasis on short-term performance of the company. It has been frequently

observed that short-term performance indicators like sales and growth in the
earnings provide a greater weightage in the incentive compensation that is paid
to the executive.
More focus on the accounting measures is given while designing the

compensation contracts. Some of these measures are the earnings and the return
on the investments.
Finally, it is important to mention that while designing a well laid out compensation
contract, the following points need to be considered:
Integrating the incentive plan to the total compensation architecture of the firm.
Choosing an appropriate level of risk bearing and focus on the time.
Using the objective criteria.
Sselecting the right set of performance measure.
Discouraging parochial behavior.
Abandoning the attempts to measure what the executives control.
Lengthening the decision making time horizon of the executives.
Employing the stock options plans judiciously.
Ensuring tax efficiency.
69
11.7 SUMMARY
The degree to which the managerial incentives match with that of the shareholders
depends upon the time the managers spend on the job and the number of shares they
own.
Firms with concentrated ownership are lively to be better monitored and are hence
better managed. However, the cost of having a less diversified portfolio is borne only by
the large shareholder. Because of the lost of bearing firm specific risk, ownership is
likely to be less concentrated than it would be if management efficiency were the only
consideration.
Entrepreneurs may obtain a better price for their shares if they hold a larger part of the
share capital of a company. The incentive to hold shares is also related to risk aversion.
Managers prefer investments that minimizes risk. This means that they might prefer
larger, diversified firms and investment that pay off more quickly than those that
maximize shareholders wealth.
The benefit of managerial discretion are greater in more uncertain environments and
when there is a gap in the alignment of the interest of the managers and shareholders.
Shareholders prefer a higher leverage than managers. Hence, firm which are strongly
influenced by shareholders employ higher leverage.
A large debt obligation prohibits the managements ability to use resources in wage that
do not enhance shareholders wealth.
Agency problems partly arise because of imperfect and risk aversion.
Stock based compensation has this advantage that it motivates manages to improve
share prices.
However, stock prices change for reasons beyond managerial control. Hence, a cash
flow based compensation plan might provide the best way of motivating the managers.
11.8 GLOSSARY
Limited Liability Provision shareholders financial responsibility for any and all
liabilities that the corporation incurs is limited to the assets of the corporation, and does
not extend to shareholders personal assets.
High Leverage Capital structure which contain more debt than equity.
Tracking Error is the difference in performance of a particular fund relative to a
benchmark portfolio.
Cost of Capital is the minimum rate of return the firm must earn on its investments in
order to satisfy the expectations of investors who provide the funds to the firm. It is
often measured as the weighted arithmetic average of the cost of various sources of
finance tapped by the firm.
Cost of Debt is the rate that has to be received from an investment in order to achieve
the required rate of return for the creditors.
Systematic Risk is the risk that cannot be diversified away. It is also referred to as
market risk or non-diversifiable risk.
Unsystematic Risk is the risk that can be diversified away. It is also referred to as
unique risk, specific risk, residual risk, or diversifiable risk.
70
[v2]11.9
SUGGESTED READINGS/REFERENCE MATERIAL
Mark Grinblatt. and Sheridan Titman. Financial Markets and Corporate

Strategy. 2nd ed. Tata Mcgrawhill, 2002.
Aswath Damodaran. Corporate Finance Theory and Practice. Tata Mcgrawhill,

2000.
Eugene F. Brigham, and Phillip R. Daves. Intermediate Financial Management.

7th ed. Thomson, 2004.
Brealey Myers. Principles of Corporate Finance. 6th ed. US: Mcgraw-Hill

Companies Inc., 2000.

a.
Under the limited liability provision, shareholders financial responsibility for

any and all liabilities that the corporation incurs is limited to the assets of the
corporation, and does not extend to shareholders personal assets (whether the
shareholder is an individual, a financial institution, another corporation, or any
other entity). If the corporation defaults on its liabilities, creditors may force the
firm into bankruptcy proceedings, but their claims are limited to corporate assets.
Alternatively, if the firms liabilities become onerous, the firm can voluntarily
enter bankruptcy proceedings as a means of protecting shareholders financial
interest in the firm.
b.
Suppose an arbitrageur who has substantial capital believes that the management
of a given firm is failing to maximize the market value of the firms equity,
perhaps because management is relatively incompetent or is making self-serving
decisions. In the arbitrageurs opinion, the firms shares are undervalued relative
to their potential under better management. The arbitrageur has an incentive to
purchase the undervalued shares until their accumulated shares, perhaps in
combination with those of other shareholders who have been persuaded by the
arbitrageurs argument, is sufficient to vote out incumbent management. As this
process is unfolding, the firms current management realizes the threat to their
positions and may offer to purchase the arbitrageurs shares, using company
funds, at a substantial premium to the current market price if the arbitrageur
promises to cease and desist. Such a payment is called greenmail.
a.
When the founder holds a considerable portion of the firms shares, he actually
reflects his confidence about the future prospects of the company and that he has
further plans on implementing a strategy that can maximize the value of the
companys share. It has been suggested in one of the studies conducted by
Demsetz and Lehn that the executives in the industries that have the greatest
potential for incentive problem, tend to retain the largest share of ownership in
their firm. By selling the shares of founders of a company, the founder may
himself throw wrong signals to the shareholders of the firm regarding the value
of the shares.
71
b.
The evidence of the fact that financing choices of the firms are influenced by the
outside shareholders of the firm was provided by Mehran (1992). In his sample
of 124 manufacturing firms, he observed that a positive relationship exists
between the firms leverage ratio and
i.
Percentage of the total executive compensation that is tied to the

