COURSE: CORPORATE GOVERNANCE

PROFESSOR: MARÍA GUTIÉRREZ URTIAGA

EXERCISES

Unit 1

1.1(Modified version of Tirole 2006)

Consider an economy with many potential entrepreneurs. Each enterpreneur

has assets worth A, and, in the population, A follows a uniform distribution
in the interval [0,10].

Each enterpreneur has access to an investment project, which is the same

for all of them. Each project requires a fixed investment 10. Therefore to
implement the project the entrepreneur must obtain 10-A from investors.
There are many competing risk neutral investors that require a zero interest
rate.

The project returns are 15 with probability p and 0 otherwise. The actions of
the entrepreneur affect the probability of success. With the standard
productive technology the probability of success is 0.5 but the enterpreneur
can implement a new productive technology with probability of sucess 0.7.
Implementing the new technology requires a lot of work and effort for the
enterpreneur. The extra utility that the entrepreneur gets for not
implementing can be valued at 1 monetary unit.

a)Which is the minimum value of A for which the enterpreneur will get
financing?

Imagine now that once the project is implemented with a given technology
it is possible modify the production process to increase the probability of
success by an additional 0.1. This modification would however increase very
much the work load of the enterpreneur, generating a disutility for him
valued at 2.

The initial financial contract can specify who has the rigth to decide whether
to modify or not the production process.

b) Which is the minimum value of A for which the enterpreneur will get
financing if he retains control?

c)Which is the minimum value of A for which the enterpreneur will get
financing if he gives the control rigth to the investors?

1.2. The Spanish banking crisis and the Cajas de Ahorros

Spain experienced strong economic growth and a real estate boom during
the first years of the century. Real GDP grew by 34.5% from 2000 to 2007,
with real estate prices increasing by 250% in real terms. The accompanying
loan increase was funded with bank debt. The debt of the Spanish banks, in
the form of covered bonds, senior unsecured debt and securitization deals,
was mainly owed to other Eurozone banks.

The Spanish banking system had no exposure to the US subprime market.

Nevertheless, by the end of 2007, when the first signs of trouble appeared
in the international financial markets, growth stopped. During the following
two years GDP contracted by 4.6% in real terms and real estate prices fell
by 10% while unemployment rose from 7.95% to more than 20%.

Non-performing loans increased from 1% in 2007 to 6% in 2009. The

banking crisis that ensued was exacerbated by the importance of the Cajas
the Ahorros in the Spanish banking system.

The first Cajas were founded in the early XIX century as non-for-profit
provincial credit institutions aimed at channelling the savings of the popular
classes towards profitable investments and helping the very poor, using
their profits for charity and social works. After the liberalization of the
banking system that took place during the 1980s Cajas were able to operate
like banks and to offer their depositors the same range of financial products.
Nevertheless, two important differences subsided.

The first difference was their legal status as foundations. This meant that
their growth opportunities were limited by their retained profits, because
Cajas were not corporations and were unable to issue shares. To soften this
restriction, the Ley del Entidades de Crédito of 1988 allowed Cajas to issue
a tradable security that could share in their profits: the “coutas
participativas”.

The second important difference was their corporate governance. The Cajas
were controlled by their boards of directors, where representatives of
depositors held between 15% and 45% of the votes, employees
represented between 5% and 15%, founders took between 10% and 35%
of the votes with the remaining (15% to 45%) going to public
administrations (including city halls, local and regional governments). In
practice, because many Cajas were public foundations, adding up the
percentage of founders and public administrations, politicians had total
control.

a) How is the corporate governance of cajas diferent form that of a

standard bank?

b) How are the investment (i.e. loan) decisions of the cajas going to be
different from those of a standard bank?

c) Cuotas participativas were never very popular and this compounded the
liquidity problems of cajas during the crisis. Why do you think investors
did not find them attractive?
 Unit 2

