Practice Problems
Prof. P.V. Viswanath

Objective Function of the Firm

Short Questions:


  1. Greenmail
  2. Agency Costs
  3. Board of Directors
  4. Golden Parachute
  5. Poison Pills
  6. Super-majority Amendment
  7. Capital Market Efficiency
  8. Bond covenants

Problem 1. (Fall 1999) Read the following article by Susan Carey from the Wall Street Journal of 10/05/99 and answer the questions that follow:

US Air Mechanics to Vote on Labor Pact  As Union Continues to Prepare for Strike

Mechanics at US Airways Group Inc. vote Tuesday on a tentative labor agreement reached last month, just four days before they were scheduled to strike.

If the five-year pact is approved by a majority of the 7,500 mechanics and cleaners in the International Association of Machinists union, US Air, Arlington, Va., is expected to try to settle contracts with its 9,000 flight attendants and 10,000 customer-service agents.

If the mechanics reject the pact, however, the union has said it will give the airline 48 hours to position its airplanes and crews, and then walk off the job. It is expected that 6,200 ramp workers also represented by the union would honor the mechanics' strike, a scenario that potentially could shut down US Air, the nation's sixth-largest airline and a dominant player on the East Coast.

The pact is an improvement over an earlier deal the mechanics rejected in July, union leadership maintains. It promises a signing bonus valued at 5% of members' annual wages and an immediate 6% raise. After two years, workers would receive a lump-sum payment valued at 3% of their annual wages. Premiums paid to licensed mechanics also would increase from $2.20 an hour to $4 an hour after three years. The pact would provide further raises if the US Air workers fell behind the salaries of their peers at the four largest U.S. airlines.

A top-scale mechanic at US Air earns $23 an hour, excluding the license premiums. A top-paid cleaner earns more than $16 an hour. The group, which has been seeking a new contract since 1995, shot down an earlier 3 1/2-year agreement.

The union, which is endorsing the pact, held information meetings last week throughout the US Air system to brief members on the new tentative agreement. But turnout at some locations was low, with more vocal opponents showing up than contract supporters. The greater the number of union members who cast ballots today, the better the pact's chance of being approved, union officials said.

The mechanics last struck US Air in 1992. The airline managed to operate about 55% of its schedule. But during that four-day walkout, there were no sympathy strikes. This time, the ramp workers have pledged to respect a mechanics' strike. The Association of Flight Attendants union said its leadership will decide, once a strike is under way, whether to honor the mechanics' picket lines.

  1. (20 points) Employees are stakeholders in the firm.  However, employees do not necessarily own shares in the firm.  This means that they might not act in the best interests of shareholders.  For example, the mechanics' strike described in the article above is clearly not in shareholders' interests.  How would you recommend that management (acting on behalf of shareholders) try to align employees incentives with those of shareholders?

  2. (20 points) US Air has an advantage in its negotiations with the union, in that the mechanics might not be able to hold out for long, particularly if flight attendants do not respect the mechanics' picket line.  Is there any reason why management should not try to beat down the US Air union to as low a salary as possible?  I'm looking for an answer related to the question of firm objectives.

 Note:  Use no more than one side of your answer book for each part.  Rambling answers will be penalized.   


Problem 2: (Spring 1999) Read the following article and answer the questions given at the end.

Allstate Corp. Adopts A Takeover Defense Tied to Share Rights
The Wall Street Journal - 02/16/99

Brief Summary of Article: Allstate Corporation adopts a takeover defense by giving existing shareholders a greater share of value in the corporation relative to groups attempting to acquire 15% or more of the company's stock. Interestingly, the company also increased its dividend per share. The market, nevertheless, did not seem to like Allstate's actions. It would be worthwhile to take a closer look at management's stake in the company.

NORTHBROOK, Ill. -- Allstate Corp. adopted a share-purchase rights agreement intended as a defense against a potential hostile takeover. But Chairman Edward M. Liddy said the car and home insurer is "not aware of any takeover attempt at this time."