performance.
Ii.
iii.
iii.
Thus, it can be said that the firms tend to be more highly leveraged if they are
managed by the individuals who have a strong sense of interest in increasing the
stock price of the firm or if they are monitored by the board members or large
shareholders whose shares have same level of interest.

A. Multiple Choice
1.
2.
3.
4.
72
In which of the model the assumption of transaction costs and personal taxes are
not exist __________.
a.
the M&M Propositions.
b.
the Capital Asset Pricing Model (CAPM).
c.
the Binomial Pricing Model.
d.
the Black-Scholes Option Pricing Model (BSOPM).
e.
All the above options.
Who are NOT interest party/ies in the company?

a.
Stakeholders.
b.
Governments.
c.
Creditors.
d.
Employees.
e.
Non of the above.
The firms general employees depend on the firm for __________.

a.
Their wealth conditions and living standards.
d.
their education levels and children education.
c.
Their personal income, and medical and retirement benefits.
d.
their family relations and family planning.
e.
their entertainment expenditure and retirement benefits.
Identify which of the following is not an Opportunity for Management to

Increase their Compensation.
a.
Excessive Consumption of Perquisites
b.
Manipulating Earnings and Dividends.
c.
Maximizing the Size of the Firm.
d.
Maximizing the Value of the Firm.
e.
Siphoning Corporate Assets.
5.
Mehran (1992) observed that a positive relationship exists between the firms
leverage ratio and __________.
a.
Percentage of the total executive compensation that is tied to the

performance.
b.
c.
d.
e.
All the above.
B. Descriptive
1.
What are the factors to be considered design a well laid out compensation
contract?
2.
Is Pay-for-Performance Sensitivity Increasing?
3.
Explain the factors that Influence the managerial incentives.
practice only.
73
UNIT 12 DECISION SUPPORT MODELS

Structure
12.1
Introduction
12.2
Objectives
12.3
The Modelling Process
12.4
Financial Modelling
12.5
Marakon Model
12.6
Alcar Model
12.7
McKinsey Model
12.8
Summary
12.9
Glossary
12.10 Suggested Readings/Reference Material

12.1 INTRODUCTION
Corporate decisions are affected by a large number of variables. Many-a-times, the
interlinkages between these variables and their resultant effect on the decision is
extremely complex. Decision-support models are tools used to spell out the relationships
clearly in order to help the management arrive at the optimal decision. There is a wide
variety of decision-support models optimization models, simulation exercises, models
for predicting a firms bankruptcy etc. In this unit, the Modelling Process, Financial
Modelling, Marakon Model, Alcar Model and McKinsey Model are discussed.
12.2 OBJECTIVES
Know the steps involved in the process of using a model;
Illustrate Financial Modelling;
Develop Marakon Model;
Analyze Alcar Model; and
Identify McKinsey Model.
12.3 THE MODELLING PROCESS

The following are the major steps in the process of using a model to arrive at the
optimal decision:
Feasibility study,
Model construction,
Compatibility of the model with the tools used,
Model validation,
Implementation,
Model revision, and
Documentation.
Feasibility Study
The foremost step in developing a model is to ascertain the feasibility of a model
assisting the decision making process. The various points that are required to be
considered are:
Whether the decision under consideration is a one-time process, or is required to

be taken as a routine measure.
The suitability of the area in which the decision is required to be made, to be

supported by a model.
The possibility of all the relevant variables being unambiguously identified.
The possibility of all the variables being built-in into a single model.
The expected effectiveness of the model.
The acceptability of a model replacing human judgment to the management.
The possibility of obtaining the required data on an ongoing basis.
The possibility of integrating the model with the normal decision-making

