Strategic Financial Management

Chapter II

Firms Environment, Governance and Strategy

After reading this chapter, you will be conversant with: Business Environment of a Firm Operational Structure of a Firm Financial Structure of a Firm Performance Plans and Types of Executive Compensation

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Strategic Financial Management

FIRMS BUSINESS ENVIRONMENT

Let us look into each of the elements of a firms business environment and also see as to how it affects the internal structures and operations of the firm.

State of the Economy

The state of the economy both in the current as well as the predicted future plays a significant role on the firms businessmen strategies, as well as its operational and financial structures and its risks, performance and contingencies. These issues can be addressed based on the business environment that the US had experienced since the Second World War. From the time of end of the Second World War, till the early 1980s, the firms encountered not only the problem of high rates of taxes but also increased government regulations, antitrust restrictions on mergers and acquisitions and several other allocated problems. Coupled with these were the problems of high inflation rates, and high volatility rates. Further there was also the problem of economic recession. Though recession has always proved to be disastrous for individuals as well as businessmen firms, but the issue of consistent below par economic performance has been even more devastating. The American Economy went through such period during 1974 to 1982. In contrast the economic condition between the years 1983 to 2001 proved to be much more stable. There was a positive signal for interest rates, inflation and regulation as imposed by government. There was strengthening of the technological advancements that included both the external as well as internal corporate governance structures. Let us now try to answer one intriguing question as to whether the observed average aggregate returns on stocks corresponds to the markets example expected return. This has always been an important issue to the managers, because the markets ex ante required expected return on equity corresponds to the cost of equity capital of the firm. So one can say that if at all the average returns match with the expected returns, then the expected returns on the stocks and the cost of equity capital, will vary to a large extent on a period of time, and perhaps even with the state of the economy. Then in brief it can be said that, the manager of the firm should keep himself updated with the state of the macro economy for two reasons (i) to enable himself to predict future economic conditions and (ii) to affect the profitability of capital investment projects. Added to this it may also be stated that the unexpected changes in the economic conditions can attribute to a major risk factor. The other reason being that the state of the economy affects a firms overall weighted average cost of capital (WACC), by having an influence on both the equity as well as the duelist capital of the firm.

Resources Available to the Firm

The dependence of a firms ability to operate in its chosen product and service market to that of its ability to secure resource equitably on its business strategy need not be overemphasized. These resources take into account real estate and property plant and equipment, talented labor and management personnel, cost effective technologies, and low cost product and service providers. It is important for the firm to continuously seek out for resources at lower cost, so as to secure and maintain a fair level of competitive advantage. The increased level of technology in the industrial front has given way for enhanced profit for a firm. This can be explained from the fact that increased technology has resulted in the increased productivity of both the labor and capital inputs. In the long run, the betterment of technology results in the evolution of new firms and the death of the older firms which fail to keep themselves at pace with the fast moving technological changes. For any firm that is carrying out its business, it has to procure a lot of products and services from the product and service providers. These may include labor, electricity, transportation, distribution and legal services. To procure these services, one needs to attain the economies of scale. On a holistic 11

Firms Environment, Governance and Strategy

manner, the firms management should be able to manage between the vast nexus of contracts with the stakeholders. Any firm can be characterized as having three types of financial markets. They are equity markets, debt markets and derivatives market. As it is commonly said that, having a liquid public market is essential to a firm for its equity. The reason being, the liquid market enhances the value of the shares, as well as it provides with a better accent to raise finance to external equity and debt finance. In any firm, there exists a separation in ownership and control. This issue gives rise to the fundamental problem that has been constantly addressed as the principal-agent conflict and information asymmetry. As a result of these, several structures, contracts and operations of a public firm are designed so as to lessen these problems and their costs, keeping in mind the benefits accrued out of public equity. It is the equity investors that estimate the final measure of management performance, which is the stock of the firm. Here the investors are those who not only own a firms shares but also to those potential investors who keep a constant watch on the price movement of the stocks and consistently compare those stocks market prices with that of their true value. Further, they also include those investors who might be in a position to take a short position in a stock they consider to be overpriced. And finally it may also include other firms, and other major investors in the market who continuously question the efficacy of the firms management. They even stand ready to take control of the firm in case it performs poorly. The importance of the debt markets is also to be cited here. The reliance to the public firms on the debt markets is due to the externally generated funds. The proportion of debt fund in the total capital structure is determined by several characteristic features. It is also to be stated that the derivative instruments include the forward contracts, and swaps. These are now playing a dominant role in the financial strategies and policies. These take into account the interest rate risk, hedging of the businessman risk, and currency risk.

