DRAFT,CONFIDENTIAL,CHAPTER 9,The Information Conveyed by Financial Decisions,9.1 Information Asymmetry in Corporations,Top managers may have proprietary information that outside investors do not have. There are varieties of reasons why managers cannot disclose the private information to the market The information may be valuable to the firms competitors. Firms run the risk of being sued by investors if they make forecasts that later turn out to be inaccurate. Managers may prefer not to disclose unfavorable information. The information may be difficult to quantify or substantiate. These information enable them to derive more accurate internal valuations of their companies than the investor valuations determined in the market.,Information Asymmetry in Corporations,If direct disclosures provide imperfect and incomplete information, investors will incorporate indirect evidence into their evaluations. Investors will attempt to decipher the information content of observable management decisions related to the firms, Capital expenditure Financing choices Dividends Stock splits Managers decisions to acquire or sell shares for their personal account These decisions could be viewed as signals, because they reveals managers opinions (information) about the companies.,9.2 Management Incentives When Managers Have Better Information Than Shareholders,Information structure and the value of firms, There are two types of firm value: Intrinsic Value (fundamental value): the actual value of a company based on an underlying perception of its true value Market Value: the value of a company, which is traded in the market. The market value may not be necessarily equal to the intrinsic value. A firm is under (over) -valued if the market value is lower (higher) than the intrinsic value. Given the information structure, it is reasonable to assume that managers know the intrinsic value better than the outside investors.,Short-Term and Long-Term Share Price Maximization,If the intrinsic value and market value are different, managers objective to maximize firm value needs further elaboration, even if they act exactly in the interest of shareholders. In this case the goal of value maximization depends on whether shareholders are long-term investors or short-term investors. Long-Term Investor: shareholders who plan to hold onto their shares for a long time will capture the intrinsic value. Hence long-term shareholders prefer managers to make decisions that maximize the intrinsic value of the shares. Short-Term Investors: shareholders who plan to sell their shares in the near future prefer managers to take actions that improve the firms current share price.,Management Incentives,If managers hold stock and options in the firm for a long period, he or she is likely to want to maximize the firms intrinsic value. But most managers also are concerned about the firms current stock price for several reasons, Managers may plan to issue additional equity or sell some of their own stock in the near future. Managers may be concerned about the acquisition of the firm by an outsider at a price that is less than the firms intrinsic value. Managerial compensation may be directly or indirectly tied to the current stock price of the firm. The ability to attract customers and other outside stakeholders may be related to outsiders perceptions of the firms value. Managers objective could be viewed as maximizing a weighted average of the firms current stock price and intrinsic value.,Conflicting Incentives That Motivate Management,Management decisions,Incentive to increase current stock prices,Incentive to increase the intrinsic value of the firm,Compensation considerations,Pressure from short-term stockholders,Concern about unwanted takeover bids,Pressure from long-term stockholders,Example: The Trade-Off between Current Value and Intrinsic Value,John Jones, CEO of Tremont Corporation, has just exercised 10,000 stock options and now owns 20,000 shares of Tremont stock. He plans on selling the 10,000 shares within the next month and will hold the remaining 10,000 shares indefinitely. Assuming that his salary is fixed and that Mr. Jones is entrenched in his job and is unconcerned about outside takeover threats, describe how Joness objective function would weight current value and intrinsic value. Jones would weight current value and intrinsic value equally. In other words, he would be willing to make a decision that reduces Tremonts intrinsic stock price by $1 per share if it increased its current stock price by more than $1 per share.,9.3 Earnings Manipulation,Managers sometimes manipulate the earnings numbers of their firms in ways that increase reported income in the current year at the expense of reporting lower earnings in the future. The discretion of managers over firms accounting methods allows them to shift reported income from the future to the current year. The choice of depreciation methods The choice of inventory valuation methods The choice of service lives and estimation of salvage values of depreciable assets. The choice of the lives of intangibles The estimation of uncollectible rate on account receivable,