process.
The costs involved with setting up and running the model, and its comparison
with the expected benefits.
If it is feasible to construct an efficient and effective model for the decision process
under consideration, and if the model can be easily integrated with the process, the firm
can proceed to the next step of constructing the model.
Model Construction
The construction of the model depends on a number of factors. Some of these are:
The decision to be made using the model.
The issues that are relevant for making the decision.
The way in which these issues and factors affect the decision.
The external factors that restrict the decision making process.
Depending on these factors, the input requirement for the model is identified and the
numerical and theoretical relationships between variables are specified. This is followed
by developing the structure of the model.
Model Compatibility
Once the model is in place, it needs to be made compatible to the tools to be used to
implement it. For example, if a particular model is to be solved using computers, the
model needs to be programmed and converted to a language that the computer
understands.
75
Model Validation
A number of test runs are conducted on the model to check whether it produces
reasonably accurate results. The test runs may use actual past data of the input variables,
and the results generated by the model are compared with the actual results.
Alternatively, the model may be tested by using probability distributions. Test running a
model checks the effectiveness of the structure of the model, as well as its predictive
ability.
Implementation
The implementation of a model includes integrating it with the normal decision-making
process. Further, it needs to be ensured that the results generated by the model are
relevant enough for the decision-maker to take them into consideration while making a
decision.
Model Revision
No model remains useful for an indefinite period. The relationships between different
variables that form a basis for the model may change over a period of time. External
factors affecting a model may also change. Use of the model over a period may provide
an insight into its drawbacks. It is necessary that such changes are noted and the model
periodically revised to accommodate them. Unless a model is continuously updated, it
may lose its relevance.
Documentation
Documentation is a way of institutionalization of the knowledge created during the
process of developing and installing a model. It involves making detailed, systematic
notes at all the stages of the process. The records should be maintained right from the
stage when the need for the model was felt, detailing the factors that gave rise to the
need. The various ideas considered at different stages need to be documented along with
the reasons for their acceptance or rejection. The various problems faced during the
development and implementation of the model, together with their solutions should also
form a part of the records. Documentation also helps in proper communication between
the members of the team working on the development of the model. In addition, it
makes the process of revising the model less tedious.
While developing and implementing models, certain issues need to be kept in mind. It is
not just necessary to specify the objectives of the model, it is also necessary to build the
relative importance of the different objectives into the model. For example, the
objective may be to maximize the profits of the firm, while restricting the debt taken by
it to a certain percentage of the total assets. The model should specify the objective
(maximum profits or limited debt) that would be held supreme, if there were a clash
between the two. Another important point to be remembered is that the model should
preferably focus on some key aspects, rather than be a collection of all relevant and
irrelevant data. A focused model is more likely to generate effective decisions.
76
12.4 FINANCIAL MODELLING

The following is an example of a model built to predict a firms debt capacity during a
recessionary period.
Extended Probabilistic Analysis
The assumptions underlying this model are
All sales are cash sales
The duration of recession is variable
The daily sales during the recession are variable
While the interest burden associated with debt is inescapable, the principal
repayment obligation can be deferred till the recession lasts.
Given these assumptions, the cash balance at the end of the recession will be:
Cash balance at the
beginning
Sales during the recession
Variable cash expenses during
recession
the
Fixed cash expenses
Interest payment
other than debt servicing burden
during the recession

Income tax during the recession
In symbols,
C1
%% vns
%% nf
% ni
%
= C0 + ns
%% vns
%% nf
% ni
% nf')
%
(ns
Where,
C1
ending cash balance
C0
beginning cash balance
n%
duration of the recession in months
s%
monthly sales during the recession
%%
ns
total sales during the recession
proportion of variable cash expenses to sales
total variable cash expenses during the recession
monthly fixed cash expenses, other than debt servicing

burden, during the recession
total fixed cash expenses, other than debt servicing burden

monthly interest payment associated with the

contemplated level of debt during the recession
total interest payment associated with the contemplated

level of debt during the recession
77
monthly non-cash fixed expenses
total non-cash fixed expenses during the recession
corporate income tax rate.
To illustrate the application of the above model, let us look at the case of Anekal
Corporation which is considering the implication of employing a certain level of debt
which will entail a monthly interest burden of Rs.21,000. The joint probability
distribution of and is given below.
(000) (in months)
10
20
30
40
40
.01
.15
.10
.04
50
.03
.15
.15
.04
60
.06
.10
.12
.05
Table 1
Other relevant information about Anekal is as follow:
C0
Rs.2,50,000
0.6
15,000
4,000
0.5
Given the above information, the cash balance at the end of recession would be
C1
%% 0.6 ns
%% 15,000 n% 21,000 n%
2,50,000 + ns
%% 0.6 ns
%%15,000 ns
%%21,000 n% 4,000 n%)
0.5 ( ns
%% 16,000 n%
2,50,000 + 0.2 ns
The probability distribution of the cash balance at the end of recession would be as
shown in the table given below. From this we find that the probability of cash
inadequacy is 0.04. If this probability for cash inadequacy is acceptable to the
management of the firm then the contemplated level of debt is acceptable. Analysis of
this kind would perhaps have to be done for several levels of debt to arrive at the most
desirable level of debt.
n%
s%
C1
Probability of the Event
10
60
2,10,000
0.06
10
10
20
20
20
30
30
30
40
40
40
50
40
60
50
40
60
50
40
60
50
40
1,90,000
1,70,000
1,70,000
1,30,000
90,000
1,30,000
70,000
10,000
90,000
10,000
30,000
0.03
0.01
0.10
0.15
0.15
0.12
0.15
0.10
0.05
0.04
0.04
Table 2: Probability Distribution of the