External Governance Groups

The federal, state and the local governments play a dual role towards the firms. On one hand, they provide the adequate service and protection to the firms, whereas on the other hand, they impose taxes, regulations and even restrictions on these firms that operate within the industry. The primary service that is provided by the government to its firms is concerned with the establishment of the property rights through proper legislations and enforcing the legal contracts with the help of its judicial systems. The latter function deals with the protection of the property rights. As stated earlier, the government also imposes taxes, regulations as well as restrictions on the various activities that are carried out by the firms, in order to protect the interest of the social structure. As a result of this, the government constitutes an external governance group. This group can be described as a group of outsiders that is responsible to keep a constant vigil on the activities of the firm by exerting external control and constraints over the firm. Another external group can be considered to be the one that is composed of the creditors. This is because the creditors to a firm also impose constraints on the firms activities by the use of covenants in debt contracts as well as constant monitoring. The main purpose of having these two types of creditor governance mechanism is to find a proper and adequate solution to the problem that arises due to the existing conflict of interest between the firm and its creditors. There also exists a third external governance group. This group comprises of the various professional business analysts and professional commentators. The media plays an important role in communicating any information that is available, of the firms activities, to the general public. The general public refers to the investors and the ultimate consumers. Added to this, there is also another group of financial analysts that is constantly analyzing the strategies of the different activities as carried out by almost all the publicly traded firms. They carry out the activity of estimating the values of these companies shares and comparing them with their market values. Thus it can be safely said that the firms financial performance is not guided by the periodic financial statements that are submitted by these firms to the securities exchange commission, rather the 12

Strategic Financial Management

estimation of the true value of the firm is the result of the constant effort of the analyst and the media. If studied in detail, it can be seen that the monitoring done by the media and the analysts results in two important implications. The first being that the information that is generated by these analysts and the media helps in lessening the information disparity between the firm and its investors. This can be explained from two points, one being that the reduction in the information asymmetry helps in increasing the liquidity and efficiency of the market for the firms stock. At the same time, with more information being made available by the media and the analysts it will be very difficult for the firm to maintain those valuable information that it wants to keep private. This is of greater significance because in order to maintain good competitive advantage, a firm needs to keep some of its valuable information within its four walls. The other important implication being that the financial analysts and the commentators provide an enhanced picture of the firms management which, in turn, creates a better image of the company in the minds of its shareholders. It is always seen that the analysts and the commentators are very prompt in pointing out to the management that involves in the excessive consumption of the perquisites, not performing their duties to the best of their capacities or even involving in self engaging empire building. Thus one can firmly conclude that the above stated external governance groups play an important role in reducing the agency cost that goes with managerial discretion.

Internal Governance and Business Strategy

Let us now study in detail about various elements of the firms internal governance structure and its business strategy. It has been always an issue of argument that the firms governance structure is of greater importance than its business strategy. As a result of which, the former should always be placed on a higher cadre over the latter. But as it is the case with most of the firms, the promoters of the firms decide upon the predetermined product and service markets. Further, the role that is to be played by the firms board of directors is dependent on the firms business strategy to a large extent. At the same time, the senior managers of the firm in association with the board of directors, works out on the firms business strategy and at the same time its operational and financial structures on a constant basis. Keeping these considerations in mind one has to keep the firms governance structure and the business strategy on an equal basis. INTERNAL GOVERNANCE The internal governance structure of a firm is made of shareholders, the board of directors and the firms managerial hierarchy as well as its internal capital markets. For a publicly traded non-financial American firm, there can be four major classes of shareholders. The insiders, the mutual funds, the pension funds and the outsiders that comprise the individuals as well as the other outside firms. It is to be noted that the common stockholders have the voting right of one vote per share if at all they are allowed to vote. These shareholders vote on the issues of elections for the board of directors. They also vote on the issues of mergers, acquisitions and the sale of the various assets. Let us now discuss on a couple of shareholder activism that has gained prominence in recent times. One being the proxy contests and the other being the shareholder initiated proposal. Proxy contests take into account the campaign among the competing groups for the right to cast the shareholders vote on their behalf. In other words, the process calls for casting proxy votes for the shareholders. Let us now take a look into the shareholder initiated proposals. This proposal generally calls for some changes in the firms internal governance structure. This may include the structure and composition of the firms board of directors, say for example, proposal to increase the number of outsiders in the currently existing board of directors. After the decline of the takeover activity in the 1980s, the shareholder initiated proposals gained prominence. The primary objective for framing these proposals was to increase upon the performance of the companies and to provide them with a positive market 13