2.1. In October of 1993, the Marriott Corporation separated into Host

Marriot and Marriot International. Host Marriot retains the real state
holdings of the venerable hotel chain while Marriot International focuses on
the management of hotels, cafeterias, and other service activities. The
proposal to divide Marriott into separate firms was made public in the fall of
1992 when Marriott shares were selling at $17. Immediately after the one-
for-one distribution, Host Marriot shares traded at $5.50 while shares of
Marriott International traded at $25 for a total of $30.50 (and implying total
shareholder gains of $1.4 billion). Moreover, by June of 1994, Host Marriott
was at $11 and Marriott International was at $28, thus representing a
substantial run-up in shareholder value surrounding the decision to create
two separate entities.
Host Marriott retained almost all of the old Marriott’s debt and this
arrangement created a year-long battle with the bondholders who argued
that their security was eroded by the spinoff and threatened management
with legal action against the firm. In fact, Marriott’s unsecured straight debt
decreased in value by 16.5%, or $333 million, immediately after the spinoff
announcement, which in turn contributed to (but by no means explained all)
the shareholder gains.
Management justified its decision to concentrate the debt burden on the real
estate division, Host Marriott, by saying that this would free the high-growth
management services operation to pursue its aggressive growth strategy
unencumbered by the existence of large amounts of debt.
– Which type of conflict is illustrated by this business case?
– The decision did not result in a mere transfer of wealth from the
bondholders to the stockholders. It generated additional wealth.
Which could be the source of this additional wealth?
– If you were a judge that had to decide wether to let the shareholders
complete the plan, what would you do? Why?
– As a debtholder, which types of covenants would you wish you had
included in the debt contract when you lent your money to Marriott
Corporation?
2.2. Consider a two-date economy t=0,1 in which the investors are risk-
neutral, there are no taxes and the risk-free interest rate is zero. We are at
t=0 and the firm XYZ has a safe investment opportunity that requires an
initial capital outlay of $800.000 at t=0 and gives a cash flow of $1,2 million
at t=1.
Previously to t=0 the firm had invested in risky assets that will also produce
cash-flows at t=1. The amount of these cash-flows depends on the success
or failure of a business operation that now being implemented. If the
operation succeeds these cash-flows will be $2 million, but if it fails they will
be $600.000. The estimated probability of success is 0.5.
The firm does not have funds to invest in the new project. Therefore, if the
project is undertaken, it will be necessary to issue either equity or debt to
raise $800.000.

a. Assume that the firm is financed 100% with equity and that the current
shareholders have enough funds to finance the project buying the new
shares. Would you recommend that the Board of Directors accepts the
project?

b. Assume now that previously to t=0 the firm had issued debt with a face
value of $1,6 that must be repaid at t=1. At t=0 the firm still considers
issuing equity to raise the funds needed to finance the new project.
Calculate the net gain or loss that this operation would represent for the
existing shareholders. ¿By how much would the value of debt increase if the
new equity is issued?

c. Discuss the disposition of both the shareholders and the debt-holders to

accept the following proposal to fund the project: the shareholders would
contribute $800.000 to fund the project and the debt-holders would receive
only $1,4 million for their debt holdings.

d. Compare the previous proposal with an alternative one under which the
shareholders would still contribute $800.000 to fund the project, but the
debt-holders would receive a 50% share in the equity of the restructured
company in exchange for their debt holdings.
2.3 Consider a three-date economy (t=0,1,2) in which investors are risk
neutral and the risk-free rate is zero. At t=0 a firm has cash for an amount
8 and it can choose between two different investments. The expected cash-
flows from each investment in each period depend on the state of the
economy during that period as follows:
t=0 t=1 t=2

Investment 1 -8 60 w.p.1/2 0
20 w.p.1/2

Investment 2 -8 0 60 w.p. 1/2

30 w.p. 1/2
The firm had issued senior debt in the past in order to finance past
investments. Because of this, the firm will have to repay debt with face
value B1 at t=1. Therefore, if Investment 2 is chosen the firm will have to
issue new junior debt at t=1 with face value B2 to be repaid at t=2.

a. Which investment will be undertaken if B1=0?

b. If B1=35, and we want to undertake Investment 2, new junior debt will

have to be issued with market value of 35. But, given that at time t=2
the firm may go bankrupt (i.e. with probability ½ the CF will be 30,
which is lower than 35), the face value of the new debt has to be higher
than 35. Which is the required face value, B2, of the junior debt that we
must issue at t=1, so that given the probability of bankruptcy its market
value will be 35? Which is the value of equity in this case?

c. If B1=35, which is the value of equity if the shareholders choose

Investment 1, rather than Investment 2? Which investment will be
chosen?

d. If B1=35, determine which project will be chosen by the shareholders if

the initial debt-holders agree to renounce the repayment of debt B1 at
t=1 in exchange for 70% of the shares of the company, and it is no
longer necessary to issue new debt. Compare the value of debt and
equity at t=0 under this agreement with those that would be obtained if
there is no agreement. In view of those values, will the shareholders and
the debt-holders accept the agreement?
2.4. Read the article and answer the questions bellow

Debt: Switching off the lites

Oct 11th 2007

From The Economist print edition
The balance of power in credit markets is finally shifting

WHEN a handful of big Wall Street banks reluctantly funded part of a $26
billion takeover of First Data, a transaction-processing firm, in early autumn,
there was jubilation among those eager for any sign that the chaos in
financial markets was abating. It did not mean debt would flow freely again,
though. Indeed, it marked the first, feeble sign that creditors were regaining
the upper hand after years of bowing and scraping to borrowers.