Cash Balance at the End of Recession
78
MODEL FOR MAXIMIZING SHAREHOLDER VALUE

The following section discusses a few models for maximizing shareholders wealth.
Management focused on maximizing shareholders wealth is referred to as value-based
management. The models being discussed are:
Marakon model.
Alcar model.
McKinsey model.
12.5 MARAKON MODEL

The Marakon model was developed by Marakon Associates, a management consulting
firm known for its work in the field of value-based management. According to this
model, a firms value is measured by the ratio of its market value to the book value. An
increase in this ratio depicts an increase in the value of the firm, and a reduction reflects
a reduction in the firms value. The model further states that a firm can maximize its
value by following these four steps:
Understand the financial factors that determine the firms value.
Understand the strategic forces that affect the value of the firm.
Formulate strategies that lead to a higher value for the firm.
Create internal structures to counter the divergence between the shareholders

goals and the managements goals.
FINANCIAL FACTORS
The first step in this model is to identify the financial factors that affect the value of the
firm. The model states that a firms market value to book value ratio, and hence, its
value depends on three factors return on equity, cost of equity, and growth rate. This
conclusion is drawn indirectly from the constant growth dividend discount model.
Let
P0
M be the current market price of the firms share
D1
be the dividend per share after one year
be the cost of equity
be the growth rate in earnings and dividends
be the return on equity
be the current book value per share
be the dividend pay-out ratio.
The constant growth dividend discount model says that

P0 =
D1
kg
Further,
D1 = B x r x b
79
Substituting the value of D1 in the dividend discount model, we get

P0 =
Br b
k g
Dividing both sides of the equation by B, we get
P0 rb
=
B kg
Further, we know that
g = r (1 b) or,
rxb=rg
Replacing the value of r x b in the equation, we get
P0 M r x b
= =
B B kg
Thus, a firms market value to book value ratio can be derived from its return on equity,
its cost of equity and its growth rate. It can be observed from the formula that,
A firms market value will be higher than its book value only if its return on
equity is higher than its cost of equity. This is supported by the other theories of
valuation of equity.
When the return on equity is higher than the cost of equity, the higher a firms
growth rate, the higher its market value to book value ratio.
Hence, a firm should have a positive spread between the return on equity and the cost of
equity, and a high growth rate in order to create value for its shareholders.
STRATEGIC FORCES
The financial factors that affect a firms value are in turn affected by some strategic
forces. The two important strategic factors that affect a firms value are market
economics and competitive position. The market economics determines the trend of the
growth rate and the spread between the return on equity and cost of equity for the
industry as a whole. The firms competitive position in the industry determines its
relative rate of growth and its relative spread. The following figure illustrates the effect
of the strategic factors on the firms value.
Market Economics
Structural
Factors and
trends
Average Equity
Spread and Growth
of Market(s)
Over Time
Financial
Determinants
Average Equity
Spread
Over Time
Value
Creation
Competitive Position
Differentiation
and Economic
Cost Positions
and Trends
Average Equity
Spread and Growth
of Market(s)
Over Time
Average Growth
Over Time
Figure 1: Strategic Determinants of Value Creation

80
Market economics refers to the forces that effect the prospects of the industry as a
whole. These include,
Level of entry barriers
Level of exit barriers
Degree of direct competition
Degree of indirect competition
Number of suppliers
Kinds of regulations
Customers influence.
While the degree of direct competition and customers influence are considered as the
core factors affecting an industrys prospects, the other factors are considered only
limiting forces.
This is reflected in the following figure:
Intensity of Indirect
Competition
Threat of Entry
Supplier Pressures
Regulatory Pressures
Limiting
Forces
Direct
Forces
Intensity of
Direct
Competition
Market
Profitability
Customer
Pressures
Figure 2: Determinants of Market Economics (or Profitability)

Competitive Position refers to a firms relative position within the industry. A firms
relative position is affected by its ability to produce differentiated products and its
economic cost position. A product can be referred to as a differentiated product when
the consumers perceive its quality to be better than the competitive products and are
ready to pay a premium for the same. The firm can benefit from a differentiated product
in two ways. It may either increase its market share by pricing it competitively, or can
command a higher price for its product than its competitors, and forego the higher
market share. Thus, the ability to produce differentiated products improves a firms
relative position vis--vis its competitors. The other factor that helps a firm enjoy a
strategic advantage over its competitors is a low per unit economic cost. Economic costs
include operating costs and the cost of capital employed. A low economic cost may
result from a number of factors like,
Access to cheaper sources of finance
Access to cheaper raw material