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value. Thus they find their applications more in those firms that are found to perform poorly. Several studies done on these relevant subjects have thrown some light on the conflicts of interest between the shareholders and the management. Such studies have found out a negative correlation between the percentage of votes cast in favor of the proposals and the percentage of stocks held by the corporate insiders and the non-management members of the board of directors. At the same time, these studies have also shown positive correlation between the votes that have been cast for proposals and the management members of the board. Another study done by Karpoff et al on the shareholder initiated corporate governance proposal has concluded that such proposals have the ability to increase the firms market share primarily because of two reasons. The first is that even if the proposal turns out to be unsuccessful, the message may reach the management that the shareholders are unhappy with their performance. Added to this, the shareholders proposals can also add value if they help in gaining control of a corporation or tend to exert pressure for specific policy changes. There is yet another school of thought that is of the opinion that the shareholder activism seems to impair firm management, degrade the level of performance, as well as decrease the value of the firm. There is also the possibility that the public institutions may use the corporate governance proposals so as to gain influence over the target firms decisions, and to compel the firm to pursue the politically motivated and value decreasing investments. Keeping this in mind, it can be concluded that the corporate governance proposals that are sponsored by the public institutions will have a tendency to decrease the value of the firm as well as its operating performances. There has been enough evidence to justify the fact that the voting of the shareholder and the reaction of the stock market is dependent on several issues that are considered in a proposal as well as the identity of the proposed sponsor himself. Those proposals that are sponsored by the individual investors bring fewer votes and at the same time they tend to impact the stock price to a very lesser extent as compared to those proposals that are sponsored by the institutional investors. They receive a larger share of votes and at the same time they tend to have a negative impact on the stock prices. Further, the outcome of the voting has shown that though the percentage of votes cast in favor of the proposal averaged less than the majority of the casted votes, this percentage never showed any sign of increase over a sample period. Let us now shift our focus towards the corporate boards. The corporate boards generally have a membership of around 6 to 12 people. The primary functions that are carried on by the board involve the hiring, compensating as well as firing the senior management, voting on the major management proposals, voting on the issues relating to stocks and bonds, the payment of dividends, decisions regarding the repurchase of companys stocks and finally providing the senior management with the much needed strategic information and advice. One of the important factors of the board is the ratio of the number of outsiders to that of the number of insiders that constitute the members of the board. An insider to a board is the one who has been in the employment of the firm for a long time, and who has shown the ability to rise on the corporate hierarchy. Any employee to the firm who has got employment because of having any family relationship with the senior management may also be referred to as the insider to the board. On the other hand, the outsiders are those who have not been in the employment of the firm and did not have any long-term relationship with the top boss of the company. But the bottom-line is pretty clear, that the optimal structure of the board will comprise of both the insiders as well as the outsiders to the firm. The insiders to the board carry along with them a lot of experience, perspective and insights which they have gained during their long tenure of employment. Whereas the outsiders to the board bring along their experiences that they have gained while working in other

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firms. It is worthwhile to mention here that the outsiders can express a more free opinion about the performance of the CEOs as and when they feel like doing so. Management Hierarchy and Internal Capital Markets For any typical firm, the management hierarchy starts at the top level with the firms president, the board chairman and the chief executive officer. It may also happen that all these three positions are being held by one single individual. The ultimate responsibilities of the company are vested with that of the chief executive officer. This may involve major capital budgeting decisions that may include the strategic and logistical planning of capital investments and divestitures as well as decisions relating to the financial structures, including financial planning, issuance of debt and their retirements, issue of equity as well as the concerns involving their repurchase of shares, dividend policies and compensation policies. Due to the increasing work pressure, certain firms may also hire a chief financial officer (CFO) for the smooth running of their business. Larger firms may also have a broader span of management hierarchies. Say, for example, they may be having regional and divisional managers who shoulder the responsibilities of firms operations within their sphere. BUSINESS STRATEGY The business strategy of a firm can be said to have three essential elements. They are: 1. 2. 3. Targeting the specific products or the service markets. Establishing the goals in terms of the market shares and profits. Developing an effective competitive strategy against its competitors within the industry.

Let us now study some more details about the financial strategies and policies of a firm. It is worthwhile to mention here that the operational as well as the financial structures of a firm are determined by the firms business strategy as well as its size to a large extent. Let us go back to the argument that was put up by Williams which stated that a typical industry will consist of a few, large, capital intensive industries which are highly profit making and which carries along with them some element of debt in their capital structures. At the same time it also stated that there will be many smaller lesser profit making companies that are labor intensive that have very little or no debt. In addition to this there may be certain firms that may go for high leverage showing their strong intention to go for aggressive competition or there may be firms with lower leverage strategies that help it to squeeze out the highly leveraged firms. This, in other words, is that what we term as the long purse hypothesis.