At the end of weeks of wrangling over the terms of the loan, the banks
finally managed to squeeze from Kohlberg Kravis Roberts (KKR), a private-
equity group buying First Data, a concession helping them make sure that
the debt would be repaid. Such “covenants” vary, but the important ones
are those that either prevent a company from borrowing too much (known
as leverage covenants), or force it to earn enough to pay interest (coverage
covenants). These girdles were fairly common until a few years ago.
Companies that broke them had to pay a penalty to their creditors or were
forced into bankruptcy.

In recent years as liquidity expanded, banks held on to fewer of the loans

that they originated, syndicating them instead to money managers such as
hedge funds. Borrowers found that such creditors, in their hunger for higher
yields at a time of low interest rates, were quite willing to drop safeguards
altogether, leading to a surge of “covenant-lite” loans. Because banks held
on to fewer loans, they relaxed their guard. According to Standard & Poor's
LCD, a research unit which tracks leveraged lending, the share of non-
investment grade loans held by banks in America fell by over 30 percentage
points to around a fifth between 2000 and the first six months of this year.
In Europe that share fell from over 90% to well under half.

But as the credit markets have slowed and institutional investment has
clammed up, banks have returned, keeping more loans on their books. And
they have also brought back covenants. It may be too late in some cases—
Moody's, a rating agency, expects the proportion of lowly rated companies
that default to rise from 1.3% to 3.5% globally in the next 12 months. But it
is welcome nonetheless.

If credit conditions deteriorate, banks and other creditors will be far less
patient with erring companies than they were. During the boom, borrowers
could often get covenants waived. Not any more. Whereas covenants exist
mainly to keep companies on the straight and narrow, they also earn banks
a handsome fee each time they are breached. That is an incentive to be
tough.

Banks have also sought to stop large borrowers, such as private-equity

funds, from funnelling money to companies they own that are in danger of
violating covenants. This practice, known as an “equity cure”, was used to
give companies a quick bill of health even if the finances were unsound. It is
likely to stop. As William May of Fitch Ratings, another rating agency, points
out, companies hoping for a prepayment option on any new borrowing in
order to refinance their loans at a cheaper rate, will almost certainly have to
pay their lenders a premium for doing so. Finally, more exotic forms of
borrowing such as payment-in-kind notes, which allowed companies to pay
interest in bonds rather than cash, have faded—for now, at least.

The new conditions that the banks finally imposed on First Data after long
negotiations with KKR are considered to have been quite lenient. “What we
are seeing even now is a mix of the older, more aggressive form of lending
coexisting with newer, more conservative types of loans,” says Kristi
Colburn, of GE Capital Markets. The liberal regime may not have been
toppled, but it is tottering.

a. Which types of covenants are mentioned in the article? Can you think
of other types?

b. Do you think covenants are necessary? Shouldn’t the risk of

bankruptcy provide the shareholders with the necessary incentives to
repay the loan?

c. Which are the benefits and the costs of the covenants for the
borrower?
2.5 A different class: Would giving long-term shareholders more clout
improve corporate governance?

Extraced from The Economist (Feb 18th 2010)

THE spectacular collapse of so many big financial firms during the crisis of
2008 has provided new evidence for the belief that stockmarket capitalism
is dangerously short-termist. After all, shareholders in publicly traded
financial institutions cheered them on as they boosted their short-term
profits and share prices by taking risky bets with enormous amounts of
borrowed money. Those bets, it turns out, did terrible damage in the longer
term, to the firms and their shareholders as well as to the economy as a
whole. Shareholders can no longer with a straight face cite the efficient-
market hypothesis as evidence that rising share prices are always evidence
of better prospects, rather than of an unsustainable bubble.

If the stockmarket can get wildly out of whack in the short run, companies
and investors that base their decisions solely on passing movements in
share prices should not be surprised if they pay a penalty over the long
term. But what can be done to encourage a longer-term perspective? One
idea that is increasingly touted as a solution is to give those investors who
keep hold of their shares for a decent length of time more say over the
management of a company than mere interlopers hoping to make a quick
buck. Shareholders of longer tenure could get extra voting rights, say, or
new ones could be barred from voting for a spell.