The agreement gives existing shareholders rights to buy a new series of "junior participating preferred stock." The rights would become exercisable 10 days after a person or group acquired or announced a tender offer for 15% or more of the company's common stock.

It's not uncommon for a company to adopt such a takeover defense when its stock is at depressed levels. Allstate is trading at a relatively low level of 1.9 times its per-share book value (the difference between a company's assets and its liabilities) and 11 times analysts' 1999 profit projections.

Specifically, stockholders of record on Feb. 26 will get a dividend distribution of one share-purchase right for each share outstanding of Allstate common stock. Each right, which will get tacked onto the common shares and trade with them, will entitle stockholders to buy 1/1,000th of a share of the new junior participating preferred stock at an exercise price of $150. If exercised, each 1/1,000th of a share of the new preferred would give the holder $300 of the company's common shares, diluting the stake of potential acquirers.

Allstate released the news after trading closed Friday. Its shares closed at $36.4375, down $1.50, in New York Stock Exchange composite trading.

Separately, Allstate increased its regular quarterly dividend, payable April 1 to shareholders of record at the close of business Feb. 26, to 15 cents, up 1.5 cents a share.


  1. Are such takeover defenses in the interest of shareholders? Why or why not?
  2. Why might takeover defenses be attractive to management?
  3. How would you interpret the fact that Allstate's stock was marked down on the news of the takeover defense adoption?
  4. Is the dividend increase related to Allstate's attempts to ward off a takeover?


Problem 3 (Spring 1999): Read the following article by Matt Murray from the Wall Street Journal of 2/12/99 and answer the following question:

The market for corporate control is the market where shareholder groups inside the company and would-be shareholder groups outside the company fight for control of the company through tender offers, proxy fights, takeover, mergers, acquisitions and tender offers. The underlying function that the market for corporate control performs is to ensure that management’s actions do not stray too far from what would benefit shareholders. Would you say that the case of Mellon Bank represents a failure of the market for corporate control? Why or why not?

Mellon Bank Continues to Fight Battle for Independence --- It Kept Bank of New York at Bay, but Skeptical Shareholders Still Circle

