19.1Management Incentives When Managers Have BetterInformation

Than Shareholders

Most of the discussion in this text assumes that managers act to maximize their firm’s

share price. However, if there is a difference between what managers believe their

firm’s shares are worth and the market price of those shares, then the appropriate goal

of the managers needs further elaboration. Should managers act to maximize the cur-

rent market price of the firm’s shares, which reflects only public information, or should

they act to maximize what they believe is the present value of the firm’s future cash

flows, which reflects the managers’private information?

In some cases, there is no conflict between these two objectives, even when there

is a difference between the firm’s full information value, which we refer to as the

intrinsic value, and its current market value. However, as shown later in this chapter,

when a decision conveys information that analysts use to value a firm’s stock, deci-

sions that maximize the firm’s current stock price may not be in the best long-term

interests of shareholders. When this is the case, different shareholders will not neces-

sarily agree on how managers should choose between these conflicting objectives.

Shareholders who plan to hold onto their shares for a long time will capture the

intrinsic value, even if they eventually sell their shares, because the share price at the

time of the sale will reflect the manager’s private information about future cash flows

that the investor has not yet directly captured. Hence, long-term shareholders prefer

managers to make decisions that maximize the intrinsic value of the shares. This of

course assumes that managers correctly assess the firm’s intrinsic value and are not,

for example, overly optimistic. However, shareholders who plan to sell their shares in

the near future prefer managers to take actions that improve the firm’s current or short-

term share price irrespective of how this affects the firm’s intrinsic or long-run value.

Thus, there is an inherent conflict between the interests of long-term and short-term

shareholders.

As in many of the previous chapters, our examples here are simplified by assum-

ing that investors are risk neutral and the discount rate is zero. In this case, current

share prices are equal to expected share prices at any near-term horizon where the cash

flow implications of the manager’s actions are not yet fully known to investors. How-

ever, even with the risk aversion and positive discount rates, short-term share prices

tend to be higher when current share prices are higher. Hence, short-term shareholders

prefer that the managers take actions that immediately or shortly signalgood informa-

tion and concealbad information about the firm’s cash flows, even if the manager pri-

vately knows that those actions are detrimental to the firm’s long-term future

cashflows.

Conflicts between Short-Term and Long-Term Share Price Maximization

Exhibit 19.1 illustrates that managers have a number of competing pressures that deter-

mine how a firm’s current share price and its intrinsic value enter the decision criteria.

If a manager expects to be a long-term player at the firm and intends to continue to

hold stock and options in the firm, then he or she is likely to want to maximize the

firm’s intrinsic value. However, most managers also are concerned about the firm’s cur-

rent stock price. The concern for current stock prices can arise for several reasons.

•	Managers may plan to issue additional equity or sell some of their own stockin the near future.

Grinblatt1330Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1330Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

	Chapter 19The Information Conveyed by Financial Decisions	659
EXHIBIT19.1	Conflicting Incentives That Motivate Management

Management

decisions

Incentive to increase	Incentive to increase the
current stock prices	intrinsic value of the firm

Compensation

considerations

Pressure from	Concern about	Pressure from
short-term	unwanted	long-term
stockholders	takeover bids	stockholders

•	Managers may be concerned about the acquisition of the firm by an outsider ata price that is less than the firm’s intrinsic value.
•	Managerial compensation may be directly or indirectly tied to the current stockprice of the firm.
•	The ability to attract customers and other outside stakeholders may be relatedto outsiders’perceptions of the firm’s value.

Although managers usually have an incentive to increase the firm’s current stock

price, the degree to which they are willing to sacrifice intrinsic value varies. Indeed,

managers also might want to temporarily lower the current stock price of their firms,

as we illustrate in the next section.

Given these inevitable conflicting incentives, we might best view a manager’s

objective function as one of maximizing a weighted average of the firm’s current stock

price and intrinsic value. Result 19.1 summarizes this discussion.

Result 19.1

Management incentives are influenced by a desire to increase both the firm’s current shareprice and its intrinsic value. The weight that managers place on these potentially conflict-ing incentives is determined by, among other things, the manager’s compensation and thesecurity of the manager’s job.

Example 19.1 illustrates how the weights on current and intrinsic value are determined.

Example 19.1: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

Grinblatt1332Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1332Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

660Part VIncentives, Information, and Corporate Control

and that Mr.Jones is entrenched in his job and is unconcerned about outside takeover threats,

describe how Jones’s objective function would weight current value and intrinsic value.

Answer:Jones would weight current value and intrinsic value equally.In other words, he

would be willing to make a decision that reduces Tremont’s intrinsic stock price by $1 per

share if it increased its current stock price by more than $1 per share.

If Mr. Jones, in the previous example, was concerned about takeover threats or

about losing his job for other reasons, his decisions would be further biased toward

those choices that enhance the current value of his firm’s shares. As we illustrate in the

following case, the weight that managers place on current share prices versus the firm’s

intrinsic value can have an important effect on the decisions that they make.

The Joint Venture of IBM, Motorola, and Apple Computer

The joint venture between IBM, Motorola, and Apple Computer to collaborate on personal

computers and workstations (the power PC chip) provides an example of how corporate deci-

sions can provide information that is potentially relevant for pricing a firm’s stock. On the

announcement of such a venture, analysts and investors attempt to assess whether the joint

venture is a good decision and whether it will be successful. For example, if they believe the

decision is good for IBM, there will be upward pressure on the price of IBM stock. On the

other hand, if they believe it is a bad decision, there will be downward pressure on the price

of IBM stock. In addition, the market reaction to the announcement will reflect new infor-

mation about IBM that is signaled indirectly by the announcement.

This new information may have almost nothing to do with the merits of the particular

transaction. For example, the joint venture could have been viewed as a favorable signal

about IBM’s future prospects because it shows that IBM is confident about its ability to

fund a major new investment. Alternatively, such an investment might be viewed as a neg-

ative signal if the analysts’interpretation is that IBM has unfavorable prospects in the main-

frame business and the company is not confident about its ability to develop new personal

computers and workstations on its own. If this negative information is sufficiently impor-

tant, then IBM’s stock price will drop on the announcement of the joint venture even if the

venture is believed to be a good decision.

IBM’s managers are thus faced with a dilemma in making such a choice. If IBM’s man-

agers are concerned about the firm’s current share price and they anticipate an unfavorable

stock price reaction, then they may choose to pass up the joint venture even if the project

itself makes economic sense.

Result 19.2

Good decisions can reveal unfavorable information and bad decisions can reveal favorableinformation. This means that:

•	Stock price reactions are sometimes poor indicators of whether a decision has apositive or a negative effect on a firm’s intrinsic value.
•	Managers who are concerned about the current or short-term share prices of theirfirms may bias their decisions in ways that reduce the intrinsic values of their firms.