In the early 1980s shares traded on the New York Stock Exchange changed
hands every three years on average. Nowadays the average tenure is down
to about ten months. That helps to explain the growing concern about
short-termism. Last year a task force of doughty American investors
(Warren Buffett, Felix Rohatyn and Pete Peterson, among others) convened
by the Aspen Institute, a think-tank, published a report called “Overcoming
Short-Termism”. It advocated various measures to encourage investors to
hold shares for longer, including withholding voting rights from new
shareholders for a year.

An advisory committee in the Netherlands has proposed loyalty bonuses for

long-term shareholders, such as increased dividends or additional voting
rights after holding a share for four years. Likewise, Britain's minister for
financial services, Paul Myners, has suggested that short-term holders of
shares should have inferior voting rights. Roger Carr, the chairman of
Cadbury until it was taken over recently by Kraft, suggested earlier this
month that investors who bought shares in a firm after it had received a
takeover bid should not be allowed to vote on the offer.

The theory behind these proposals is that those who hold shares longer are
more likely to behave like owners than those who trade frequently to bet on
short-term movements in prices. Disenfranchising the punters would not
only give investors an incentive to hang onto their shares for longer, the
argument runs, but would also encourage those with voting rights to use
them, as they would know their votes would be more likely to count in
board elections and so forth.

Would it work? Happily, an experiment in dual classes of shareholders has

long been under way in France, where shares often gain double voting
rights after being held for a specified period—usually two years, although
sometimes as long as ten. A recent paper, “Disclosure and Minority
Expropriation: A Study of French Listed Firms”, by Chiraz Ben Ali, an
economist at the University of Paris Dauphine, found that the main impact
of the dual-class structure was to increase the exploitation of minority
shareholders (which tended to own the shares with weaker voting rights) by
the controlling majority. Accounting practices, for example, tend to be much
less transparent. Admittedly, France's feeble safeguards for minority
shareholders may be partly responsible for this result—but at the very least
that suggests that extra voting rights are no cure-all.

Although no American firms have dual classes of shareholders, they do

sometimes resort to another device designed to resist pressure to pursue
short-term goals: “staggered boards”, in which only a minority of directors
face re-election each year. According to Lucian Bebchuk of Harvard Law
School, who has studied their impact, they are strongly associated with
lower long-term returns.

Short-term vigour, long-term neglect

Equally, there is some evidence, albeit not conclusive, that short-term

shareholders from activist hedge funds and the like can improve the
performance of poorly run companies through brief campaigns to improve
their strategy or management. As Colin Melvin, the boss of Hermes Equity
Ownership Services, an advisory firm with activist leanings, points out,
“Disproportionate voting rights can (and often do) serve to insulate
management and make it less accountable to shareholders.” In short, the
length of time that an investor holds a share does not tell you a lot about
how much interest he will take in the management of the firm concerned.
Many long-term index investors hold shares for years without taking the
slightest interest in how the firms they invest in are run, let alone doing
anything to improve matters. There is also a moral argument, of course,
against depriving property-owners of their rights, no matter how seldom
they make use of them.

The real issue is not how to encourage investors to keep hold of their shares
for longer, but how to encourage more of them to take their duties as
owners seriously, irrespective of the length of their tenure. Instead of
creating multiple classes of shareholders, governments and regulators may
want to think about how they define fiduciary duties in the financial realm.
Better yet, the investing public, whose retirement savings have atrophied in
the financial crisis thanks in part to the short-term way in which they were
invested, may sort things out themselves, by demanding a longer-term
perspective from the pension and mutual funds that they have entrusted
with their money.
The article argues that many shareholders, as well as managers,
take a short-term perspective on firm value and that this destroys
long-term value.

Why does the conflict between long-term (“good”) investors and

short-term (“bad”) investors arise? How does market efficiency
affect this conflict?

Which types of policies can boost profits on the short-term but

destroy value on the long-term?

Why can managers be expected to care more about the short-term

than shareholders?

Which types of shareholders are more (less) likely to be more

interested in the short-term and why?

According to the article, which measures could be devised to reduce

short-termsm? Which are their pros and cons? Can you think of
other measures?
 Unit 3

3.1 An entrepreneur needs investors to finance an investment which

requires an initial investment of 5 monetary units. The project yields 20 in
case of success and 0 in case of failure. The probability of success is
pH=0.75 or pL=0.25, depending on the effort of the manager (High or Low).
With low effort the manager enjoys private benefits amounting to B=2. The
manager only receives a fixed salary S=1 which is enough to satisfy his
participation constrain.

