Office hours: Tues & Thurs 8:45 9:45 or by appointment (please use to set up an appointment).

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1 FBE 431: Financial Policies and Corporate Governance Spring semester 2013 Professor Harry DeAngelo Kenneth King Stonier Chair in Business Administration Office: ACC 308-D Office Phone: (no voice mail messages, please) (best way to contact me) Class meetings: Tues & Thurs 10:00 11:50 HOH 301 Office hours: Tues & Thurs 8:45 9:45 or by appointment (please use to set up an appointment). Course objectives: This course develops a framework that is useful for understanding a broad range of real-world corporate financial decisions. Applications to be covered include: features of real-world capital structures and payout policies Wall Street s view of share dilution economic dilution IPOs, seasoned stock offerings, private equity placements, rights offerings common stock repurchases Dutch auction versus fixed-price tender offers equity carve-outs, spinoffs, splitoffs, and tracking stock corporate growth and over-expansion managerial concern with bolstering EPS growth and avoiding EPS dilution financial flexibility and corporate capital structures capital structure: target leverage ratios, zones, and planning heuristics transitory debt financing credit lines junk bond financing event-contingent debt obligations stock pyramids capital structures with dual classes of common stock value of corporate control proxy contests poison pills takeover attack and defense strategies LBOs and leveraged recapitalizations stock market manipulation and the corporate cost of capital the modern crisis in corporate governance the too big to fail doctrine and the recent financial crisis

2 The conceptual framework and applications developed in this course will be useful to students who seek to understand both the institutional details of, and substantive motivations for, important corporate financing decisions. In terms of career tracks, the skill set developed in this course will provide a strong foundation for analyzing corporate financial policies for (i) those people who will work for corporations, with or without a specialization in finance, (ii) those who will serve as outside consultants to corporations on appropriate financial policies, (iii) those who will work as external financial analysts, or more generally for (iv) anyone interested in understanding the financial decisions made by corporate management. Course structure: The course format will be lecture with classroom discussion. Students are responsible for material discussed during class meetings, assigned readings (see below), eight problem sets, a midterm examination, and a final examination. Midterm and final examinations: The midterm will be given during the regularly scheduled class meeting on Tuesday, February 26. The final will be given on Tuesday, May 14 from 11 a.m. until 1 p.m. Attendance at both of these exams is a requirement of the course. Grading: Course grades will be determined by approximately curving the total points earned on three class requirements: Point range 1. Problem sets 0 to Midterm examination 0 to Final examination 0 to 130 Total 0 to 270 Problem sets: There will be eight graded problem sets. Each problem set is to be done in groups of three to five students. The problem sets are due at the beginning of class on the following dates: Problem set Due date Points 1 Tuesday, Jan Tuesday, Jan Thursday, Feb Tuesday, Feb Tuesday, Feb Thursday, Apr Thursday, Apr Thursday, May 2 12 Note that Problem set 8 is due at the last class meeting of the semester. You should be ready to start thinking about this problem set after the midterm. The problem set refers to an article listed later in the syllabus under leveraged recapitalizations. We will discuss that article in class, but you can read that article shortly after the midterm and be ready at that time to start into Problem set 8. Regular messages with course-related materials: I will use Blackboard to send you s throughout the semester about ongoing developments in the world of corporate finance (and for other course-related items). I will rely to a large degree on the Wall Street Journal as a source for this material. Student subscriptions to the WSJ may be obtained at: An alternative link is: For the zip code, type in 900. For school, highlight U STHRN CAL LS ANG. For professor, highlight DEANGELO, HARRY. [MyMarshall has a link to the WSJ, but the interface is not user friendly.] 2