81
State-of-the-art technology resulting in better quality control
Better management
Strong dealer network
Exceptional labor relations.
STRATEGIES
Once a company has identified its potential growth prospects and analyzed its strengths
and weaknesses, it needs to develop strategies that would help it utilize its strengths and
underplay its weaknesses, thus achieving the maximum possible growth and creating
value. For achieving this objective two kinds of strategies are required participation
strategy and competitive strategy.
A company, to create value for its shareholders, has to either operate in an area where
the market economies are favorable, or has to produce those products in which it can
enjoy a highly competitive position. The strategy that specifies the broad product areas
or businesses in which a firm is to be involved is referred to as its participation strategy.
At the level of a business unit, this strategy outlines the market areas (in terms of the
geographical areas, the high-end market or the low-end market, the level of quality and
differentiation to be offered) to be entered.
Alternative
Strategy
Development
Participation Strategy
Options
Entry Strategy Options
In which
markets should
we participate?
Exit Strategy Options
Competitive Strategy
Options
How should we
complete in each
market?
Product Offering
Strategy Options
Cost and Asset

Strategy Options
Pricing
Strategy Options
Figure 3: Elements of Business Strategy

The strategy on the preferred markets is followed by the competitive strategy, which
specifies the plan of action required for achieving and maintaining a competitive advantage
in those markets. It includes deciding the way of achieving product differentiation, the
method for utilizing the differentiation so created (i.e. by increasing the price of the product
or the market share) and the means of creating an economic cost advantage.
INTERNAL STRUCTURES
The separation of ownership and management in the traditional manner results in the
management bearing all the risks associated with value-adding decisions, without their
enjoying any of the benefits. This often results in the management taking sub-optimal
decisions. A firm needs internal structures which can control this tendency of the
management. These may include:
82
The managements compensation being linked to the companys performance.
Corporate governance mechanisms that specify responsibilities and holds

managers accountable for their decisions.
Resource allocation among projects guided by the specific requirements of the

projects rather than the past allocations and capital rationing.
A mechanism for making sure that the various projects undertaken form part of a
strategy, rather than being disjointed, discrete projects.
Plans being made in accordance with the long-term goals and target performance being
fixed in accordance with these plans, rather than the level of achievable targets
determining the plans. Performance targets should be a function of the plans, rather than
being the base for the plans.
Target performance, when achieved, should be rewarded with promised incentives.
Non-fulfillment of such promises affects the future performance.
EVALUATION OF THE MODEL
The structure of the model is quite comprehensive as it provides a holistic perspective of
the process of value creation. Nevertheless, the models contention that a firms value
can be measured by its market value to book value ratio has attracted applauds as well
as criticism. The major point in favor of the ratios use is that the market value of a firm,
and the three factors affecting the market value to book value ratio (namely, the return
on equity, cost of equity, and growth rate) are widely accepted criterion for measuring a
firms performance. The criticism is that the return on equity is an accounting measure,
while the cost of equity is a market measure. Hence, the two are not comparable.
Besides, the presence of an accounting measure as a factor affecting the market value of
a firm, leaves the value of a firm open for manipulation.
a.
On which factors construction of decision-support models depends?

.
.
.
b.
How do you measure the value of a firm under Marakon model?
12.6 ALCAR MODEL

The Alcar model, developed by the Alcar Group Inc., a company into management
education and software development, uses the discounted cash flow analysis to identify
value adding strategies. According to this model, there are seven value drivers that
affect a firms value. These are:
The growth rate of sales
Operating profit margin

83
Income tax rate
Incremental investment in working capital
Incremental investment in fixed assets
Value growth duration
Cost of capital.
Value growth duration refers to the time period for which a strategy is expected to result
in a higher than normal growth rate for the firm. The first six factors affect the value of
the strategy for the firm by determining the cash flows generated by a strategy. The last
term, i.e. the cost of capital, affects the value of the strategy by determining the present
value of these cash flows. The following figure represents the Alcar approach.
According to the model, a strategy should be implemented if it generates additional
value for a firm. For ascertaining the value generating capability of a strategy, the value
of the firms equity without the strategy is compared to the value of the firms equity if
the strategy is implemented. The strategy is implemented if the latter is higher than the
former. The following steps are undertaken for making the comparison:
Valuation
Components
Value
Drivers
Shareholder Return
* Dividends
* Capital Gains
Creating
Shareholder
Value
Corporate
Objective
Cash Flow From

Operations
* Value Growth
Duration
Management
Decisions
Discount Rate
* Sales Growth
* Opening Profit
Margin
* Income Tax Rate
* Working Capital
Investment
* Fixed Capital
Investment
Operating
Investment
Debt
* Cost of
Capital
Financing
Figure 4
Source: Alfred Rappaport, Creating Shareholder Value: The New Standard for Business
Performance.
Calculate the Value of the Firms Equity without the Strategy
The present value of the expected cash flows of the firm is calculated using the cost of
capital. The cash flows should take the firms normal growth rate and its effect on
operating flows and additional investment in fixed assets and working capital into
consideration. The cost of capital would be the weighted average cost of the various
sources of finance, with their market values as the weights. The value of the equity is
arrived at by deducting the market value of the firms debt from its present value.
84
Calculate the Value of the Firm if the Strategy is Implemented

