CHAPTER 34
Control, Governance, and Financial Architecture
Answers to Practice Questions
1. a. In the U.S., the largest shareholders of corporations are financial institutions.
However, since ownership is usually widely dispersed, effective control
often rests with management. In many countries outside the U.S., families
and governments often have large equity stakes.
b. False. Top managers in Germany are more likely to balance the interests
of all stakeholders (rather than just those of shareholders), but poor
performance can still result in management turnover.
c. True. Carve-out or spin-off of a division improves incentives for the
division’s managers. If the businesses are independent, it is easier to
measure the performance of the division’s managers.
d. False. The limited life of a private-equity partnership reassures the limited
partners that the cash flow will not be reinvested in a wasteful manner. It
also tends to ensure that partnerships focus on opportunities to reorganize
poorly performing businesses and to provide them with new management
before selling them off.
e. True. The remuneration package for the general partners typically
includes a 20% carried interest. This is equivalent to a call option on the
partnership’s value and, as is the case for all options, this option is more
valuable when the value of the assets is highly variable.
2. In general, firms with narrow margins in highly competitive environments are not
good candidates for LBO’s or MBO’s. These firms are often highly efficient and
do not have excess assets or unnecessary capital expenditures. Further, the
thinness of the margins limits the amount of debt capacity.
3. The common theme is that investors do not want companies to waste resources.
Investors would much prefer that companies pay out their free cash flow, instead
of wasting it on poor capital investments or using it to subsidize an inefficient
operation. Financial leverage was a necessary part of both deals because it
increased the companies’ cash obligations and, thus, reduced managers’
flexibility.
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4. RJR issued a lot of debt and repurchased shares to reduce the equity base. Sealed
Air issued a lot of debt and paid a special dividend to all shareholders to reduce the
equity base. RJR was seen as a company that needed to streamline operations and
reexamine its capital expenditures and asset holdings. The firm was in a highly
competitive environment, but had the advantage of brand name recognition for its
products. Sealed Air needed to streamline its operations because it had grown
inefficient due to the patent protection it had for its products. Sealed Air remained
public in order to increase the pressure to perform by remaining exposed to buying
and selling pressure in the market.
5. Answers will vary depending upon the examples chosen.
6. The story told in Barbarians at the Gate is a very complicated one. Those who favor
mergers can find much evidence in this story to support their position, as can
those who oppose mergers. In a similar fashion, those who espouse one
particular theory or another as to why companies merge can find evidence here
to support their position (and evidence to refute the positions of others). Thus,
the answer will vary, depending on one’s views.
7. Private equity partnerships are usually run by professional equity managers
representing larger institutional investors. The institutional investors act as the
limited partners while the professional managers act as general partners in the
limited partnership. The general partners are companies that focus on funding and
managing equity investments in closely-held firms. The incentive for general
partners is a management fee plus a share in the company profits that they can
increase if they successfully “fix” the firm. The limited partners get paid first but are
not entitled to all the profits. Further, the limited life of the partnership precludes
wasteful reinvestment. These partnerships are designed to make investments in
various types of firms from venture capital start-ups to mature firms that need to re-
invigorate management.
8. There are, in general, four reasons for conglomerates to exist outside of the United
States. First, you can be limited by the size of the local economy. To be a larger
firm is to be a diversified firm. Second, increased size often means increased
political power when dealing with centrally managed economies or operating in
countries with unstable economic policies. Third, companies may need to be of a
certain size to attract professional management. Finally, size is important if the
external capital market is poorly developed and internal capital is an important
source of funds.
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9. The internal capital market refers to free cash flow, generated by companies in
mature industries, that can be funneled to other divisions with profitable growth
opportunities. The allocation will be efficient if managers correctly allocate funds to
the most potentially profitable projects and avoid incurring transactions costs
associated with issuing public securities. Unfortunately, funds are not allocated by
an actual market mechanism. Rather, conglomerates are centrally run and internal
corporate politics can play as important a role as economies.
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Challenge Question
1. The major problem with financial management of a conglomerate is that the
division is not forced to face the scrutiny and judgement of an external capital
market. Thus, there may easily be serious misallocations of capital within the
firm. Many of the problems might be resolved by basing performance
measurement and compensation on residual income or EVA but this may be
fraught with problems of implementation. For example, in order to measure
performance, divisional costs of capital have to be developed, as well as other
arbitrary allocations, such as determining the amount and cost of debt to be
borne by any division. Recall also that one of the important roles of an external
capital market is to assess future expectations. Measures of residual income
and EVA tend often to be single period measures. As a consequence, they can
introduce short-term incentives to avoid long-term benefits, such as declining to
purchase land at a bargain price to sit idle for five years in preparation for a major
expansion.
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