3 Target Dates of Topic Coverage Topic #s are given in the reading list that immediately follows this summary page. The dates given for in-class discussions are targets that may change as the class evolves. The main determinant of any changes in topic coverage dates will be developments in the world of corporate finance that occur during this class. We will discuss real-world developments in every class session (except exams and reviews). Some of those discussions will be short. Others will be long if developments dictate that we need more time to understand the phenomenon at hand. The longer discussions may lead to changes in the actual dates we cover a given reading list topic. I will keep you informed about any changes in coverage dates. If you have any questions, please do not hesitate to ask. Problem set due dates will not be moved earlier in time. Midterm and final examination dates will not be changed. Session # Day Date Topic #s from reading list Assignment due S1 Tues Jan 15 1 S2 Thurs Jan 17 2, begin 3 S3 Tues Jan 22 3 Problem set #1 S4 Thurs Jan 24 4 S5 Tues Jan 29 5 Problem set #2 S6 Thurs Jan 31 Finish 5, begin 6 S7 Tues Feb 5 Finish 6, begin 7 S8 Thurs Feb 7 Finish 7 Problem set #3 S9 Tues Feb 12 8 Problem set #4 S10 Thurs Feb 14 9, 10 S11 Tues Feb Problem set #5 S12 Thurs Feb 21 Review session S13 Tues Feb 26 Midterm exam Midterm exam S14 Thurs Feb S15 Tues Mar 5 Discuss exam, begin 13 S16 Thurs Mar 7 Finish 13, begin 14 S17 Tues Mar S18 Thurs Mar S19 Tues Mar 26 Finish 14, 15 S20 Thurs Mar 28 16, 17 S21 Tues Apr 2 18 S22 Thurs Apr 4 18 Problem set #6 S23 Tues Apr 9 19 S24 Thurs Apr 11 20, 21 S25 Tues Apr 16 22, 23 S26 Thurs Apr S27 Tues April S28 Thurs Apr 25 25, 26 Problem set #7 S29 Tues Apr 30 27, 28 S30 Thurs May 2 Review session Problem set #8 Final exam Final exam Final exam 3

4 Topics and Reading List (See prior page for target calendar dates of coverage of these topics) The outline below specifies readings for each topic that we will discuss in class over the semester. In addition to these readings, many handouts will be distributed during class meetings. Those handouts are an integral part of the required reading for the course. 1. Logic and limitations of the efficient markets hypothesis Review: In the text you used in your introductory finance class, review the discussion of the Efficient Markets Hypothesis. Emphasize the logic of the general concepts, not the findings of particular studies. 2. What is the appropriate managerial objective when choosing financial policy? Review: In your introductory text, review the discussion of the proper objective for management. 3. Payout policy: Foundations Review: In the textbook you used for introductory finance, review the discussion of MM s conclusions about dividend irrelevance in an idealized market setting. DeAngelo, Harry, DeAngelo, Linda, and Douglas Skinner, Corporate Payout Policy, Foundations and Trends in Finance, Designated CPP below. Read chapters 1, 2, and Payout policy: Taxes, free cash flow, and other real-world considerations CPP (see topic 3 for reference) Read the appendix on Microsoft. Vascellaro, Jessica, Apple Pads Investors Wallets, Wall Street Journal, March 20, 2012 Buckman, Rebecca, Microsoft, Awash in Cash, Declares Its First Dividend, Wall Street Journal, January 17, Wayne, Leslie, Arms Makers Find Being Cash-Heavy Is Mixed Blessing, NY Times, May 12, Monga, Vipal, After Earning Cash in China, the Trick is Getting it Out, Wall Street Journal, February 15, Fuller, Joseph and Michael Jensen, How Bigger Dividends Build Trust, Financial Times, October 6, Payout policy: What do real-world payout policies look like? CPP (see topic 3 for reference) Read chapters 4 through 8. As with all such readings, do NOT get bogged down in mastering the details of each study. Rely on the discussion in class to get the main points. 4