Imagine that a large enough shareholder, that owns a percentage  of the

shares, can prevent the manager form obtaining the private benefits B=2
with probability x at a cost c(x)=10x2. Therefore with probability x the
manager does not get the private benefits and he prefers to exert high
effort and with probability (1-x) he still get private benefits and exert low
effort. The manager and the investors are risk neutral and the risk free
discount rate is zero.

a) Which is the first best monitoring strategy (i.e. the optimal x that
maximizes total wealth, including both private benefits B=2 and
private costs c(x))?
b) Which is the optimal monitoring level that the large shareholder will
choose considering only his benefits and costs?
c) Which is the value of  that makes the large shareholder chose the
first best monitoring level?
d) For this  is it possible to satisfy the large shareholders’ participation
constrain (i.e. does he get a positive NPV from his investment)?

3.2. You are considering the takeover of company T. The value of the equity
of company T as a stand along entity is 100 million euros and it has 1
million shares. You have estimated that if you are able to obtain full control
of company T (i.e. 51% of the shares of company T) you could implement
operational changes that would generate cost savings of 20 million.

You cannot expect the help of the managers of company T. Therefore you
will have to make a tender offer to the shareholders of T. Your underwriter
will charge you 3 million euros for helping you throughout the tender offer.

The fraction of tender offers that are successful in the economy is given by
p. Since the shareholders of T are small and uncoordinated, each one of
them will assume that the probability of success of this particular tender
offer is given by p and it will not be affected by his particular individual
decision on whether to sell or retain his shares. Moreover, since they are all
equal they will follow the same strategy.
Compute the maximum price that you would be willing to pay and
shareholders preferred strategy given that price, in the following alternative
situations:

1. You do not have any holdings of shares of company T and you make
a conditional offer.
2. You already have 10% of the shares of company T and you make a
conditional offer.
3. You already have 10% of the shares of company T and you make an
unconditional offer.
4. You have a 20% toehold in company T and you make a conditional
offer.
5. You do not have any holdings of shares of company T, but you can
make a conditional offer and threaten T shareholders announcing
that, if the takeover is successful, you will transfer assets worth 10
million from company T to your own company.

3.3. Read the “Vodafone Airtouch’s bid for Mannesmann” HBS case and
answer the following questions

1. What hurdles is Vodafone Air Touch going to face to complete

its acquisition of Mannesmann? In order to replace the
management board of Mannesmann, Vodafone needs to have
control of 75% of the supervisory board. Considering the
employees and the different major shareholders in the
supervisory board, who is going to be its most likely
supporter? Who is going to resist? Why?

2. Why do you think Esser is fighting so hard against the bid? Do

you think his position would have been different under a
different remuneration scheme? Why is Gent so eager to do
the deal?

3. What role do hostile takeovers play? In their absence what

mechanisms perform the same function?
 Unit 4

4.1 Consider a two period economy (t=0,1) in which the riskfree rate of
return is zero. At time t=0 a group of risk neutral investors can set up a firm
to undertake a risky investment opportunity that requires an investment of
8 monetary units at t=0 and has a random return Z at t=1:
- Z=20 with probability p
- Z=0 with probability 1-p.
A manager must be hired to run the firm. The manager can exert high (H)
effort, or low effort (L), which is not observable to the investors. Exerting
low effort gives the manager private benefits with monetary value 2, but
exerting high effort increases the probability of success from pL=0,25 to
pH=0,75.
The manager, has no initial wealth, he is risk averse and his utility given a
total monetary payoff, a, is given by the utility function is U(a)=a1/2
His reservation utility is given by U=2.5. The investors offer him a fixed
salary S=3, plus a bonus X in case of sucess.
a) Show that the investment is has +NPV only if the manager is
induced to exert high effort:
b) Given S=3, which is the minimum bonus that the manager must
get so that he will have incentives to exert effort?
c) Given S=3, which is the minimum bonus that gives the
manager his reservation utility ?
d) Which is the minimum bonus X that satisfies both conditions ?
e) For that bonus, will the investors find the investment
interesting? What would happen if the required innitial investment
increased to 9?

4.2. Pay-offs for the boss need to be better designed

From The Economist Jan 14th 2012

RICH rewards for departing bosses are not popular. After Sir Fred Goodwin
led Royal Bank of Scotland into a ditch and dumped the bill on British
taxpayers, he left with a pension of over £700,000 ($980,000) a year. The
Sun, a tabloid, said he had “screwed the nation”.

Yet golden parachutes have their uses. If well-designed, they align the
boss’s interests more closely with those of shareholders. Suppose, for
example, a takeover is brewing. Takeovers are usually lucrative for
shareholders of the target firm: in America between 1990 and 2008, they
have received a median premium of 35%. But the boss’s interests are quite
different. If the firm is acquired, he is likely to be fired.

