Topics in Financial Economics Term 2, Lecture 5

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Topics in Financial Economics Term 2, Lecture 5

• Some empirical examples
• Agency

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A case study BP
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The big picture
The end result?
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(No Transcript)
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Activities that affect firm values

• Dividends change value of the asset
• Repurchases change the number of shares
  outstanding (exposed to market)
• Divestiture sell assets to another firm that can
  use them more efficiently
• Spin-off grant independence to a division
• Equity carve out make division
  semi-independent parent retains controlling
  interest
• Tracking stock division completely controlled
  (does not have own board)

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The impact and determinants of buybacks

• Version 1
• Broadcom Corp. reported a big drop in
  fourth-quarter profits on costs from its recently
  ended options probe, while profits before charges
  were off slightly from a year earlier. The
  company said Thursday its quarterly net income
  was 45.1 million, down from 110.2 million a
  year earlier. The results include a 50 million
  charge for related to stock options. Broadcom
  wrapped an internal investigation last month,
  saying it would revise financial statements for
  1998 to 2005 with charges of 2.2 billion for
  stock option grants that were improperly
  accounted for. Excluding charges, Broadcom said
  it earned 185 million, down 6 from a year
  earlier. Revenue for the quarter rose 12.5 to
  923.5 million. Shares of Broadcom were flat in
  after-hours trading. The company also said it
  plans to buy back 1 billion worth of its shares
  starting next week. Broadcom plans to use some of
  2.8 billion in cash to fund the buyback.
  Subsequently, shares rose significantly.
• Version 2
• RUPERT MURDOCH, the chairman of BSkyB, hinted
  yesterday that the satellite broadcaster could
  resume its controversial share buyback programme
  in future years. Mr Murdoch, who is also chief
  executive of News Corporation, parent company of
  The Times, told investors at the broadcasters
  annual meeting yesterday that Sky may revisit
  this subject again. A year ago Sky pledged that
  it would not pursue a buyback this year, amid
  investor concerns that the exercise results in
  its principal shareholder, News Corporation,
  gaining increasing control without submitting a
  takeover bid.

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(How) Do Buybacks affect shareholders?

• Aug 03 Royal Bank of Scotland this week
  became the latest group to announce the return of
  surplus capital to shareholders through a stock
  buyback because it cannot find a better use for
  the funds.
• Repurchase certainly boosts earnings per share
  (EPS), a popular measure of performance
• This link between buybacks and EPS has been
  abused, particularly during the 1990s bubble
  when investors were obsessed with EPS momentum.
  It also helped senior management, whose
  remuneration was commonly tied to EPS growth
• Empirically, buybacks do improve shareholder
  value if
• Stock is purchased at the right price (GSK
  repurchase at 18 of stock at 35 over true value
  triggered fall to 12 but exec bonuses rose)
• Needs supporting evidence of capital discipline
  (Rentokil had been following 20 annual capex
  growth after share value collapsed in 2000, they
  bought back 35 of stock as part of a programme
  of disposals and have since outperformed
  market by 120)
• do not sell off the components with the highest
  returns
• Value takes at least one year to materialise (vs.
  dividends, which produce immediate effects

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Differences
Best
Worst
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Principal-agent theory

• Interaction between 2 parties one acts for the
  other
• Not always clear who is the agent depends on
  incentives. Agent is the one who can gain by
  cheating, and therefore needs incentives to
  fulfil the bargain.
• Problem 1 hidden action (moral hazard)
  principal cannot (freely) monitor/verify agents
  action
• Problem 2 hidden information (adverse
  selection) principal cannot test whether agents
  action was justified
• Also known as contract theory
• Assumes (uninformed) principal moves first
• Distinct from signalling, where informed party
  moves first

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Agency reading

• Principal-agent theory
• Osborne and Rubinstein A course in game theory,
  ch. 10.
• D. Gale notes sec 3 http//www.econ.nyu.edu/user/g
  aled/finchap03.pdf
• Gale and Allen, Financial Innovation and Risk
  Sharing (1994) sec. 4.1
• Stole notes secs 1.1, 2.1 (more as interest
  dictates) http//gsblas.uchicago.edu/papers/lectur
  es.pdf
• Handa slides http//www.biz.uiowa.edu/class/6F215_
  handa/Pr2lec5.ppt
• Agency problems in financial economics
• Jensen, M. and W. Meckling (1976) Theory of the
  firm, managerial behaviour, agency costs and
  ownership structure, Journal of Financial
  Economics 3, 305-360 Link from Warwick machines
• Myers, S. (1977) Determinants of corporate
  borrowing, Journal of Financial Economics 5,
  147-175 Link from Warwick machines
• Grossman, S. and O. Hart (1983) An analysis of
  the principal-agent problem Econometrica 51,
  7-45 Link
• Shleifer, A. and R. Vishny (1997) A survey of
  corporate governance Journal of Finance, 52,
  737-783 Link from Warwick machines
• Murphy, K. (1999) Executive compensation, in
  Handbook of Labor Economics, O. Ashenfelter and
  D. Card (eds), 2485-2563

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Simple model try a risky venture, split proceeds

• Agent takes action s in a (finite or interval)
  set A
• The state is w in a (finite) set W the state is
  determined by a
• The probability of w given a is p(wa)
• The revenue if w occurs is R(w)
• The agents utility from consuming c (bought with
  his share of revenue) and taking action a is u(c,
  a) we assume u(c, a) U(c) J(a)
• The principals utility from her share of revenue
  is V(c)
• Both utilities are strictly increasing, concave,
  twice continuously differentiable
• We assume the agents consumption is non-negative
  (liquidity or limited liability)