5 DeAngelo, Harry, Linda DeAngelo, and Douglas Skinner, Are Dividends Disappearing? Dividend Concentration and the Consolidation of Earnings, Journal of Financial Economics, June 2004, pp Do not get bogged down in mastering the numbers. Emphasize Figure 1 and Tables 1, 2, 3, and 10. Most importantly, focus on the main points presented in section 7. Fama, Eugene F. and Kenneth R. French, Disappearing Dividends: Changing Firm Characteristics or Reduced Propensity to Pay?, Journal of Financial Economics, April 2001, pp Read pages 1 through 8 (top) and the concluding section of the study. 6. Capital structure: Foundations Review: In your introductory book, review the discussion of (i) the MM capital structure irrelevancy proposition, (ii) MM on corporate taxes, (iii) bankruptcy costs and capital structure. Miller, Merton H., Debt and Taxes, Journal of Finance, May 1977, pp Emphasize the horse and rabbit stew discussion and the material in section III that explains how personal taxes influence the gains from leverage. Do not spend a great deal of time on section IV's discussion of market equilibrium. We will discuss the main implications of Miller's analysis in class. Smith, Randall and Sharon Terlep, GM Could Be Free of Taxes for Years, Wall Street Journal, November 3, Terlep, Sharon, GM s Drive: Getting Out of Debt, Wall Street Journal, December 15, Duhigg, Charles and David Kocieniewski, How Apple Sidesteps Billions in Global Taxes, New York Times, April 28, At the time this article was written, Apple had no debt and enormous cash balances. Something to think about: What can be gleaned about the critical features of Apple s financial policies from its debt and cash positions and the facts reported in this article? 7. Capital structure and the costs of financial distress Mattioli, Dana and Mike Spector, Kodak s Rescue Plans Hit Hurdles, Wall Street Journal, December 19, Martin, Andrew and Michael De La Merced, Bankrupt, Kodak Vows to Rebound, Wall Street Journal, January 19, Weiss, Lawrence and Karen Wruck, Information Problems, Conflicts of Interest, and Asset Stripping: Chapter 11 s Failure in the Case of Eastern Airlines, Journal of Financial Economics, April 1998, pp Read sections 1, 2, and 6. Bankruptcies, Workouts, and Turnarounds, Transcript of Roundtable Discussion, Journal of Applied Corporate Finance, Summer Agency costs: Corporate ownership structure and managerial incentives Jensen, Michael and William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics, October 1976, pp The Jensen and Meckling article presents the agency theory approach to analyzing corporate finance issues and identifies important concepts that will be used repeatedly throughout the course. You should read the 5

6 article because it is a classic, and because it provides the best available treatment of agency theory. Unfortunately, the article is quite long and too technical (for present purposes) in places. Read the article for the intuition and skim the technical parts only to the extent necessary to preserve continuity in your reading. Focus in particular on the intuition of the discussion in sections 1-2.2, 2.6, 3, 4, and Asymmetric information: Raising capital given disagreements over value Smith, Clifford W., Investment Banking and the Capital Acquisition Process, Journal of Financial Economics, January/February 1986, pp Read only sections 1 and 2 for now. Focus on the evidence summarized in Table 1. Familiarize yourself with the nature of the broad range of information provided in Tables 2-4, but do not memorize these findings. It will be useful from time to time to refer back to this literature summary. Skim the section 2 data interpretations. Important reminder: In reading this paper (and all other empirical papers assigned in this course), focus on understanding the broad-brush empirical regularities. Do not memorize particular numbers or focus on details of statistical methods. Myers, Stewart and Nicholas Majluf, Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have, Journal of Financial Economics, June 1984, pp Focus on the intuitive parts of the discussion in sections 1-2.4, , and 6. Read the technical material only to the extent necessary to understand the intuition of the argument. 10. Agency costs of free cash flow Jensen, Michael C., Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, American Economic Review, May 1986, pp Focus on the introduction and sections I and VI. 11. Financial flexibility: Target capital structures and the option to borrow DeAngelo, Harry, DeAngelo, Linda, and Toni. M. Whited, Capital Structure Dynamics and Transitory Debt, Journal of Financial Economics, February 2011, pp Read only the introduction and conclusion to get the intuitive idea of (i) the distinction between the transitory and permanent roles of debt in capital structures and (ii) the value of the option to borrow. Do not focus on the mathematical or statistical details. DeAngelo, Harry, DeAngelo, Linda, and Karen Wruck, Asset Liquidity, Debt Covenants, and Managerial Discretion in Financial Distress: The Collapse of L.A. Gear, Journal of Financial Economics, 2002, Read sections 1 and 7. Midterm exam Ground rules: Closed book. Closed notes. Calculators are fine. No sharing of calculators. Exam coverage will not extend beyond topic #12. 6