Last year, Mellon Bank Corp. got squeezed by an unwanted suitor. This year, it is still feeling the pressure from shareholders.
Martin G. McGuinn, who took over as chairman of Pittsburgh-based Mellon on Jan. 1, has moved quickly, shaking up senior management and planning the sale of several underperforming units to shore up shareholder support and boost performance amid continuing takeover talk. Mellon, perennially mentioned as a desirable takeover target, has been feeling some heat since it unilaterally rejected a $22.1 billion takeover offer from Bank of New York Co., which threw in the towel in May.
Shareholders openly wondered whether Mellon could do better alone than with Bank of New York, especially after profit and revenue growth slowed a bit amid the economic tumult of mid-1998. In the words of Rob Sharps, the bank analyst at Mellon's second-largest institutional shareholder, T. Rowe Price Associates Inc., "They've got a lot to prove. It'll be quite some time before people stop comparing their stock to the value of the Bank of New York stock they turned down." T. Rowe Price owns about 6.5 million Mellon shares.
Using a simple, admittedly imprecise formula, a number of analysts estimate that the stock value of the combined institutions today would be in the range of $90 a share. That's well above Mellon, which rose $1.5625 to $66.75 in composite trading on the Big Board yesterday. As inexact as that figure is, however, it adds to the pressure on Mr. McGuinn, especially since many analysts believe Bank of New York could spring again. "He's got his marching orders to make the franchise worth $90 a share in a very short time," says Eric Rothman, an analyst at Stephens Inc. in Little Rock, Ark.
Bank of New York won't comment.
Adding to the challenge is the long shadow of Mr. McGuinn's successor, Frank V. Cahouet. Though Mr. Cahouet, an often abrasive manager, wasn't always well-liked personally on Wall Street, he was viewed widely as a commanding figure who saved Mellon from the brink of failure and reshaped it as a highly profitable asset manager and mutual-fund provider. Next to him, Mr. McGuinn looked like a less charismatic manager with big shoes to fill.
But so far, the new chairman has acted like a man under the microscope. Two weeks after taking over, he placed on the block three low-returning businesses -- the credit-card portfolio, mortgage operations and automated-teller machine processing -- to focus on higher-returning businesses such as asset management. Mellon is trying to free up capital to invest in higher-returning businesses. "The biggest job we have is keeping the revenue growing," Mr. McGuinn says. "That's what will drive our shares."
Meanwhile, in Mellon's corporate-banking business, which has the worst returns of its major operations, bankers are under orders to assess the profitability of each relationship. Corporate clients are getting pushed to consider Mellon's cash-management and other operations, which are far more profitable than classic corporate banking. Those that bite might win more favorable terms on a wider array of products. Those that balk might find Mellon asking them to take their corporate-banking business elsewhere.
"The broad sense I'm getting is they are less wed to the notion they have to emphasize traditional banking to be as successful," says Judah Kraushaar, a bank analyst at Merrill Lynch & Co. "Once, you had to be a big corporate bank. Here there's a little healthier skepticism."
Mr. McGuinn also says he plans to deploy the freed-up capital -- analysts expect the unit sales alone to generate as much as $600 million -- to mollify shareholders. The company plans to begin buying back stock as soon as this summer. It hopes to continue making niche acquisitions that bolster its profitable, fee-generating businesses such as mutual funds. And Mr. McGuinn says he plans to invest money in marketing, product development and salary incentives at some of the bank's existing businesses such as Dreyfus Crop., the mutual-fund company that Mellon, sometimes accused of being tightfisted, acquired in 1994.
"Clearly, investing in our businesses is one of the highest priorities," Mr. McGuinn says in a clear departure from his predecessor. "We see opportunities, for example, outside the United States in asset-management and trust and custody. Our higher-growth businesses like that demand continuous investment."
That talk is having an effect. "We like what we see," says Kevin Holt, bank analyst at Strong Capital Management in Milwaukee, which owns about 450,000 shares and was highly critical of the company's rejection of Bank of New York. "Focusing on some of the not-so-strong parts of the bank, i.e. the commercial bank, is positive. He's sending a strong message."
Mr. McGuinn sent another strong message during his first week on the job, when he ousted a longtime vice chairman and former rival, David R. Lovejoy. The move stunned many insiders because Mr. Lovejoy had been a close ally of Mr. Cahouet. Outside the firm, many saw the action as a sign that Mr. McGuinn wanted to assert an image as tough as his predecessor -- possibly to alert Bank of New York and others that he is no pushover. "Marty's actions are those of someone who intends to run his company as an independent entity," says Michael Mayo, an analyst at Credit Suisse First Boston. "Nothing that Marty's done has given any indication that Mellon wants to join up with someone else."
Mr. McGuinn says he won't comment on personnel matters. But in general, he wants to position Mellon to go "to the next level, to be able to continue our growth and make sure shareholders will see tremendous appreciation in our investment. As a corollary to that, it means we continue to control our own destiny, and the team can show it's being very active and be very decisive in trying to do what's right."
Shareholders seem to like what they have seen so far, but Mr. McGuinn's term is still young. "They're doing the right types of things," says T. Rowe Price's Mr. Sharps, "but the jury's still out."


Problem 4: (Spring 1999) Here is an excerpt from a Feb. 25, 1999 WSJ article, entitled “Executive Compensation.”  Answer the questions below, using no more than two sides of a page.

Conventional wisdom suggests that stock-option grants send a powerful signal that the interests of management are aligned with those of shareholders. But investors are well advised to be less optimistic.

 The standard stock-option plan clearly fails the "reward for superior performance" test. The exercise price is equal to the market price on the day the options are granted and remains fixed over the entire option period, typically 10 years. These options reward executives for any share-price increase -- even if the increase is substantially below that realized by industry peers or the overall market. 