A golden parachute can persuade the boss not to obstruct a takeover. But
their notoriety dissuades firms from using them. Dirk Jenter of Stanford
University and Katharina Lewellen of Tuck Business School find that golden
parachutes are rarer and stingier than they should be.
To test whether bosses block takeovers, they looked at what happens when
they are nearing retirement, and therefore have no future career to
sacrifice. Using data on American public firms from 1992 to 2008, they
found that companies with a boss aged 65 or over were 50% more likely to
be taken over.

Another paper, by Eliezer Fich and Ralph Walkling of Drexel University and
Anh Tran of Cass Business School, found that when golden parachutes are
larger, proposed mergers are more likely to be completed, but buyers pay
less for the shares of the target firm. The data from Mr Jenter and Ms
Lewellen show that when the boss of the target firm is old, buyers pay an
average premium of 26%. For younger bosses, the premium is 33%. This
makes sense. If younger bosses are more reluctant to sell, it will cost more
to overcome their objections.

So boards must strike a balance. As with real parachutes, poor design can
have serious consequences.

 Why do you think that golden parachutes are not popular?

 Given the findings of Jenter and Lewellen, does it make sense

to offer a golden parachute to the boss of a company that is
not performing well?

 Given the findings of Fich, Walkling, and Tran, which is the

risk of offering a parachute that is too generous?

 Why do you think that “golden parachutes are rarer and

stingier than they should be”?
4.3 Consider a three period economy (t=0,1,2) where a group of investors
has hired a manager to organize the production and distribution of a new
product. The required initial investment (t=0) is 0.1 million euros and
expected cash flows for times t=1 and t=2 will depend on the demand level.
Once demand is known at time t=1 there exists the alternative to upgrade
the productive process with an additional investmento of 0.1 million euros.

Expected cash-flows :
Demand High (prob. Medium Low
1/4) (1/4) (1/2)
t=1 0.175 0.125 0.125
t=2(without upgrading) 0.1 0.075 0.05
t=2 (with upgrading) 0.3 0.2 0.1

Only the manager can observe demand at time t=1 and he has to make the
decision on wether to upgrade the productive process by reinvesting the
funds generated at time t=1. The investors suspect that the manager, who
is an engineer, will always like to upgrade the productive process, even
when it is not profitable.

Answer the following questions assuming risk neutrality and a riskless

interest rate of zero.
a) When does upgrading have +NPV ? Which would be the value of
the firm if the manager were to invest following the NPV rule ?
b) Which is the value of the firm if no debt is issued at time t=0
(face value of debt to be repaid at time t=1, B1=0), so that the
manager always upgrades?
c) Which is the minimum value of B1 that prevents investment in
the low state ? Given that value of B1 in which states will the maanger
be prevented from investing?
d) Which is the optimal value of debt (B1) ?
e) How will your answers change if the proababilities of the high,
medium and low states where changed respectively to 15%, 75% and
10%?

4.4 Leveraged recapitalization at Sealed Air

We are in year 1989. Sealed Air Corporation is an American firm that

manufactures different types of envelopes and protective packages,
including the famous envelopes with air bubbles that everybody loves to
pop. The patents of these products, which have made Sealed Air the
industry leader, are about to expire and strong competition is expected for
the future. The market value of equity has gone down from $49 to $44
during the last six months and many analysts think that the company will be
unable to maintain its position as a market leader because Sealed Air is less
efficient and has higher operating costs than its potential competitors.
Considering this unfavourable situation the managers of the company have
announced a radical change in the capital structure of the company. They
have announced that the company will pay an extraordinary dividend of $40
per share that will be financed with the issue of new debt. This “leveraged
recapitalization” will increase the debt to equity ratio from 10% to 136%.
After the announcement the market price of equity went up to $52 per
share.

Comment on (i) the reasons that could explain the proposed change
and (ii) the market’s reaction to the announcement

4.5. A clash over cash: Japanese shareholder activism

Extracted from The Economist May 18th 2002

Trouble is expected at the annual shareholders meeting of Tokyo Style, a

Japanese clothing company, run by Yoshio Takano. Mr Yoshiaki
Murakami, manager of an aggressive investment firm, M&A Consulting,
who has a 11.9% stake in Tokyo Style, is demanding that Mr Takano
returns capital to the shareholders.
Tokyo Style holds ¥122 billion ($950 million) in cash and securities and
has no debt, yet the stock market values its shares at only ¥107 billion.
In response to Mr Murakami criticisms, Mr Takano has said: “Our cash on
hands is the result of steady efforts over 50 years. I don’t understand
why we should be subjected to criticism or demands for improvement”.
He also announced that Tokyo Style would spend the cash on 50 billion
of Tokyo commercial property, a sector in which Mr Takano considers
himself a novice.

