Intro_2 - 3 EDUCATING LEADERS FOR 800 YEARS Introduction to...

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FINANCE – Han Ozsoylev 1 3 EDUCATING LEADERS FOR 800 YEARS Introduction to Management - Finance Han Ozsoylev Hilary Term 2008 FINANCE – Han Ozsoylev 2 EDUCATING LEADERS FOR 800 YEARS Lecture 3: Finance in a less than perfect world
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FINANCE – Han Ozsoylev 3 Lesson from last lecture ± cost of external finance > cost of internal finance ± reason: outsiders know less about firm than do insiders ± imperfection: asymmetric information FINANCE – Han Ozsoylev 4 This lecture Further sources of imperfections Managerial incentives Information aggregation role of stock market Further roles of the stock market
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FINANCE – Han Ozsoylev 5 Imperfections Separation of ownership from control Examples: ± entrepreneur who sells stake to Venture Capitalist ± manager of publicly listed company ± manager of privately held, e.g. family company FINANCE – Han Ozsoylev 6 Production Function Managerial Labor Market (Professional Managers) Board of Directors Capital Market Bondholders Stockholders Product Market (Customers) Factor Market (Labor) The Market for Corporate Control Market interactions
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FINANCE – Han Ozsoylev 7 Imperfections Ensure that manager ± returns money to outside investors ± puts effort into his/her work ± does not waste money on perks etc. Moral hazard problem ± Shareholders of public corporation cannot observe & control all managerial actions FINANCE – Han Ozsoylev 8 Managerial incentives VC financed entrepreneur ± loss of control ± reduced incentives to perform
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FINANCE – Han Ozsoylev 9 Example of incentive problem Entrepreneurial effort e increases firm value: V = α e Effort is costly: c(e) = β e 2 Manager retains fraction λ of equity max λα e - β e 2 ± Solution: –2 β e = 0 e * = / 2 β ± Lower effort for lower residual ownership λ FINANCE – Han Ozsoylev 10 20% ownership 100% ownership effort Payoff, cost of cost of effort e 100 e 20 cost of effort Example of incentive problem
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FINANCE – Han Ozsoylev 11 Managerial incentives Entrepreneur: leave him/her with large equity stake debt financing Manager of publicly listed company ± bonus payments ± stock options FINANCE – Han Ozsoylev 12 35.6 30.3 5.3 Average nos. 6-20 54.1 23.4 30.7 Weill (Citigroup) 54.4 37.2 17.3 Silverman (Cendant) 70.5 66.2 4.2 David (United Tech.) 74.8 74.8 0 Jobs (Apple Computer) 141.1 136.0 5.1 Mark (Colgate- Palmolive) Total $m Long-term $m Salary & Bonus $m ‘Make your top managers rich and they’ll make you rich’ Robert Johnson, CEO of Johnson & Johnson Top paid CEOs 2003
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FINANCE – Han Ozsoylev 13 Who gave (or lost) the most for their pay 2001-2003 Best Value CEOs Total pay $m Share- holder return Worst Value CEOs Total pay $m Share- holder return Berks. Hath. 1.0 19% Uniphase 152 -91% eBay 3.4 292 Oracle 747 -54 Popular 1.9 84 AAB 73 -78 Biomet 1.5 39 Sun 35 -84 Harman Int’l 5.9 308 Colgate-P. 163 -17 Source: BusinessWeek, April 19 2004 FINANCE – Han Ozsoylev 14 Stock option Grants the holder the right (but not obligation) to purchase shares after future date at pre-specified price More valuable the higher the stock price Example: ±
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Intro_2 - 3 EDUCATING LEADERS FOR 800 YEARS Introduction to...

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