This isn't unusual. L.E.K. Consulting looked at the gains of chief executive officers of Dow Jones Industrial Average companies on options granted from 1993 to the end of 1998. We found that for CEOs of the 26 companies that were part of the Dow industrials throughout the period, 60% of those gains were for performance below the average of their Shareholder Scoreboard industry group. 

What executive-compensation signals should investors look for in 1999 and beyond? On the positive side, look for companies that announce plans that target a higher level of performance than standard stock options. 

A number of companies, such as Colgate-Palmolive Co., Monsanto Co. and Transamerica Corp., have recently introduced premium-priced stock-option plans. Premium-priced options have an exercise price 25%, 50% or, less commonly, 100% above the market price on the day the options are granted. For a 10-year option, these exercise prices require annual appreciation rates in the company's stock of about 2%, 4% and 7%, respectively, before they are "in the money." 

Better yet, look for companies that announce indexed option plans that link exercise prices to movements in either an industry or broader market index. These options don't reward underperforming executives simply because the market is rising, but instead reward superior management regardless of the state of the stock market. 

On the negative side, beware of companies that play by different rules when the safety net of a sustained bull market is removed. Specifically, they lower the exercise prices of out-of-the-money options or shift the executive-compensation mix from options back to the salary and cash-bonus combination that prevailed before the stock market began its rise in the 1980s. 

  1. What is behind the theory that stock options align management interests with stockholder interests?

  2. Why do most stock option plans fail to fit this theory?


Problem 5: Read the article below from the Wall Street Journal of Jan. 21, 2000 and answer the following questions:

  1. The issue at hand seems to reflect a conflict between corporate/individual objectives and social objectives.  Briefly summarize both sides of the arguments for and against Mr. von Holstein's resolution of the conflict.

  2. Different countries seem to have different ways of resolving this conflict.  For example, Swedish "social values" are not the same as American values.  Is one of the countries wrong, or is it possible to have different solutions to the same problem, depending on the context?  Explain how the contextual differences might matter.

Millionaire Crusades To Overturn Swedish Social Values

By ALMAR LATOUR,   Staff Reporter

STOCKHOLM -- There's no shortage of bearded social revolutionaries in modern history -- Lenin and Che Guevara come to mind. But Johan Stael von Holstein is the only one among them to drive a metallic-silver Porsche.

Mr. Holstein, a 36-year-old Internet entrepreneur, cuts an odd figure here in the frozen north, where austerity is deemed a virtue and egalitarianism a must. He wears thick gold chains and flaunts his wealth, openly boasting he's worth $100 million (98.8 million euros). He jets around in the Concorde and recently sent an assistant to Thailand to shop for a private beach. His ultimate goal: to stop working altogether, go fishing, and dabble in politics.

"If you work hard, you must be able to get the rewards," says Mr. von Holstein, a former ski bum. "Everybody should have a dream to work toward."

All of this is an affront to Sweden's proud traditions of social democracy. Far from apologizing, Mr. von Holstein rubs his success in the faces of Swedish government ministers -- he recently called Prime Minister Goeran Persson "the stupidest person alive" -- and lambastes silver-haired industry leaders for failing to embrace the new economy. In fact, he considers himself something of a billboard for capitalism as an alternative to social democracy.

On a recent afternoon in his Ikea-furnished office, Mr. von Holstein smiles broadly when prominent Swedish venture capitalist Kjell Spangberg walks in to discuss possible ventures. "Did you see the stock price?" Mr. von Holstein yells, pointing at a pocket computer that shows a big spike in shares of his company, Icon Medialab AB. "It's going through the roof!"

Mr. Spangberg, who runs a high-tech venture capital fund in San Francisco, smiles back but lifts a warning finger. "The game is not over yet," he says.

Some caution is called for. In America or Britain, Mr. von Holstein might be feted as a capitalist folk hero. Not so in Sweden, where his spendthrift ways and carefree spirit have shocked leftist establishment politicians and staid industrialists alike. This is, after all, a place where capitalism is OK, but capitalists tend to be personae non grata. Until relatively recently, new money was considered dirty; old money was kept behind closed doors in countryside mansions; and personalities were to be contained at all times. Modesty and equality were watchwords, and the even the country's mightiest industrial family, the Wallenbergs, hewed to a sedate motto: "To work, but not to be seen."