 Which type of conflict is identified in this article?

 Given the current market value which do you think are the
expectations of the shareholders about the future actions
of the company? What do you think about the future
investment plans of Mr Takano?

 The capital structure of the company is very particular.

Which changes in the financial policies of the firm would
you recommend to increase the value of the company?
 Unit 5

5.1 Read the “IKEA’s Global Sourcing Challenge: Indian Rugs and Child
Labor” HBS case and answer the following questions

1. What short-term actions should Barner take regarding the

IKEA supply contract with Rangan Exports? What are the
advantages/disadvantages of cancelling the contract with
Rangan Industries?

2. Consider now the long-term strategy of IKEA with regard to

its Indian operations.
a. If IKEA abandons the Indian sources, where will the firm
find alternative suppliers?
b. If IKEA wants to continue to source carpets in India, how
can the company continue outsourcing carpets and avoid
this problem recurring? Would you suggest that the
company continues IKEA’s own monitoring and control
processes or signs-up to Rugmark?
c. Is the focus on eliminating the use of child labor in IKEA’s
supply chain enough or should it engage in broader action
to address the root causes of child labor as Save the
Children is urging? What actions could IKEA undertake?

3. Should the firm stay or should it exit? Which would be the

impact of each decision in terms of profitability and associated
risks? What other factors should be taken into account?

5.2 Good for you, good for the shareholders

Extracted from The Economist Mar 17th 2012

IN OCTOBER 1996 the cover of Fortune magazine showed Roger Enrico,

then the chief executive of PepsiCo, trapped in a Coke bottle under the
headline “How Coke is kicking Pepsi’s can”. Ten years later, just after Pepsi
had surpassed Coca-Cola in market capitalisation for the first time in their
108-year rivalry, the same magazine ran another big story on the cola
giants. It admitted that it was wrong to have declared Pepsi defeated and
lauded it as one of America’s best-run companies.
Fast forward another six years and Coke is again kicking Pepsi’s can. Both
are losing cola drinkers in America as consumers switch from fizzy, sugary
drinks to healthier water, tea, juices and sports drinks. But whereas Coca-
Cola has lost on average 2% a year in like-for-like volume of fizzy drinks in
America since 2004, Pepsi has lost 3% (see chart), according to Sanford C.
Bernstein, an investment bank. That means its American drinks business
has shrunk by about 20%. Coke’s Simply juices and its lower-priced Minute
Maid are taking share from the fruity concoctions of Pepsi’s Tropicana. And
Coke’s sports drink, Powerade, is knocking spots off Gatorade, Pepsi’s brew
for athletes.

Faced with mounting investor dissatisfaction about Pepsi’s stagnant share

price, the food-and-drinks giant recently embarked on an effort to relaunch
the company. On February 9th the group announced that it was cutting
8,700 jobs, or 3% of its workforce. Having underinvested in its flagship
beverage brands for years, it is increasing investment in marketing and
advertising by $500m-600m. It has some catching-up to do: at the end of
2010 Pepsi spent 3.3% of sales on advertising compared with 8.3% of sales
at Coca-Cola, according to Judy Hong, who follows drinks makers for
Goldman Sachs.

Pepsi is also pinning its hope on the launch across America on March 26th of
Pepsi Next, a new soda sweetened with both high-fructose syrup and
artificial sweeteners which has 60% less sugar than classic Pepsi. Angelique
Krembs of Pepsi says the new drink is aimed at consumers who are keen to
imbibe less sugar with their cola but dislike the taste of diet drinks. She
splits this mostly male group in two: “dualists”, who switch between regular
and diet (and sometimes mix the two), and “resistants”, who never touch
either.
Repeat performance

Will Pepsi’s reset be enough to win over investors? Pepsi Next is dividing
opinions. “We have seen this movie before,” says Mark Swartzberg, a drinks
analyst at Stifel Nicolaus, a bank. In 2004 Pepsi launched Pepsi Edge, a mid-
calorie soda, which Coca-Cola matched with a new mid-calorie brew called
C2. Both disappeared from the shelves after a few years.

