Finance 357 Business Finance Topic 2 Corporate goals

What is the goal of a corporation?

Learning objectives Explain why corporations dominate economic activity. Identify the proper goal of the corporation Value a business firm Define corporate governance structures in different economies. Explain the agency conflict. Describe how agency control devices mitigate the agency conflict.

I. Why corporations !. ! "ar#et econo"y

)elf Interested

Consumer

Business Business Business

*ar"ets
Business Business

Business

Business

Choice creates competition and thus businesses.

B. Businesses
Business firm: n economic organi!ation that draw on mar"ets for resources that it can reconfigure to sell as goods and services in mar"ets at a profit.

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Resource markets

Business +irm

Product markets

Profit
profitable firm. (esources cost ,%'. -hey are converted into a product that is sold for ,%#. )toc"holders get a profit of ,# .rofit accrues to the company/s owners only if the business efficiently satisfies customers/ needs. non$profitable firm. (esources cost ,%'. -hey are converted into a product that is sold for ,0. )toc"holders suffer a loss of ,#. 1osses will drive a company to change or go out of business. .rofit is a residual2 .rofitable companies must:

Resources
3btain and use only recourses necessary. 4se these resources in the most efficient manner.

Business +irm

Profit

Goods and services Identify and satisfy their customers

In competitive mar"ets only the efficient earn profits and survive. Business firm: In competitive mar"ets only the efficient survive.

Competitive mar"ets Drive for efficiency Collective effort:

3rgani!e productive activities

ccess to capital:
%$%' (aise funds from investors

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C. Business organi$ational %or"s

Business organi!ational forms determine their efficiency. 5hat types of companies are organi!ed as proprietorships6
3wnership Control 1iability 1ife ccess -o Capital 3wner/s

.rop

3ne person

3ne person

4nlimited

3wner/s

Collective effort

ccess to capital

5hat types of companies are organi!ed as partnerships6

3wnership Control 1iability 1ife ccess -o Capital .artners/ capital

.art

)everal partners

)hared among partners

4nlimited

ny partners

Collective effort

ccess to capital

&. The corporation' a ne( business organi$ation

1. A new business organization Exploration in the%7''s$%0''s was VE(8 expensive and ris"y. 9ings issues royal charters creating :oint$stoc" corporations. East India Company%;'' Dutch East India Company %;'# <udson Bay Company %;=' #$>
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Corporations were not natural persons. -hey were persons before the law: legal entities that can ma"e contracts separate from their owners. *odern corporations are chartered by governments. 5hat types of companies are organi!ed as corporations6
3wnership Control 1iability 1ife ccess -o Capital 4nlimited

Corp

)hareholders

Entrusted to managers

1imited to investment

4nlimited

Collective effort
). Collective e%%ort
*odern production is a complex activity. 5almart -oyota B3 AE #?%''?''' employees >#'?@7' employees #0>?=%= employees >'B?''' employees

ccess to capital

Could a single individual design? manufacture? mar"et and service a car6 Could a single owner manage this process6 .roprietor: 3wnerC*anagerC5or"er Corporation: 3wner is separate from *anager and wor"er Collective effort: )peciali!ation22 *ost productive efforts reDuire a complex mix of talent guided by a sophisticated management structure in which ownership is separated from management.

F. !ccess to capital
5almart -oyota #?%''?''' employees ,%='?B''?'''?''' assets >#'?@7' employees ,>#>?B''?'''?''' assets #$B
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B3 AE

#0>?=%= employees >'B?''' employees

,#?#''?'''?'''?''' assets ,=0%?0''?'''?''' assets

Could a plumber raise ,>#>?'''?'''?'''6 -he plumber is limited to the capital he can raise as an individual. -he plumber faces: 4nlimited liability: <eCshe is completely responsible for the debts of the company. 1imited life: -he death of the plumber is the death of the company. -he plumber has limited funds and is not li"ely to attract others to his endeavor. -o raise large amounts of capital a company needs to issue financial securities that represent claims on the company/s cash flows. -hese securities must possess: 1imited liability: n investor cannot lose more than the amount invested. -he investor is not responsible for debts of the company in the event of default. 4nlimited life: -he life of the company is independent from the life of the owner. -he death of any owner does not affect the ability of the company to satisfy the claims against it. -hese characteristics appear only in corporations.

