The document discusses several issues related to maximizing firm value and stock price. It notes that while stock price maximization provides an objective for decision making, managerial objectives may deviate from shareholder wealth maximization. Agency costs arise due to the separation of ownership and control, and managers may pursue actions like empire building that reduce shareholder value. The document also discusses threats to using stock price as the objective function and various means of reducing agency costs.

1. Maximize Firm Value
• The objective of maximizing firm value is
often restated as maximizing the stock price
(particularly for public companies).
• Why?

2. Focus on Stock Price
Maximization
• Stock prices are easily observable and are
constantly updated
• Stock prices, in a rational market, attempt to
reflect the long-term effects of decisions made by
the firm.
• The objective of stock price maximization
provides some very elegant theory on:
– How to pick projects
– How to finance them
– How much to pay in dividends

3. Threats to Objective Function
• Managerial objectives may deviate from
stockholder wealth maximization
• Stockholders may expropriate wealth from
bondholders and other creditors
• Information produced by management may be
misleading and noisy, and market responses may
be out of proportion to the information
• Firms may create significant social costs
(externalities) which are not deducted in
determining earnings

4. Agency Costs of Separation of
Ownership from Control
• Satisfice rather than maximize (Herbert Simon)
• Consumption of excess compensation and
perquisites
– Rapid escalation in top management pay, particularly
CEO compensation
– Repricing of employee stock options
• Empire building (e.g., overpaying on takeovers)
• Maintain your position
– Greenmail
– Golden parachutes
– Poison pills

5. Empire Building
• The stock price of the acquiring firm typically
declines at the announcement of a takeover
(merger).
• Acquisitions often fail, for example:
– Kodak bought Sterling Drug for $5.2 billion and sold it
for $4.5 billion 5 years later.
– Quaker Oats bought Snapple for $1.7 billion and sold it
for $400 million 5 years later.
– AT&T bought NCR for $7 billion and sold it for $4
billion 4 years later.

6. Greenmail
• The target of a hostile takeover buys out the
potential acquirer’s existing stake, generally at a
price much greater than the price paid by the
raider, in return for the signing of a ‘standstill’
agreement.
• Negative consequences for existing stockholders:
– Cash payment by the managers makes the firm poorer
– Payment of greenmail reduces the likelihood of a
takeover, which would have raised the firm’s stock
price
• Accounting treatment?
– FTB 85-6

7. Golden Parachutes and Exit
Packages
• Golden parachutes are provisions in employment
contracts that provide for the payment of a lump-
sum, or cash flows over future periods, if the
managers covered by these contracts lose their
jobs in a takeover.
• A large number of Fortune 500 firms have
incorporated golden parachutes into top
management compensation contracts.
• Excessive exit packages (Michael Ovitz and
Disney)

8. Poison Pills
• A security, the rights or cash flows on
which are triggered by an outside event,
generally a hostile takeover, is called a
poison pill.

9. Shark Repellants
• Anti-takeover amendments have the same
objective as greenmail and poison pills –
dissuading hostile takeovers.
– However, unlike greenmail and poison pills, shark
repellants require stockholder approval.
• Examples of anti-takeover amendments:
– Super majority voting requirements
– Fair-price amendments
– Staggered election to the board of directors

10. Theoretical Means of Reducing
Agency Costs of Equity
• Annual meeting of stockholders
– Voice displeasure with incumbent management
and remove them if necessary
• Election of individuals to the board of
directors
– Fiduciary duty is to ensure that managers serve
the stockholders

11. Practical Difficulties – Annual
Meeting
• Power of stockholders to act at annual meetings is
diluted by three factors:
– Most small stockholders do not go to meetings because
the cost of going to the meeting exceeds the value of
their holdings.
– Incumbent management starts off with a clear
advantage when it comes to the exercising of proxies.
– Large stockholders often prefer to vote “with their feet”

12. Practical Difficulties – Board of
Directors
• Most individuals who serve as directors cannot
spend much time on their fiduciary duties
• Directors often suffer from a lack of expertise on
many issues
• Directors, even outsiders, are often not
independent
• Interlocking directorships (CEO lodge)
• Most directors own only a small number of shares
• CEO sets the agenda, chairs the meeting, and
controls the information flow
• Search for consensus dominates any attempts at

13. More on Reducing Agency Costs
of Equity
• Provide managers with an equity stake in the firm
– Increases risk of expropriating wealth from
bondholders
– Increases risk of misleading financial information being
conveyed to the markets
• Provide stockholders with better and more updated
information
• Have a large stockholder become part of
incumbent management
• Have more “activist” institutional stockholders
• Make boards of directors more responsive to
stockholders

14. Agency Costs of Debt
• Stockholders may maximize their wealth at
the expense of bondholders and other
creditors. For example:
– Increase leverage dramatically
– Increase dividends significantly
– Taking riskier projects than those agreed to

15. Reducing the Agency Costs of
Debt
• Use covenants to:
– Restrictions on what or where the firm can invest in
– Restrict dividends to a certain percentage of earnings
– Require the consent of existing bondholders before
issuing new secured debt
• Make existing bonds “puttable”
• Issue “rating sensitive” bonds
– Require that certain financial ratios are maintained

16. Informational Problems
• There is evidence that managers:
– Suppress information, generally negative
information
– Delay releasing bad news (the Friday after 4
effect; EBBS – everything but bad stuff)
– They sometimes reveal fraudulent information

17. Externalities
• Negative:
– Pollution
– Increased traffic
– Increased crime
• Positive:
– Access to goods or services where previously
absent
– Development in inner cities