7 12. Capital structure: What do real-world capital structures look like? DeAngelo, Harry and Richard Roll, How Stable Are Corporate Capital Structures? Working paper, USC and UCLA, Emphasize the introduction and conclusion as well as section 8 and the appendix. Denis, David and Stephen McKeon, Debt Financing and Financial Flexibility: Evidence From Pro- Active Leverage Increases. Review of Financial Studies, 2012, pp Emphasize the introduction, conclusion, and section 3. Press Releases for Kroger, Safeway, Caterpillar, and Yum! Brands, various dates. Ng, Serena, Banks Get Tougher on Credit Line Provisions, Wall Street Journal, May 4, Stol, John, GM s Move to Tap Credit Line May Intensify Worries, Wall Street Journal, September 22, Marketing common stock: Rights offerings, underwritten sales, and private placements Smith, Clifford W., Investment Banking and the Capital Acquisition Process, Journal of Financial Economics, January/February 1986, Read only section 3.1 for now. Sears Rights Offering, Press Release dated February 23, Initial public offerings (IPOs) Ritter, Jay, Equilibrium in the Initial Public Offering Market, Annual Review of Financial Economics, 2011, pp This article gives an excellent overview of the systematic evidence on IPOs. Ignore sections 8.2 to 8.4. Rusli, Evelyn and Peter Eavis, Facebook Raises $16 Billion in IPO, New York Times, May 17, Chon, Gina and Drew Fitzgerald, As Facebook s Shares Sink, Focus on Morgan Stanley, Wall Street Journal, May 21, Langely, Monica, Das, Anupreeta, and Aaron Leccheti, Morgan Stanley was Driver on Facebook s Wild IPO Ride, Wall Street Journal, June 18, Utal, Bro, Inside the Deal that Made Bill Gates $350,000,000, Fortune, July 21, 1986, pp Seasoned equity offerings and stock-market timing DeAngelo, Harry, DeAngelo, Linda, and René Stulz, Seasoned Equity Offerings, Market Timing, and the Corporate Lifecycle, Journal of Financial Economics, March 2010, pp Emphasize the introduction, conclusion, and table 2. 7

8 16. Spinoffs, splitoffs, equity carve-outs, and tracking stock McDonald s Split-off of Chipotle, Press Release dated October 12, Market Place Column, Happy Days After the AOL-Time Warner Merger, New York Times, November 2, Sorkin, Andrew, With AOL Spinoff, Time Warner Ends an Era, New York Times, May 29, Stock-market manipulation and the corporate cost of capital Lewis, Michael, His So-Called Life of Stock Fraud, New York Times Magazine, February 25, 2001, pp Corporate voting rights: Alternative arrangements, ownership, and value Google IPO registration statement DeAngelo, Harry and Linda DeAngelo, Managerial Ownership of Voting Rights: A Study of Public Corporations with Dual Classes of Common Stock, Journal of Financial Economics, March 1985, pp Focus on (i) the motives for substantial vote ownership by managers (section 2), (ii) the motives for dual class structures (section 5), and (iii) the summaries in the introduction and conclusion (sections 1 and 7). Read the empirical material only to get an intuitive understanding of the nature or managerial ownership in firms with multiple classes of common stock. Lublin, Joan and Spencer Ante, A Fight in Silicon Valley: Founders Push for Control, Wall Street Journal, July 10, Proxy contests DeAngelo, Harry and Linda DeAngelo, Proxy Contests and the Governance of Publicly Held Corporations, Journal of Financial Economics, June 1989, pp Reuters, Icahn on Icahn, interview of Carl Icahn, dated March 27, Large block stockholders and managerial monitoring CPP (see topic 3 for reference) Read section 11.3 on the sleeping dogs theory of payout policy DeAngelo, Harry and Linda DeAngelo, Controlling Stockholders and the Disciplinary Role of Corporate Payout Policy: A Study of the Times Mirror Company, Journal of Financial Economics, May 2000, Anders, George, The Barbarians in the Boardroom, Harvard Business Review, July-August 1992, pp Munk, Nina, How Levi s Trashed a Great American Brand, Fortune, April 12, 1999, pp