OPERATIONAL STRUCTURE
Let us now discuss some of the most important aspects of a firms operational structure.

Capital Budgeting Process

The capital investment decisions are unarguably the most important decisions that a firm has to make. This is mainly due to the reason that these decisions ultimately result in the shareholders value creation. The basic rules of capital budgeting takes into account the concept of net present value (NPV), it further teaches us that a project should be accepted only if it yields a positive value of NPV, where the estimation of the NPV is done by discounting the projects expected cash flows at the rate of the firms WACC. In an ideal capital market a firm shows an indifferent approach while raising funds it needs to pursue for a positive NPV. This required fund can be procured by the issuance of equity or debt or by using the retained earnings. The indifference nature of the firm can be attributed to the fact that in an 15

Firms Environment, Governance and Strategy

ideal capital market all the securities are sold at a fair price and all the capital structure yields the same level of WACC. Thus one can say that the capital budgeting and the financing decisions are exclusive in nature. Based on this platform, the focus of the capital governance is towards the monitoring of the managements ability to identify the positive NPV projects, because the financing decisions are obligatory in nature. As it has been stated earlier, the cost that is associated with the principal-agent conflicts and information disparity can negatively effect the capital investment and the financial decisions of the firm. Say for example, in the case of a self serving manager, there may be cases where the project is accepted though it has a negative NPV, because he is more concerned with building his own empire. There may also be cases of firms having risky debts outstanding in their balance, but still it may go for increasing the riskiness of the firms operations as a means of expropriating wealth from the creditors. Finally there may even be cases where a firm may sacrifice a positive net present value if only its creditors derive benefit out of it. The problem of delegation has always been a cause of concern for many firms, especially in a multidivisional firm. The problem may be of the form that the divisional manager may have better information about the profitability of the project than the senior management of the firm. Coupled with this if the divisional manager has a self serving incentive to build his or her own division, he/she may indulge in the practice of showing a better picture about the quality of the proposed project so as to garner greater capital funds from the companys headquarters. Thus it is the duty of the senior managers to plan out incentive compatible contracts so that such problems can be avoided.

Advantages of Being Large

The very fact that the larger firms are generally more profit making than the smaller and the lesser ones need not be mentioned. But perhaps no absolute answer can be given to as why certain firms grow large and earn more profits whereas others do not. But it can be said that towards the way to success, most of the firms have treaded on a similar path. Successful firms possessed innovative, strategy wise founders who were succeeded by the equally competent CEOs. Further it has been seen that almost all these firms had a well developed market structure where it could supply its products. These firms enjoyed the benefits of being the first mover in the market and as a result of this they could capture at least temporary profits and were able to exploit the opportunities effectively following an initial public offering. This provided them with greater access to the debt and equity markets so that they could raise additional funds when required. With the increase in the number of these firms, they could reap the benefits of the economies of scale which in turn helped them in generating extra profits and to force the competitors out of the existing markets. Finally it can be mentioned here that as far as the firms financial policies and the strategies are concerned, they go for funding the expansions using the internal equity. As per the pecking order hypothesis, this is always a preferred method of financing growth under the conditions of asymmetric information which considers the element of external capital, especially the external equity capital, to be costly. Thus here it can be said that the profitable firms have an added advantage in financing growth.

Firms Production Function

For any firm, the balance between the capital and the labor intensities depend on the industry within which the firm operates. Certain firms that are engaged in the transportation and the utilities industries have larger scale of operations and as such they are the most capital intensive industry in the American market. Other large and manufacturing firms such as the general motors are also highly capital intensive. Thus for such firms, there is a close relation between the economies of scale or in other words their profitability, and their capital intensive nature. On the 16

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other hand, certain firms such as Microsoft that falls in the service industry characterizes labor intensiveness.

Internal Auditing: Quality and Cost Control

The birth of a capital investment project begins when the board gives its approval for the expenditures that are to be made. The procedure of developing the intricacies of a marketing strategy is a long drawn process. It is the policy of many firms to engage an internal auditing team that will oversee the entire product development process. The internal auditing team provides the firm with valuable information that may include information pertaining to whether all the parties involved in the project are working on a consensus basis, whether all workings are done according to the plans and if any further changes are required in those plans. Whether the company is complying with the quality and cost controls and finally whether the reports on all the activities are accurate. Here it should be noted that the internal auditing and the cost control procedures are major aspects of any firms operations especially for a firm that is operating in a highly competitive product or service market.