So what does the old guard think of Mr. von Holstein, the bad boy wonder?

"He embodies the culture of greed," says Johan Arenberg, the Socialist chief executive of a media company with the unlikely name Etc. AB.

More damning still: "His selfish views are bad for society," adds leftist author Goeran Greider. "He's crusading to break away our shared values."

At the very least, "he's very un-Swedish," adds Eric Belfrage, a senior vice president of Wallenberg bank SEB. "He's stirring the pot."

If so, there's a lot to stir these days. The new economy is fast making deep inroads in Sweden. Last year alone, more than 10 Internet-related companies made it big on the country's stock market, compared with none so far in Web-crazy Holland. An estimated 300 more Swedish high-tech start-ups plan to go public this year, with more than 800 expected to be founded next year, according to consultants McKinsey & Co.

The result: an unprecedented injection of wealth into a layer of society that's never seen big money before: free-wheeling Swedes in their 20s and 30s. Like Mr. von Holstein, members of this Web elite live the good life and slough off Calvinist shame. They dine at exclusive restaurants in London and Paris, hit the beaches of St-Tropez and tool around Stockholm in Ferraris.

"The spirit of Gordon Gekko has come alive in Sweden," says Kjell Nordstrom, a professor at the Stockholm School of Economics. "It's cool to make money, be greedy. Some people find that hard to accept." Adds Lars Ilshammar, an economic historian: "Traditional political and industrial leaders are losing their grip. Young Swedes dislike the old distribution of wealth. Von Holstein is a symbol for them."

Mr. von Holstein's status is all the more remarkable given his unusual upbringing. He was born out of wedlock, but his mother later married into a noble family, where he at times felt rejected. He was obliged, for example, to call his stepgrandfather "uncle," and the bulk of the family inheritance went to his stepbrother.

Dyslexic and overactive, he struggled to make his way through school and eventually studied information science at the University of Lund and, later, economics at the University of Stockholm. But his determination eventually carried the day.

The University of Stockholm, for example, initially rejected his application, partly because of his inability to read and write well. But Mr. von Holstein refused to give up, people close to him say. In the end, he pestered the admission officer so many times that he was allowed to enroll on the strength of his enthusiasm alone. He became an outstanding student. One time, he and a friend volunteered to write a report for Positive Sweden, a nonprofit organization that promotes the country.

"The content was excellent," says Mr. Belfrage of SEB, who reviewed the report at the time. "But the language was awful. He thinks fast but does not care who he's addressing. He suffers from a modern laziness."

After his studies, in fact, Mr. von Holstein took off for the Swiss Alps, where he worked as a ski instructor for a couple of years. But a nasty auto accident in 1987 severely injured one leg. Unable to ski, he decided to return home.

Back in Stockholm, he joined Kinnevik, a media and financial conglomerate controlled by Jan Stenbeck, a millionaire devotee of American-style capitalism who has trained an entire generation of young Swedish entrepreneurs. Mr. von Holstein soon became Mr. Stenbeck's protege, working his way up in four years from a marketing director for Z-TV, a commercial TV channel for young people, to president of Interactive TV and vice president of Inlux, a bank in Luxembourg.

Despite his rapid rise, Mr. von Holstein soon tired of working for others. In 1996, he gathered a few friends around his kitchen table and founded Icon Medialab, which specializes in building Web pages. Mr. von Holstein quickly put the company on the map by bragging about how much it would be worth in a few years -- an incendiary assertion in these parts.

From the beginning, Mr. von Holstein was determined to practice a new management philosophy at Icon: Employees at all levels should be eligible for bonuses, partnership, options and chances to progress personally. Today, all 1,100 workers at the company own options. Many go abroad for as long as a few months to take specialized university classes.

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