To grow a company must invest retained earnings in things that will generate more return Retained earnings boost a company’s value and boost the amount that will be investedinto it. With managers keeping retained capital the companies are valued as less6. Why do regulators feel a need to intervene? What do you expect to be the results of closer government involvement?Companies were converting for the managers benefit- once converted managers were giving themselves a large benefit package that drew criticisms from congress, depositors, and regulators.oThey want to make sure conversions were taken under for fiduciary reasons, not for the managers benefitI think less firms would convert because of the increased regulation which will slow down efficiency
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Chapter 15:Equity market is the market for shares in the ownership of corporations- investors hand over money for a promise of a part of the distributed profitsoNo default because promised payment is not specific Equity finance requires corporate governance (legal protection and reliance on some party with power to monitor arm’s length investors) Public equity (function of liquidity and price discovery) is arm’s lengthprivate equity is relationshipdispersed shareholding is of necessity an arm’s length arrangement- each hold small share so don’t really have a say and don’t want it they’d rather exitinsiders have a say in enterprise- can abuse arm’s length lendersoways to protect- 1) legal protection, and 2) reliance on some party with sufficient power to monitor the enterprise on behalf of arm’s lengthin absence of monitoring and control, large corporations were run for the benefit of their managers rather than for the benefit of their shareholders. This is what we call FREE CASH FLOW PROBLEMowhen managers are not monitored, they can invest internal funds on projects that are not worthwhile from the perspective of a shareholderoFREE CASH FLOW- excess of internal funds over the amount needed to finance worthwhile investmentsShould be paid out to owners (shareholders) through dividends or repurchase of stockManagers gain nothing from this so they will use free cash flow to their interestCould hold on to cash (protection if company runs into trouble) Can fund new projects without having to persuade the capital market of their value (can expand even when expansion is unprofitable) Reinvestment of internal funds faces the “free cash flow” problemPrice discovery of equity market that reveals the existence of the problem when share prices rise by less than the amount invested Leveraged buyout LBO- addressed issue w large corporations and how it was difficult to come up with someone who had significant power to make monitoring worthwhileoMakes equity of corporation smaller by replacing with debt – borrow to buy the outstanding shares of the company, then the company issued debt to pay retire part of the shares they heldInstead of firing managers, they gave them a stake in the companyA good secondary market has good liquidity and good price discovery
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