FINANCIAL STRUCTURE
Let us now discuss about the basic pillars of a firms financial structure. a. b. c. Ownership structure Financial planning and leverage Executive compensation policies.

Let us now discuss each of these elements in detail.

Ownership Structure
The optimal structure may widely vary across firms due to the factors that affect the trade offs that exist between the advantages of diffused ownership and cost of managerial discretion. One particular way by which one can study the trade off as stated above is by examining the effect of incentive alignment devices on a firms market value. There have been several studies done so as to focus on the importance of such devices. One of such devices has been the executive stock ownership. These studies focused on the relationship of the fraction of the firms shares that is held by the executives and the market value of the firm. Studies relating to this have shown that with the increase of the stock ownership from about zero to about three to five percent, the value of the firm as measured by the Tobins Q simultaneously increases as expected. But once the ownership of the stocks increases beyond this level, the firms value no longer increases. Another way by which the trade off can be seen is to relate the top executive turnover with that of the firms ownership structure. It has been further found out that if the top executives own a substantial amount of the firms share then they can establish themselves despite the firms poor performance. But, on the other hand, they may find it rather difficult to do so in case a majority of the firms shareholding is with outside investors. This aspect can at least to some extent explain the absence of positive relationship between the insider share ownership and the performance of the firm, when such an ownership becomes substantial. A secondary trade off can also be brought into the picture, if the outside shareholders need to reduce the adverse value effects of the management entrenchment, it will be always at the cost of the less diffused ownership and its associated benefits.

Financial Planning and Leverage

Let us here discuss some of the factors that affect the firms leverage. FINANCIAL PLANNING Financial planning mainly takes into account two major aspects, one being the predictions regarding the timings and the future capital expenditures on the 17

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projects and the future earnings that the company will produce. And the other issue being how the firm will finance its capital expenditures, debt payments, dividends and stock repurchases over the period of time. The main purpose of the financial planning analyses is to reveal the expected future needs of the firm as far as the external debt or equity funds is concerned. Thus in a nutshell it can be said that the primary purpose of the financial planning process is to strike a balance between the amount as well as the timing of the future outflows of the firm with that of the net cash flows that may accrue from the operations and the proceeds of the debt or equity issues. Say as an example, the leverage of a firm may depend on whether the firm has recently gone for raising debt funds for its capital investments because it faced lack of sufficient internal cash. LEVERAGE, INVESTMENTS AND THE GROWTH OF A FUND There have been several studies that have shown a negative relationship between the leverage of a firm and its growth. One of the studies that have been conducted puts forth two competing relationships. In one instance it mentions about the negative relationship between the growth of the firm and its financial leverage. On the other hand, it seems strange that a firm that is expected to be highly profitable would face problems in securing debt financing when the firms current capital expenditures exceed its available internal funds.

Executive Compensation
As it has been stated earlier the incentive devices in executive compensation contracts play a crucial role in determining and linking the shareholders and the managers interest. These incentives generally include the portion of the firms share that is held by the management, those annual bonuses that are tied up to the firms earnings, the grants of the restricted stock or the stock options that provide compensation that is a function of the future performance of the stock price. Let us now delve into the problems that are generally confronted with the standard incentive devices in executive compensation contracts, the recent developments that have taken place in alternative incentive devices, and long-term performance plans. Further, we will also discuss some evidences relating to the compensation devices in brief. PROBLEMS WITH INCENTIVE DEVICES It is to be borne in mind that there cannot be any perfect incentive device. The primary problem is from the firms point of view. It can be said that, an executives personal portfolio is not well diversified and is exposed to the firms risk to a great extent. In contrast, a typically diversified shareholder is only exposed to the firms systematic or diversified risk. As a result of which, an executive who is risk adverse in nature personally motivates himself so as to reduce the firms business risk and financial risk. As far as reducing the business risk is concerned, he tries to reduce the firms operating leverage or taking on only the low risky projects. With regard to the financial leverage, he tries to reduce the firms leverage below its optimal level if at all such a level does exist. Further, as explained by Shleifer and Vishny, there can also be the potential for the performance indentures to boomerang. Let us now explain this in more detail. The serious problem that one can associate with the high powered incentive contracts is that they result in creating avenues for self dealing managers. The problem can be even more serious, if those contracts are negotiated with poorly motivated board of directors rather than with larger blocks of investors. In such situations, the managers may negotiate for their vested interest, because they know that the earnings or stock prices are likely to go up, or they may even indulge in manipulating the accounting numbers and investment policies so as to increase upon their pay. To site an example, Yermack (1997) found out that managers tend to receive stock option grants shortly before any announcement of good news and they tend to delay such grants until after any announcement of bad news. The results he found out are suggestive of the fact that, option may not always be so much an incentive device as some what canceling mechanism of self dealing. Any how, the strengths of incentive devices in executive compensation contracts is associated with their importance and to their positive net worth. But it is also to be noted here, that the observed cross sectional variations in incentive devices and their complexity 18

