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Managerial Objective
Maximize Firm Value
Who are the Players that Influence Firm Value ?
• Employees of the Firm:
– Board of Directors
– Senior/Middle/Line Managers
• Competitors of the Firm
• Suppliers of goods and Services
• Suppliers of capital:
– Internal
– External
What Does it Mean to “Maximize Firm Value”?
• Firm value is measured by market value.
• The market value of any asset is the present value of the
cash flows generated by that asset.
• Therefore, to maximize firm value is to maximize the
present value of the cash flows generated by the firm’s
assets.
What Decisions Influence the Present Value
of the Firm’s Cash Flows?
• The present value relationship is given by:
CFt
t
t  0 (1  r )
N
PV  
• Therefore, the decisions that influence PV and, hence,
market value are decisions that influence the level of the
cash flows, CFt ; the discount rate, r; the timing, t; and the
length of the cash flow stream, N.
A Numerical Example:
• Suppose a startup firm wants to invest in assets that will
produce expected cash flows of $100,000 a year for each
of the next 10 years.
• What is the maximum amount manager/owners (or outside
investors) should be willing to pay for these assets?
• Questions:
– What is the value of these assets in the market place?
– Are there look-alike assets, i.e., comparable assets whose value can
be readily observed from a well functioning market?
– How risky are the assets? What risk “counts” in determining
value?
Numerical Example (Continued)
• What is the market value of the assets?
$100,000
PV  
?
t
i  0 (1  .12)
10
• Suppose the assets are commonly sold to other firms in the
startup company’s industry for $ 400,000. Suppose also
that the risk of the cash flows implies that the discount
rate, r, the company should use is 12%.
Numerical Example (Continued)
• The market value of the assets under the startup firm’s
management with the cash flows as projected is $565,022.
Thus, managers should be willing to pay no more than this
amount for these assets.
• If managers can acquire the assets for $400,000, like the
other firms in the industry, they will be earning a premium
on their investment.
• (The NPV = $165,022; the IRR = 21.4%)
• Question: Under what circumstances will such a premium
exist?
Numerical Example (Continued):
Suppliers
Competitors
Startup
Numerical Example (Continued)
• Suppose suppliers and competitors have no obvious way to
to prevent the firm from earning the premium.
• Suppose, however, that the $400,000 exceeds the financing
capacity of the founders.
• Question: What implication does the need to resort to
“outside” funding have for firm value?
Numerical Example (Continued)
• Suppose founders have $225,000 of their own funds for
investment and they must raise $175,000 from external
sources?
• Questions:
– Do external capital suppliers believe cash flow projections of the
founders?
– How much nurturing of the project must managers engage in
after external funds have been raised to make sure cash flow
projections are realized?
– How will external capital suppliers monitor managerial nurturing
of their investment?
– Will the claims of external capital suppliers be liquid?
– What are the implications of control?
Numerical Example (Continued)
Founding Shareholders
Managers
Outside
Capital Suppliers
“The Economics of Organizational Architecture ”
by
Brickley, Smith, and Zimmerman
• Critical Aspects of Corporate Organizations:
– The assignment of decision rights within the firm
– The structure of systems to evaluate the performance of individuals
and business units
– The methods of rewarding individuals
• Challenges
– Managers at different levels have different information.
– Managers have different incentives.
Brickley, Smith, and Zimmerman (Continued)
• Determinants of Organizational Architecture
–
–
–
–
Technology
Markets
Regulation
Firm Size
• Increased technology may either centralize or decentralize decision
making.
• Increased competition tends to decentralize decision making.
• Increased regulation tends to centralize decision making.
• Increased firm size tends to decentralize decision making.
Brickley, Smith, and Zimmerman (Continued)
• Costs of Changing Organizational Structure
– Direct Costs
– Indirect Costs
• Costs of Not Changing Organizational Structure
“Total Compensation Strategy”
by
Stephen F. O’Byrne
• The Objectives of Executive Compensation
–
–
–
–
Alignment
Leverage
Retention
Shareholder Cost
• Management Wealth
– The value of current stock and option holdings
– The present value of
•
•
•
•
salary
bonus
long-term incentive grants
pension
Stephen F. O’Byrne (Continued)
• Total Wealth Leverage
– {%  Manager’s Wealth} /{ %  Shareholder Wealth}
– For “pure” entrepreneurs, this ratio is 1.00
• Total wealth leverage varies by component of the
manager’s compensation. For example,
– For stocks, leverage = 1.00
– For salary, leverage = 0.00
– For stock options, leverage > 1.00
Stephen F. O’Byrne (Continued)
• To replicate “pure entrepreneur” total wealth leverage,
different components of the compensation package can be
weighted appropriately.
• If , for example, options have a leverage factor of 2.0, they
could be combined with the present value of salary and
pension as follows
1.00 = .5*PV(Salary and Pension) + .5*PV (Options)
• That is, half the wealth could could come from salary and
pension, and half could come from options.
Stephen F. O’Byrne (Continued)
• There are tradeoffs in balancing compensation risks:
– Increasing total wealth leverage to align managers’ interests more
closely with investors’ interests increases retention risk if the
market turns down for reasons managers cannot control. It also
increases shareholder cost in good times that, likewise, may have
more to do with broad market movements than with managerial
decisions.
– Paying more in fixed salary and pension may reduce retention risk,
but increase shareholder costs and reduce managerial alignment
with shareholders’ interests.
• The optimal balance should mix incentives appropriately to
maximize shareholder wealth.