Homework #3

Question 1
Yes, I do believe that an agency conflict exists in this situation between McKinsey
and H-P, because their best interests do not necessarily align. The acquisition of
Compaq by H-P had the potential to result in higher fees charged by McKinsey
consultants for both advising on the acquisition and additional business afterwards.
This gave them an incentive to push for H-P to go through with the acquisition and
see the deal come to fruition even if it was not in the best interest of H-P
shareholders.

Question 2
Patricia Dunns perspective that overcoming challenges within the first two years of
the H-P and Compaq merger is based on representativeness. Representativeness
occurs when a person makes judgements about an event under uncertainty based
on past experiences.
Dunns past experience with mergers influenced her
prediction of the outcome of the H-P and Compaq deal and as a result she believed
the McKinsey consultants that it would produce cost savings when in fact this may
not have been the most objective decision.

Question 3
The technique H-P executives used was slightly comparable to the traditional DCF
model, but had faults. If H-P were to achieve cost savings of $1B after tax every
year for perpetuity and discount these savings by 5%, then the value of those
savings would be $20B. H-P executives wrongly valued these cost savings as
incremental earninings that extend in perpetuity. At the H-Ps P/E ratio was 16.1,
which meant they valued the earnings stream by multiplying $1B by 16.1. Given
that these cost savings would occur at future dates, H-P discounted the $16.1 by
roughly 15% per year. H-Ps executives didnt rationally think about how to value
the company. The exectuives should have valued the incremental earnings by
multiplying the P/E ratio.

Question 4
The experience of Colgate-Palmolive does present evidence that contradicts the
behavioral position. Reuben Mark, Colgates CEO, is described as overconfident and
excessively optimistic, which are both behavioral biases that lead to inefficient
prices and paying premiums for acquisitions. However, Mark refuted this theory
with several acquisitions during his tenure and helped the company achieve a ROE
that was 25% above the industry average.

Question 5
The main arguments introduced by those who oppose introducing the U.S. system
to Canada are centered around (1) the benefits associated with having the same
directors serve on both the board of a holding companies and their subsidiaries and
(2) the differences in business structure between companies in the U.S. and
Canada. They argue board members of holding companies, who are also board
members of subsidiaries, are able to create value because they have expertise in
their own fields (finance, operations, etc.), but also have knowledge in the workings

of the subsidiaries, which ultimately contributes to the earnings of the holding

company and the value that is created for shareholders. These board members are
able to utilize their knowledge and act in the interest that will best help the overall
company by leveraging their in-depth perspective and interaction with both
companies. Another way the Canadian system might be preferred is that Canadian
companies tend to be smaller and more closely held than their American
counterparts. As a result of this, directors and managers might be more likely to
have close relationships with these people and they argue this will lead to effective
boards because both will be less likely to mislead or compromise the other party
because of this familiarity. On the contrary, the Canadian system leaves more room
for behavioral biases to come into play and have an impact on the businesses. For
example, if a person sits on both boards, they may have a tendency to exhibit
groupthink leading to accuracy issues and an illusion of effectiveness. These boards
may lead to additional risk because the members are more likely to accept
decisions easily.

Question 6
The S&P 500 is traditionally a good indication of general market performance.
When reviewing exhibits 9-1 and 9-2, we see that Enron was making a return that
was significantly larger than this benchmark (about 300%), however, there is clearly
something peculiar about their operations. As a director, I would definitely dig
deeper into how the company is earning a return so much higher when their return
on capital is just 7% and their cost of capital is 9-12%. When looking at the years
1987 to 1994, I may not have thought too much into how the company was getting
this return. However, during the late 1990s, I definitely would have raised flags and
questions about how the firm was able to generate such a high return. It is the
obligation of board members to be aware of the inner workings of a company and
while it is easy to celebrate high returns and an increasing share price, it is
extremely important to make sure there is no wrongdoing.

Question 7
Gerald Levins desire to pursue the acquisition of AT&Ts cable business without
consulting any of the board of directors is likely because he held the perspective
that the acquisition was an excellent idea for the company and felt that it would be
too difficult to reach a decision for a group because there would be too many
differing perspectives. While groups do tend to perform worse on judgmental
decisions, I still believe that this was the wrong decision by Levin for several
reasons. First, while evaluating a company certainly involves some judgmental
aspects, there are also many objective metrics that can be used to evaluate the
feasibility of a project and whether it will create value for shareholders. The boards
of large corporations are generally comprised of knowledgeable professionals who
are qualified to analyze an acquisition and offer their opinions. By consulting them,
a company can make a more informed decision and something like this should not
be a judgement call. By not consulting the board, Levin displayed overconfidence in
both his ability as CEO and the acquisition. He also displayed confirmation bias by
overweighting information that pointed to the acquisition creating value and

disregarding potential indicators of its failure. By consulting the board members

who are well versed and experienced, they could have pointed this out and made a
more informed decision. Additionally, the board has a sole purpose of adding value
for the shareholders, while CEOs may sometimes pursue acquisitions for with
ulterior motives in mind such as media spotlight and building resumes. The board is
there for a reason and this is why it is crucial to consult them. Information sharing
between management and the board of directors is key to the long term success of
a company.

Question 8
This quotation suggests that consultants prefer to be hired by the management
team of a company over an independent committee evaluating a company. The
reason for this is rooted in the belief that if consultants are to do good work for a
company, the management team will continue to hire them and they will continue
to be able to continue to receive consulting fees for their services. Consultants
prefer this to being hired by independent committees because these committees
will not continue to hire them for business. This presents an agency conflict
because the interests of consultants involve developing closer relationships with
management so they can continue to earn fees rather than be critical of the
business and management and do a really good job that ostracizes management
and makes them less desirable for hire by the firm and others.

Question 9
The relationship between the audit firm and management is the main agency
conflict associated with HealthSouths pristine-audit program. Managers were
paying auditors an absurd amount of money to check for things like cleanliness of
facilities, which amounted to greater fees collected by the auditors than the
financial statements they were auditing. This is a conflict because the auditors did
not want to lose this business that was generating a ton of money for them and
thus, may not have been as diligent in their financial statement audits. Auditors
need to have independence and be free of ulterior motives presented by a conflict
like this to properly analyze statements. This allowed financial statements to be
manipulated to show the company was not performing as well as it was, which
people like CEO Richard Scrushy took advantage of by selling shares and raking in
millions for personal gain. It is important to shareholders to not have a conflict like
this so that personal agendas cannot be advanced like they were in the case of
HealthSouth.

Question 10
The relationship between the audit firm and management is the main agency
conflict associated with HealthSouths pristine-audit program. Managers were
paying consultants an absurd amount of money to check for things like clean toilets
so they had less incentive to asf;lajkl;fd.