Pepsi’s boss, Indra Nooyi, is seeking to revive the company’s core business
while continuing her ambitious drive to transform the company into a maker
of healthier drinks and snacks, and a better corporate citizen. In the past
few years Ms Nooyi has spent disproportionate time and effort on promoting
products that Pepsi calls “good for you” (oatmeal, fruit juices and sports
drinks), which make up about 20% of its sales. She is aiming nearly to triple
the revenue of nutritious products, to $30 billion, by 2020.

Ms Nooyi has also devoted resources to cultivating a corporate image

focused on global social responsibility. In 2010 Pepsi skipped soda ads at
the Super Bowl, launching instead a $20m online competition for the
nomination of worthy causes that Pepsi might finance. The Refresh Project
succeeded in gathering 80m online votes and helped numerous homeless
shelters and orphanages. But it did not sell much soda, which is why Pepsi
went back to its usual ads at the 2011 Super Bowl.

It will take time for the revised strategy to bear fruit, as it did for Coca-Cola
when it reset its course in the late 2000s after a series of management and
marketing mishaps. Coke’s bosses now feel they are on the right track with
its offering of fizzy drinks, vitamin water, juice, coffee and tea. They think
they are giving health-conscious customers sufficient choice. Of the 3,500
drinks Coke sells worldwide, more than 800 are zero- or low-calorie.

If Ms Nooyi’s relaunch does not work Pepsi may get a new chief executive.
The company seems to be preparing for a possible change at the top. On
March 12th it put John Compton, the current head of Americas Foods, in
charge of all the company’s global groups, making him an heir apparent in
the newly created role of president.

Ms Nooyi may leave before she is pushed out. She is one of the contenders
for the top job at the World Bank. Though she says she loves her job, she
has talked in the past of her desire to spend some of her career in public
service. And the World Bank may suit her zeal to do good on a global scale
rather more comfortably than the maker of popular but largely fatty, salty
and sugary foodstuffs.
Which are the policies that Pepsi has introduced in the corporate
social responsibility programm of the firm?

Why do you think that If Ms Nooyi’s is keen in pursuing these

policies? Are they compatible with maximizing shareholders
wealth?

5.3 Going bananas

Extracted from The Economist Mar 31st 2012

SOMETIMES you bend over backwards to please, but still get nowhere. That
is what appears to have happened to Chiquita Brands, an American firm
which is one of the world’s biggest suppliers of bananas and other fruit.
Despite accommodating eco-warriors, social activists and unions, it has
found little reward.

After a campaign by a green group called ForestEthics, Chiquita agreed in

November to avoid fuel from Canadian tar sands. Extracting this oil is a dirty
process. Environmentalists have worked furiously to block a pipeline, called
Keystone XL, which would carry it from Canada to America. Chiquita told
ForestEthics that it does not use such fuel in its ships and agreed to avoid
its use in lorries.

This may have pleased environmentalists, but it infuriated Canadians who

depend on the oil industry. A pro-business lobby called EthicalOil.org is
urging a boycott of Chiquita’s products that is said to be costing the
company a fortune. Chiquita would not quantify its losses.

Chiquita traces its origins to the late 1890s and the United Fruit Company,
which treated some of the Central American countries it operated in as
banana republics. In recent years, however, the firm has made huge efforts
to promote social responsibility and sustainability, working with activist
groups such as the Rainforest Alliance. “We can do good and do well at the
same time,” Fernando Aguirre, the firm’s chief executive, wrote in the
company’s latest social responsibility report, issued in 2008.

Chiquita has signed and largely upheld a global agreement with local and
international food unions. It has embraced sustainable farming techniques
and allows products to be certified for environmental and other standards.
Last year it promised to promote more women and to ensure there is no
sexual harassment on the plantations it owns and buys from. But that has
not provided protection from big retailers buying bananas direct from
plantations and bypassing Chiquita and its main rivals, Dole and Fresh Del
Monte Produce.
Many firms in conflict zones face extortion. In 2003 Chiquita became the
only American company voluntarily to admit to the Department of Justice
that it had paid protection money to Colombian paramilitary forces
surrounding its plantations. Now it is facing a raft of American and
Colombian lawsuits.

Chiquita’s conspicuous lack of reward is beginning to worry some veteran

campaigners. Neither Dole nor Del Monte has been interested in following
Chiquita in signing a global union agreement, says Ron Oswald, head of IUF,
the international foodworkers’ union.“It’s not sustainable for any company in
a competitive sector to make progress and gain no recognition for it,” he
grumbles.

Has Chiquita succedded in its policy of “doing good and doing well”
simultaneuosly?

How can you measure the degree of success of such a strategy?

Which are the risks of pursuing this type of policy?