The firms cash flows are calculated over the value growth duration, taking into
consideration the growth rate generated by the strategy and the required additional
investments in fixed assets and current assets. These cash flows are discounted using the
post-strategy cost of capital. The post-strategy cost of capital may be different from the
pre-strategy cost of capital due to the financing pattern of the additional funds
requirement, or due to a higher cost of raising finance. The PV of the residual value of
the strategy is added to the present value of these cash flows to arrive at the value of the
firm. The residual value is the value of the steady perpetual cash flows generated by the
strategy, as at the end of the value growth duration. The post-strategy market value of
debt is then deducted from the value of the firm to arrive at the post-strategy value of
equity.
The value of the strategy is given by the difference between the post-strategy value and
the pre-strategy value of the firms equity. A strategy should be accepted if it generates
a positive value.
EVALUATION OF THE MODEL
This model is considered superior to the Marakon model because it uses the discounted
cash flow model instead of relying on accounting-based measures. However, the
computations involved in the model are more tedious compared to the Marakon model.
Nevertheless, the computations lead to a more reliable result as both the inputs and the
process are less open to distortion. The disadvantage of the model is that it focuses on
individual strategies rather than on the overall direction of the firm.
12.7 McKINSEY MODEL

The McKinsey model, developed by leading management consultants McKinsey &
Company, is a comprehensive approach to value-based management. It focuses on the
identification of key value drivers at various levels of the organization, and places
emphasis on these value drivers in all the areas, i.e. in setting up of targets, in the
various management processes, in performance measurement, etc. According to
Copeland, Koller and Murrin, value-based management is an approach to management
whereby the companys overall aspirations, analytical techniques, and management
processes are all aligned to help the company maximize its value by focusing
management decision-making on the key drivers of value. According to this model, the
key steps in maximizing the value of a firm are as follows:
Identification of value maximization as the supreme goal
Identification of the value drivers
Development of strategy
Setting of targets
Deciding upon the action plans

85
Setting up the performance measurement system
Implementation.
Value Maximization The Supreme Goal

A firm may have many conflicting goals like maximization of PAT, maximization of
market share, achieving consumer satisfaction, etc. The first step in maximizing the
value of a firm is to make it the most important goal for the organization. It is generally
reflected in maximized discounted cash flows. The other goals that a firm may have are
generally consistent with the goal of value maximization, but in case of a conflict, it
should prevail over all other objectives.
a.
Mention the value drivers that affect a firms value according to Alcar model.
.
.
.
b.
How does Alcar model better than Marakon model?
Identification of the Value Drivers

The important factors that affect the value of a business are referred to as key value
drivers. It is necessary to identify these variables for value-based management. The
value drivers need to be identified at various levels of an organization, so that the
personnel at all levels can ensure that their performance is in accordance with the
overall objective. The other objectives of a firm mentioned above may act as value
drivers at some level of the organization. For example, degree of innovation in products
may be identified as the value driver for the design department. The three main levels at
which the key value drivers need to be identified are:
The Generic Level: At this level, the variables that reflect the achievement or nonachievement of the value maximization objective most directly are identified. These
may be the return on capital employed or operating margin or the net profit margin, etc.
The Department Level: At this level, the variables that guide the department towards
achieving the overall objective are identified. For example, for the sales department, the
key value drivers may be achieving the optimum product mix, maximizing market
share, etc.
The Grass Roots Level: At the grass roots level, the variables that reflect the
performance at the operational level are identified. These may be the level of capacity
utilization, cost of managing inventory, etc.
86
Development of Strategy
The next step is to develop strategies at all levels of the organization, which are
consistent with the goal of value maximization, and lead to the achievement of the
same. The strategies should be aimed at and give directions for the achievement of the
desired level of the key value drivers.
Setting of Targets
Development of strategies is followed by setting up of specific short-term and long-term
targets. These should be specified in terms of the desirable level of key value drivers.
The short-term targets should be in tune with the long-term targets. Similarly, the
targets for the various levels of the organization should be in tune. They should be set
both for financial as well as non-financial variables.
Deciding upon the Action Plans
Once the strategy is in place and the targets have been determined, there is a need to
specify the particular actions that are required to be undertaken to achieve the targets in
a manner that is consistent with the strategy. At this stage, the detailed action plans are
laid out.
Setting up the Performance Measurement System
The future performance of personnel is affected by the way their performance is
measured, to a large extent. Hence, it is essential to set up a precise and unambiguous
performance measurement system. A performance measurement system should be
linked to the achievement of targets and should reflect the characteristics of each
individual department.
Implementation
The first step in implementing value-based management is to identify the current
position of the firm in terms of the six factors shown in the figure below.
Performance
driven
Low c ost
5
4
3
2
1
Value
based
Managed bottom
up as well as to down
Strong
Self-reinforcement
process
Two-way
Com munic ations
Figure 3: Elements of Business Strategy