9 21. Delusion in corporate finance: Growth, over-optimism, and contraction Jensen, Michael, The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems, Journal of Finance, July 1993, pp This article is thought provoking, but too long to cover in totality in the time we have available. Read sections I through V. Focus on section IV ( The Difficulty of Exit ) and especially on the discussion of the asymmetry between the growth and decline stages for an organization. Treat sections I through III and VI primarily as background for section IV. Dreazen, Vochi, Wildly Optimistic Data Drove Telecoms to Build Fiber Glut, Wall Street Journal, September 26, Keats, Nancy, Fore Sale: Prices Crash at Luxury Golf Communities, Wall Street Journal, May 20, Loomis, C., The 15% Delusion, Fortune, February 15, Buffett, Warren, Avoiding a Mega-Catastrophe: Derivatives Are Financial Weapons of Mass Destruction, Fortune, March 3, Junk bonds: Michael Milken and the ascent and collapse of Drexel Burnham Lambert Rabinowitz, Dorothy, Mr. Giulani and Mr. Milken, Wall Street Journal, December 26, 2000, p. A The modern crisis in corporate governance Smith, Greg, Why I Am Leaving Goldman Sachs, New York Times, March 14, The important message in this opinion piece is not about Goldman Sachs per se, but rather about the issue of trust and ethical behavior on Wall Street and, more broadly, in Corporate America. McLean, Bethany, Why Enron Went Bust, Fortune, December 24, 2001, pp Common stock repurchases: Alternative methods, tendering behavior, and motives CPP (see topic 3 for reference) Read chapter Takeover bargaining: Attack and defense strategies Dann, Larry and Harry DeAngelo, Corporate Financial Policy and Corporate Control: A Study of Defensive Adjustments in Asset and Ownership Structure, Journal of Financial Economics, April 1988, pp Focus on sections 4 and 5. Read the appendix only to the extent that you are interested in learning more about particular cases. 9

10 Moeller, Sara, Schlingemann, Frederick, and René Stulz, Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave, Journal of Finance, April 2005, pp Read from the introduction through the second full paragraph on page 761 (plus Table I on page 762). Davidoff, Steven, The Case Against Staggered Boards, New York Times, March 20, Leveraged buyouts and leveraged recapitalizations Denis, David, Organizational Form and the Consequences of Highly Leveraged Transactions: Kroger s Recapitalization and Safeway s LBO, Journal of Financial Economics, 1994, pp Read section 2.2 and use the information provided there as background for problem set 8. Kravis, Henry, Keynote Speech Delivered at the Private Equity Analyst Conference in New York City on September 22, 2004, unpublished manuscript. Jensen, Michael, Eclipse of the Public Corporation, Harvard Business Review, September-October 1989, pp Private versus social consequences of corporate investment policy DeAngelo, Harry and Linda DeAngelo, Ancient Redwoods and the Politics of Finance: A Study of the Hostile Takeover of the Pacific Lumber Company, Journal of Financial Economics, January 1998, pp McCoy, Charles, For Takeover Baron, Redwood Forests Are Just One More Deal, The Wall Street Journal, August 6, 1993, pp. A1+. Walters, Mark, California s Chain-Saw Massacre, Reader s Digest, November 1989, p The too big to fail doctrine and the recent financial crisis Taibbi, Matt, Secrets and Lies of the Bailout, Rolling Stone, January 4, Final exam Ground rules: Closed book. Closed notes. Calculators are fine. No sharing of calculators. Exam coverage will emphasize post-midterm material. Pre-midterm material is also relevant, since it is the foundation for the material covered in the second half of the course. USC and Marshall policies that govern this and all Marshall courses: University policy on disabilities: Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to me as early in the semester as possible. DSP is located in STU 301 and is open 8:30 a.m. - 5:00 p.m., Monday through Friday. The phone number for DSP is (213)

11 Add/Drop Process: In compliance with USC and Marshall s policies classes are open enrollment (R-clearance) through the first week of class. All classes are closed (switched to D-clearance) at the end of the first week. This policy minimizes the complexity of the registration process for students by standardizing across classes. I can drop you from my class if you don t attend the first two sessions. Please note: If you decide to drop, or if you choose not to attend the first two session and are dropped, you risk being not being able to add to another section this semester, since they might reach capacity. You can only add a class after the first week of classes if you receive approval from the instructor. Statement on Academic Integrity: USC seeks to maintain an optimal learning environment. General principles of academic honesty include the concept of respect for the intellectual property of others, the expectation that individual work will be submitted unless otherwise allowed by an instructor, and the obligations both to protect one s own academic work from misuse by others as well as to avoid using another s work as one s own. All students are expected to understand and abide by these principles. SCampus, the Student Guidebook, contains the Student Conduct Code in Section 11.00, while the recommended sanctions are located in Appendix A. Students will be referred to the Office of Student Judicial Affairs and Community Standards for further review, should there be any suspicion of academic dishonesty. The Review process can be found at: Failure to adhere to the academic conduct standards set forth by these guidelines and our programs will not be tolerated by the USC Marshall community and can lead to dismissal. 11