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shows that it is rather difficult to bring together the interests of the senior management and the shareholders through terms in a compensation contract. EARNINGS BASED BONUSES VS STOCK RELATED GRANTS The everlasting debate served by placing the managements attention on earningsstock price performance. A bonus plan based on earnings may be better off because it is a reward to the CEO for the realized performance. In contracts, the stocks and the stock options grant focus directly on the shareholders interest, so as to increase the market value of the firms equity. But it has been seen that both these kinds of incentive devices are not free from problems. Taking into account, the annual earnings based bonuses, the problem that arises is that the manager become more concerned on the firms short-term accounting earnings, which may be of potential harm to the firms long-term profitability, which is actually the ultimate determining factor of the share value of the firm. Further, the management can also manipulate accounts of earnings, at least in the short run. It is of the common practice that managements use accounting methods according to their convenience. They can do it by switching depreciation methods, recognizing on delaying the revenues, and writing down assets though the extent to which they can manipulate accounts is limited as companies have to rise by the generally accepted accounting principles [GAAP]. The problem that can be associated with the stock related grants is that, the stock price of the firm depends not only on the firms performance, but also certain other factors that are beyond the contract of the manager. They may also include market wide factors that generally affect the stocks price. There may also be the chances, where management might manipulate the stocks price. This may be due to the existence of information asymmetry; the markets valuation of the firms stock price is dependent on the information that comes directly from the firms management. Say for example, enhancing the profit potential of the existing or pending projects or price of the firms shares. Let us now discuss the recent developments that have taken place in alternative forms of incentive plans, like long-term performance plans.

Long-Term Performance Plans

The development of the long-term performance plans can be partially attributed to the fact that there existed certain problems with both the annual earnings based bonus plans and the stock related grants. As a result of which many firms have actually removed both these forms of incentive plans, and replaced them with the long-term performance plans that reward the executives according to the firms earnings or stock price performance over a period of three or five years rather than rewarding annually as it is the case with earnings based bonuses. A positive aspect of a long-term performance plan is that, a manager may be of the opinion to hire off a poorly performing asset even if by doing, it adversely affects the short-term earnings of the firm because of the writing down. Studies conducted have revealed that the reaction of the market to the announcement of an asset sale is more favorable if the firms management has a long-term performance plan than if it does not have. The studies have concluded saying that the long-term performance plans serve as an effective mechanism to motivate managers to make better decisions. Another study as conducted by Kumar and Sapariwala (1992) probed into the markets reaction to the announcement of adopting the long-term performance plans and the subsequent changes in the performance of the adopting firm. Their studies have reported a considerable positive excess returns around the time when such plans were adopted. This is consistent with the fact that such plans would result in the reduction in the agency problems. Further it has also been observed that, there exists a close allocation between the adoption of long-term performance plans and the resulting growth in the firms profitability. One last finding in the study was in relation to the excess returns generated around the announcement of the performance plan adoptions which showed that such excess 19

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return is positively skewed with the subsequent change in growth of earnings per share, the most commonly used accounting performance measure. Relationship between the Executive Compensation and Firms Financial Policies and Performance The relationship between the firms executive compensation and its financial policies is not that simple. It may happen that the contingencies that are involved in the executive compensation contract may both effect as well as get effected by other associated financial variables. Let us now try to understand the relationship of the compensation plans with some of these variables.