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Pareto optimality

• Contract (a, h(.)), where a is the contracted
  action and h(w) gt 0 is the payment to the agent
  in state w.
• Principals problem choose contract to maximise
  principals utility subject to agents
  participationPP
• Theorem A contract is Pareto efficient iff it
  solves this problem
• If the (risk-sharing) payment h is always gt 0 and
  optimalB
• If a is interior and p and J are differentiable

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Incentive efficiency

• If agents actions cannot be observed or
  verified, they must be incentive-compatibleIC
  
• A contract is incentive efficient if it is Pareto
  optimal relative to the set of incentive
  compatible contracts. It solves the original
  problem (PP) with the added IC constraint.
• Any solution to this enhanced problem (PP) is
  incentive efficient if the participation
  constraint always binds.
• To solve this problem
• Fix a and compute the payoff V(a) from providing
  incentives to do a.
• Now choose a to maximise V(a)
• Because U and V are concave, the first part is
  easier to solve than the whole, and gives many
  useful insights. If V is linear (the principal is
  risk-neutral) this just minimises the expected
  payment to the agent

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Does moral hazard prevent first-best?

• If the principal is risk-neutral and the agent is
  strictly risk-averse, condition B implies that
  payment h is independent of state, hence of
  agents action. The agent will choose the
  cost-minimising action and first-best can be
  achieved only if the optimal action (for the
  principal) is also the cheapest (for the agent).
• If the principal is risk-averse and the agent is
  risk-neutral, condition B implies R(w)-h(w) is
  constant for interior solutions sell the firm
  to the agent, providing firm remains profitable
  (agent gets gt 0).
• In general, there is y s.t. R(w)-h(w) miny,
  r(w), and h(w) maxR(w) y, 0

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If both parties are risk-averse

• The first-order condition for the first-best
  is
• The first-order condition for incentive
  compatibility is
• The first-best and incentive-efficient contracts
  only coincide if

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An example 2 states W (win) or L (lose)

• We assume winning is worthwhile R(W) gt R(L)
• The necessary condition is
• If effort is productive (i.e. pgt0), this implies
  paying the agent the full marginal
  contributionR(W)-R(L)h(W)-h(L)
• This does not satisfy condition B unless the
  agent is risk neutral on the interval h(L),
  h(W).

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Optimal incentives, 1

• Assume the principal is risk-neutral (always
  prefers the action with higher expected revenue
  if costs are equal).
• There are a finite number of states and actions,
  strictly increasing revenue
• The monotone likelihood ratio property (MLRP)
  for any actions altb, the ratio p(w,b)/p(w,a) is
  non-decreasing in w. Also assume that the vectors
  p(.,b) and p(., a) are distinct (ratio sometimes
  rises). Expected revenue is increasing in a.

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Optimal incentives, 2

• Because it only uses a one-sided IC constraint,
  is at least as big as V. Suppose it is bigger
  for some a, so the agent wants to choose more
  effort but the principal will always prefer
  more effort if it comes at the same price, so the
  a that maximises the two V-functions will be the
  same., so we can limit attention to the modified
  problem.
• Most incentive schemes are increasing a higher w
  brings a higher h though not necessarily a
  higher h(w)/R(w). Is this true of the optimal
  scheme?
• Rearranging the Kuhn-Tucker conditions for an
  interior solution to the modified problem, we
  get
• By the MLRP, the RHS is non-increasing in w so
  too is the LHS, hence the optimal h(w) is also
  non-decreasing

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Examples

• 2 states W (win), L (lose)
• 2 projects or effort levels (A,B)
• let 0 lt pA p(W,A) lt pB p(W,B) lt 1
• Effort cost J(A) 0 lt J(B).
• U(0) reservation utility 0.
• To implement the inferior project (A), set
• h(L) hL h(W) hW 0
• Constraints to implement BICIR

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Relation between IC, IR constraints

• Can rewrite IC as
• IR implies positive consumption in at least one
  state, so
• Therefore, IC implies IR holds strictly (doesnt
  bind)
• We can thus rewrite principals problem as

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Optimum and project choice

• Clearly, optimality implies hL 0, and the
  optimum level of hW satisfies pB -
  pAU(hW)J(B)
• What makes managerial compensation hW higher?
• Higher effort cost J(B)
• Higher managerial risk aversion U(hW) U(hL)
• Lower managerial marginal productivity pB - pA
• Optimal project compare profits from both schemes

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Incentive-efficiency example

• Set-up as before (2 states, 2 effort levels, 0
  reservation utility, risk-neutral agent,
  principal)
• Also assume
• R(L) 0 lt R(W) revenues in 2 states
• J(A) 0 lt J(B) effort cost to 2 actions
• 0 lt pA lt pB lt 1 probability of winning state
  for 2 actions
• Optimal implementation
• Project A hW hL 0
• Project B hL 0 hW J(B)/pB pA
• Principals payoff V(w)
• Project A pAR(W)
• Project B pBR(W) - J(B)/pB pA
• If it happens that v(W) V(L), the contract
  implementing project A solves the principals
  problem, but is not incentive efficient, because
  the project implementing B gives the agent
  strictly higher utility.

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Corner solution example

• In previous example, the agent gets 0 in state L
  regardless of which action (project, effort
  level) he chooses. You might think this is due to
  risk neutrality, but corner solutions are
  possible even when U(0) ?. Suppose U(h) ha
  for 0 lt a lt 1.
• U(0) is still 0, so the optimal incentive scheme
  implementing A in the above example is still h(w)
  0
• To implement B, the optimal scheme is h(L) 0
  and h(W) J(B)/(pB pA)(1/a)
• Thus it is not always safe to simply assume
  interior solutions