Source: Copeland, Koller & Murrin, Valuation: Measuring and Managing the Value of
Companies.
The next step is to use the action plans laid out to stretch the firm to the maximum
possible extent in terms of each of these factors. The outer limit of the hexagon reflects
the maximum limit to which an organization can stretch itself. The aim of value
maximization is to make the firm reach these limits.
87
12.8 SUMMARY
Decision support models help management to identify the relationship between different
variables and help them to get an optimal decision.
Modeling process follows steps like feasibility study, model construction, compatibility
of the model with the tools used, model validation, implementation, revision and
documentation.
Probabilistic analysis can be used at the time of recession.
Marakon model uses four steps like understanding of financial factors that determine the
firms value, understanding the strategic forces that affect the firms value, formulate
strategies that lead to a higher value of the firm and create internal structures to counter
the divergence between the shareholder goals and the managements goals.
Alcar model uses the discounted cash flow analysis to identify value-adding strategies.
According to this model there are seven value drivers that affect a firms value.
Mckinsey model identifies value drivers at generic level, department level and grass root
level. The key steps in maximizing the value of a firm are identification of value
maximization as the supreme goal, identification of value driver, development of
strategy, setting of targets, deciding upon the action plan, setting up the performance
measurement system and implementation.
12.9 GLOSSARY
Financial Modelling C1
%% vns
%% nf
% ni
%
= C0 + ns
%% vns
%% nf
% ni
% nf')
%
(ns
Where,
C1
ending cash balance
C0
beginning cash balance
n%
duration of the recession in months
s%
monthly sales during the recession
%%
ns
total sales during the recession
proportion of variable cash expenses to sales
total variable cash expenses during the recession
monthly fixed cash expenses, other than debt servicing

burden, during the recession
total fixed cash expenses, other than debt servicing burden

monthly interest payment associated with the

contemplated level of debt during the recession
total interest payment associated with the contemplated
level of debt during the recession

88
monthly non-cash fixed expenses
total non-cash fixed expenses during the recession
corporate income tax rate.
In financial analysis, Leverage represents the influence of one financial variable over
some other related financial variable.
Internal Rate of Return is the rate of discount at which the net present value of an
investment is zero.
Intrinsic Value of an asset is the present value of the stream of benefits expected from
it. It is also referred to as the fair value or reasonable value or investment value.
At the Generic Level, the variables that reflect the achievement or non-achievement of
the value maximization objective most directly are identified.
At the Department Level, the variables that guide the department towards achieving
the overall objective are identified.
At the Grass Roots Level, the variables that reflect the performance at the operational
level are identified.
Aswath Damodaran. Investment Valuation. John Wiley & Sons, Inc., 2002.
Donald De Pamphillis. Mergers, Acquisitions and other Restructuring Activities.

Academic Press, 2001.
Frank C. Evans, and David M. Bishop. Valuation for M&A Building Value in
Private Companies. John Wiley and Sons, Inc., 2001.

a.
The construction of the model depends on a number of factors. Some of these

are:
i.
The decision to be made using the model.
ii.
The issues that are relevant for making the decision.
iii.
The way in which these issues and factors affect the decision.
iv.
The external factors that restrict the decision making process.
Depending on these factors, the input requirement for the model is identified and
the numerical and theoretical relationships between variables are specified.
This is followed by developing the structure of the model.
b.
According to Marakon model, a firms value is measured by the ratio of its

market value to the book value. An increase in this ratio depicts an increase in
the value of the firm, and a reduction reflects a reduction in the firms value.
a.
According to Alcar model, there are seven value drivers that affect a firms
value. These are:
i.
The growth rate of sales
ii.
Operating profit margin

89
b.
iii.
Income tax rate
iii.
Incremental investment in working capital
iv.
Incremental investment in fixed assets
v.
Value growth duration
vi.
Cost of capital.
Alcar model is considered superior to the Marakon model because it uses the
discounted cash flow model instead of relying on accounting-based measures.

A. Multiple Choice
1.
2.
3.
As per the Marakon approach which among the following that shapes market
economics can be termed as a direct force?
a.
Supplier pressures.
b.
Regulatory pressures.
c.
Customer pressures.
d.
Threat of entry.
e.
Intensity of indirect competition.
Which of the following is not a value driver as per the Alcar approach?
a.
Income tax rate.
b.
Operating profit margin.
c.
Dividend payout.
d.
Cost of capital.
e.
Investment in working capital.
Which of the following is analyzed at the generic level as per the McKinsey
approach?
a.
Return on invested capital in terms of operating margin and invested

capital.
4.
90
b.
Product Mix.
c.
Customer Mix.
d.
Capacity Utilization.
e.
Operating Leverage.
Which of the following value drivers is to be considered at the business unit

level as per the McKinsey Approach?
a.
Return on invested capital.
b.
Capacity utilization.
c.
Operating leverage.
d.
Cost per unit.
e.
Operating margin.
5.
Which of the following is an assumption underlying extended probabilistic

analysis to determine the debt capacity?
a.
All sales are made for cash only.
b.
The duration of a recession is predictable with certainty.
c.
The firm can postpone both interest on debt and principal repayments
during periods of recession.
d.
All sales are made on credit only.
e.
Both (a) and (c) of the above.
B. Descriptive
1.
Explain the factors to be covered under feasibility study.
2.
What are the financial factors that affect the value of the firm according to
Marakon model?
3.
Explain the key steps in McKinsey model to maximize the value of a firm.
practice only.
91
NOTES
92