Executive Compensation, Board and Ownership Structures, and Performance

Studies conducted by Tarcker et al (1999) analyzes the interactions among the executive compensation, internal governance, and performance. One of their findings says that, for firms with boards, the executive compensation will be higher and the firm performance lower, both because the boards of these firms have not resolved the agency problem of managerial discretion. Forms of Executive Compensation and Managerial Risk Taking Studies conducted by Agarwal and Mandellear (1987) have focused on the effects or provisions in executive compensation contracts on a firms financial policies. The studies were conducted on the platform that the managers generally have a self serving incentive so as to decrease the volatility of the firm. Apart from this, they were also of the opinion that those managers who either hold shares in their firm or have stock options on the equity of the firm, will then be indulging in risk reducing activities because their compensation contract better aligns their interest with that of the firms shareholders. Thus it can be said, that managers who hold the share or stock options will be more willing to take actions that increase the risk, whereas those managers who do not hold shares or stock options are more biased towards the risk reducing actions. In order to test the validity of the hypothesis, the profounders of the theory had identified the firm that had actually taken one of two types of actions that could change the volatility of the firm i.e. a capital investment or a change in the leverage. They studied the change in the variance of returns on the firms stock with the announcement of any capital investment. Based on this they divided the firms into two categories. One category belonged to that group that subsequently experienced an increase in the variance and the other group that subsequently underwent a decrease in variance. The authors also divided the leverage changing firms into two groups. Those firms that increased the leverage and those that decreased the leverage. Their ultimate study dealt with the estimation of the common stock and options holding of managers in each group. Their findings can be summarized in the following points. i. For those firms whose variance in return increases upon an investment announcement, their managers common stock and the options are larger than those firms for which the variance in returns decreases upon such announcements. Further, it has been found out that the security holdings of managers of firms with a debt-equity ratio that increases are larger than those for which the ratio decreases.

ii.

Executive Compensation, Ownership and Governance Structures of Leverage Study conducted by Mehran (1992) on 170 US manufacturing firms tested the hypothesis from agency theory about the relationship that existed between the firms leverage and the executive incentive plans, managerial equity investments, monitoring by the board and the firms major shareholders. The study found a positive relationship between the firms leverage ratio and the percentage of executives total compensation in incentive plans, percentage of equity held, the 20

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percentage of investment bankers on the board of equity held, the percentage of investment bankers on the board of directors and the percentage of equity that is held by individual investors. Investment Opportunities, Financial Policies and Executive Compensation Studies conducted by Smith and Watts (1992) speak about the relationships among the firms investment opportunities, financial policies and executive compensation. Some of their findings are: a. b. c. d. Firms attached with more growth options use stock options more frequently, because the management in such firms is more difficult to monitor. Larger proportion of value attributed to growth options is representative of greater management compensation. Regulations tend to prohibit the managers investment discretion and reduces the marginal product of the decision maker. As a general finding, the larger the proportion of the value of the firm in terms of growth options, the more it is likely that the firm attaches compensation to the effect of the firm value.

Evidence on the Pay Performance Relationship Jensen and Murphy (1990) studied the sensitivity of the chief executive officer compensation that comprised pay, options and stockholdings on the firms performance. They found out that, on an average, the wealth of the chief executive officer changes by 0.325% for a change in the shareholders wealth. These results appear to be very surprising and suggest that the chief executive officer has very little personal incentive to increase the shareholders wealth. But this fact is pretty surprising, as it rises the basic rationale behind the compensation plans, as they should contain performance incentives that actually bring together the managers and the shareholders interest. But the authors suggest that this argument may fail as the management executives are averse to risk and thus they may refuse to accept the risk that is associated with such incentives. But it is to be mentioned that the studies conducted by Jensen and Murphy may not have yielded accurate results, as it used data on ex post compensation, rather than the ex ante terms in the executive contracts. This issue was given recognition by Kole (1997), by examining the shareholders authorized compensation arrangements that provide a more critical ex ante perspective. He focuses on the flexibility the firms board has while negotiating a contract with the senior management.

Risks, Performance, and Contingencies

Business Risk and Financial Risk as Determinants of Equity Risk The riskiness of the firms operating earnings, that is, its business risks become well defined, once the management decides on its business strategy and operational structure. One of the important ingredients of a firms business strategy that determines its business risk is the industry in which the firm chooses to operate. There are two aspects of a firms operational structure that can influence its business risk. One, that a larger firm is generally more geographically diversified, say in terms of its customers base, alternative suppliers, employees, plants, etc. The second advantage being, that the firm enjoys a semi monopoly status within its industry by the virtue of economies of scale though this status will not protect the firm from a decline in aggregate demand for the industry products. As far as the capital intensity is concerned, a traditional debate exists stating that a firms business risk is positively related to its capital intensity, or in other words, its operating leverage. The argument states that, any capital intensive firm is filled with a considerable fixed cost and as a result its operating earnings are more prone to changes in its revenues. At the same time, the relationship between the capital intensity and business risk may be difficult to prove empirically, because any typical capital-intensive firm is larger and so enjoys the business risk-reducing 21

Firms Environment, Governance and Strategy

effects of the large sized firms. Thus, the question still remains unanswered as to which effects influence in determining a firms business risk. Let us now use empirical evidence on this issue. Business Risk, Financial Risk, Leverage and Equity Risk It is to be mentioned here that the risk associated with the firms equity is dependent not only on the firms business risk, but also on the firms financial leverage. This is due to the fact that the financial leverage works to focus more on the firms business risk on a smaller equity base. The term financial risk is used in reference to either a firms risk of bankruptcy or to the effects of leverage on earnings and stock price volatility. Say, for any given set of risky assets and operations, the firms financial risk increases with its financial leverage. The business risk and financial leverage work in accordance to determine the risk of a firms equity, so, the management is concerned with the interest of the firms equity holders, and the importance of their interest lies in the riskiness of the firms business risk. Further, one can suppose that the firms that have higher business risk will tend to have lowest leverages. Let us now take the case, where the firms management initially decides on its optimal business strategy and its operational structure, that best explains its business risk and then it considers its leverage. If the firms management wishes to limit the firms equity risk to some level of tolerance, then it has to employ less financial leverage when its business risk is higher. Let us now discuss this in detail. Cost of Capital, Profitability and Share Value The traditional capital budgeting identifies projects which have higher expected rate of return (IRR) than the firms weighted average cost of capital. With few exceptions, this criterion holds good for all projects. It is worthwhile to mention here, that only such projects are beneficial because they tend to increase the share value. Estimating the IRR of a project may not be that simple as it seems. Though the initial outlay on the project may be relatively easier to determine, it is much more difficult to estimate the expected future cash flows, both in terms of amount and timing. This problem is coupled with the fact that there exists even the present issue of future contingencies. Say for example, if the initial results on the projects profitability are favorable, additional capital expenditures may be called for, whereas, on the other hand, if the cash flows are adverse, the project may be abandoned and the assets may be liquidated or even redeployed further estimating the firms WACC may not be always an easy task. The firms WACC is dependent on both its business risk as well as its capital structure. Also, at some point of time, the firms WACC will depend on the state of the economy. Let us now try to answer one peculiar question. Do firms ever adopt projects whose IRRs exceed their respective WACCs, and if so by what extent? Studies conducted by French and Tama have concluded that firms generally invest in projects whose IRR exceeds their WACC, though by a marginal percentage. Contingencies Managers generally confront with contingencies as a result of past performances, irrespective of the fact whether such performance has been good or disappointing. Let us here discuss four classes of contingencies: i. ii. iii. iv. Growth opportunities Restructuring Merger, acquisition or buyouts Bankruptcy or liquidation.

It is to be remembered that the decisions related to these contingencies, and not the profitability of firms original projects, determine the majority of the firms future profitability and the shareholders value. It is mainly for this reason, that the interest of the shareholders and the management are aligned. If that is not so, then the decisions related to such contingencies may be suboptimal. Say for example, it 22

Strategic Financial Management

may be seen that many firms are growing, but as a matter of fact, only some of these firms are pursuing profitable growth opportunities, whereas in other managements, the managers are engaged in self serving empire building. There have been two milestones in the development of US firms in 1980s and 1900s. These are: i. ii. Internal Corporate Governance. Alignment of the interest of the shareholders and the management through the incentives in the executive compensation contracts. This has led firms to pursue their core competencies coupled with their growth opportunities. Another important form of contingency for acquiring firms and targets refer to the mergers and acquisitions. For a firm that is going to acquit, it may try to gain critical economies of scale in its existing products market or to pursue a profitable opportunity in a complementary product market. As far as the target firm is concerned, it generally is profitable to the shareholders of the acquired firm. A final contingency deals with the bankruptcy or liquidation element.

These types of contingencies after reshuffling its assets and financial structure. In the case of liquidation, the assets of the firm are sold, and the proceeds are distributed to its claimholders may be of the last resort, for any company that is in financial distress. Once a firm declares bankruptcy, it gets protection from its creditors and also an opportunity to remerge, based on priority, and the firm ceases to exist.

SUMMARY
The business environment of the firm consists of the state of the economy, resource availability, external governance groups (media, government and the creditors), internal governance groups (The shareholders, board of directors, managerial hierarchy and the internal capital markets). The operational structure of the firm consists of the a. b. c. d. e. The capital budgeting decisions. Decision regarding the size of the company. Decision regarding the production function (capital\labor intensive operations). Internal audit consisting of the cost and the quality audit. Decision regarding the financial structure of the company.

The financial structure decisions typically comprises of the ownership structure, financial leverage, dividend and stock repurchase policies and the executive compensation policies. The designing of the executive compensation policies is a difficult task as the interests of the managers and that of the stakeholders tends to clash. It thus views executive compensation not only as an instrument for addressing the agency problem between managers and shareholders, but also as part of the problem itself.

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