Block
Unit
Nos.
Unit Title
INTRODUCTION TO STRATEGIC FINANCIAL
MANAGEMENT
1.
Strategic Financial Management: An Overview
2.
Firms Environment, Governance and Strategy
3.
Valuing Real Assets in the Presence of Risk
4.
Real Options
II
STRATEGIC CAPITAL STRUCTURE

5.
Capital Structure
6.
Dividend Policy
7.
Allocating Capital and Corporate Strategy
8.
Financial Distress and Restructuring
III
STRATEGIC ENVIRONMENT ANALYSIS

9.
Industry Analysis, Financial Policies and Strategies
10.
Information Asymmetry and the Markets for Corporate

Securities
11.
12.
IV
CORPORATE ACCOUNTING AND BUSINESS

STRATEGY
13.
Financial Statement Analysis
14.
Inflation Accounting
15.
Working Capital Management
16.
Strategic Cost Management
STRATEGIC RISK MANAGEMENT

17.
Corporate Risk Management
18.
Risk Management and Corporate Strategy
19.
Organization Architecture, Risk Management, and

Security Design
20.
The Practice of Hedging
21.
Enterprise Risk Management

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MBA-0000

Strategic Financial Management

Dr. Lata Chakravorty

Prof. P. Bala Bhaskaran

Dr. Dhananjay Keskar

Course Preparation Team

Prof. Hilda Amalraj

Prof. Bratati Ray

Dr. Vijaya Lakshmi S

Dr. Vunyale Narender

Ms. Sunitha Suresh

Prof. Arup Chowdhury

The ICFAI University Press, All rights reserved.

The ICFAI University Press, Hyderabad.

This block extensively covers strategic environment analysis. It briefly discusses

UNIT 9 INDUSTRY ANALYSIS,

Principal Agent Conflicts in Industry Setting

Designing Executive Compensation as a Competitive Strategy

Joint Ventures and Strategic Alliances

Suggested Readings/Reference Material

Understand the dynamics of Asset-Liquidity and Financial Strategy;

Realize the implications of Managerial Agency Cost;

Know the Competitive Strategy in Designing Executive Compensation; and

Analyze Joint Ventures and Strategic Alliances.

9.3 PRINCIPAL AGENT CONFLICTS IN INDUSTRY SETTING

Strategic Financial Management

DYNAMICS OF ASSET-LIQUIDITY AND FINANCIAL STRATEGY

It is not always necessary that the asset liquidation process, be it through an

Strategic Financial Management

What will be depicting of equilibrium in an industry accounting to William?

What is the hypothesis postulated in leverage aggressiveness hypothesis?

MANAGERIAL AGENCY COST COST OF COMPETITIONS

Strategic Financial Management

9.4 DESIGNING EXECUTIVE COMPENSATION AS A

It is to be remembered that the component of incentives in an executive compensation

9.5 JOINT VENTURES AND STRATEGIC ALLIANCES

Strategic Financial Management

Illustrate the relationship between Financial Decisions and Production and

Explain the advantages of Joint Ventures.

9.8 SUGGESTED READINGS/REFERENCE MATERIAL

Strategic Financial Management

Brealey Myers. Principles of Corporate Finance. 6th ed. US: Mcgraw-Hill

James C. Van Horne. Financial Management and Policy. 11th ed.

Eugene F. Brigham, and Michael C. Ehrhardt. Financial Management Theory

Prasanna Chandra. Financial Management Theory and Practice. 6th ed.

9.9 SUGGESTED ANSWERS

This particular hypothesis postulates that the component of leverage in a firm

9.10 TERMINAL QUESTIONS

Separation of ownership and control is a problem especially common for

Small, privately held corporations

Large, publicly held corporations

Common stock, preferred stock, secured debt

Long-term government debt, subordinated debt, common stock

Long-term government debt, secured debt, preferred stock

Secured debt, common stock, preferred stock

Subordinated debt, preferred stock and common stock.

Common stock, long-term government debt, preferred stock

Long-term government debt, common stock, preferred stock

Preferred stock, common stock, secured debt

Common stock, secured debt, treasury bills

Common stock, long-term government debt, preferred stock.

A _________ is a merger between firms operating at different but related levels

The person who assumes full co-ownership of a business, including unlimited