*. &o"inance o% the corporate %or"

In competitive mar"ets? corporations are superior at: 3rgani!ing large collective efforts (aising large amounts of capital -hus? corporations dominate the mar"et economy. 5hile imperfect? the corporate form of organi!ing economic activity produces tremendous benefits to society.

II. *oal o% the Corporation !. What is the goal o% the corporation

5hat are the possible goals of the business firm6 #$7
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Resources

Corporation

Goods and services

Profit

-he goal: *aximi!e stoc"holder wealth fiduciary responsibility of managers. +iduciary: person legally appointed and authori!ed to hold assets in trust for another person. -he fiduciary manages the assets for the benefit of the other person rather than for his or her own profit.

B. Why shoul+ society support this goal

In the 4)? maximi!ing the wealth of the stoc"holders is a legal responsibility of managers. 5hy should society support this goal6 -his goal benefits society through efficient production and efficient capital allocation. 1. Efficient production .roductive resources are scarce )toc"holders have an incentive to use only the resources needed to produce only the productsCservices that consumers actually want.

E E

5ithout profit? no one has a sta"e in efficiency. (esources are wasted reducing the value society gets from its scarce resources. company will profit only if it produces products that consumers actually want.

E E

2. Efficient capital allocation Businesses that produce profits will attract investorsF businesses that produce losses will lose investors. Aovernment investment: Earmar"s$$,B?7B7?''' government program on wood utili!ation research.

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-his system will truly wor" for the benefit of all members of society only if there are three controls on business activity. %. Aovernment regulation. E Aovernments must protect wor"ers? consumers and the general welfare of society. Child labor 5arranties )afety regulations <ours and conditions for wor"ers. #. Competition E Economic choice leads to a higher standard of living E *onopolies and oligopolies limit choice. E Aovernments should ensure that competitive mar"ets exist. >. (estriction on managerial behavior. E *anagers may see" to benefit themselves at the expense of the stoc"holders and other sta"eholders in the company. E Issues of corporate control.

C. What about the other sta#ehol+ers

-here are many people and organi!ations that have a connectionGa sta"e$$in the corporation. Customers )uppliers 5or"ers 1ocal communities

<ow does the stoc"holder welfare goal affect them6

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III. !. Fir" value

,aluing a business %ir"

-he value of a firm is the sum of its present and proposed pro:ects. firm can only invest in a pro:ect if it raises funds from investors? who in return for giving money to a company get promises of future payments. Every asset of the firm thus has a financial mar"et claim against it in the form of financial securities.

-he Economic Balance )heet

Value of assets HOI +inancial securities

+inancial securities are promises of future benefits in return for a payment today.

+inancial mar"ets are where financial securities are issued and traded.

B. -ri"ary %inancial "ar#et transactions

.rimary mar"et transaction: 5here firms issue securities and receive funds )ecurities created in the capital mar"ets: o Bonds: )ecurity representing a debt of the firm? on which it must pay interest and eventually return the amount borrowed. -hese cash flows are a fixed commitment of the firm. o Common stoc": )ecurity representing an eDuity claim. 3wners of these securities share in the profits of the firm? but alos in the firm/s ris"s. -hese cash flows are a residualGprofitGand are not guaranteed by the firm. o )ecurities are also created by ban" loans.

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C. .econ+ary Financial /ar#et transactions

)econdary mar"et transaction: investors. fter initial issue? securities are also traded among

5hile the firm receives no funds? secondary mar"et transactions are important. Crucial to the functioning of our economic system. o 1iDuidity: -he degree to which an asset or security can be bought or sold in the mar"et without affecting the assetJs price. -he ability to convert an asset to cash Duic"ly. lso "nown as Kmar"etabilityK.

August 2007 is far more significant because it provides the first piece of evidence that problems in one corner of the financial system - possibly the sub-prime mortgage andrelated credit markets - can spill over so directly to a completely unrelated corner: long short e!uity strategies" L5hat happened to the Duants in ugust #''=6/ mir 9handani and ndrew 1o? *I-

Determine the ability of the firm to raise capital.

.roduce security prices that are the ma:or source of guidance for managers. o -he 5all )treet wal": Dissatisfied investors sell stoc"? causing price to drop. o Institutional investors: 3rgani!ations which pool large sums of money and invest those sums in securities? real property securities and other investment assets. -heir role in the economy is to act as highly speciali!ed investors on behalf of others.

-ypes of institutional investors Commercial and investment ban"s *utual funds <edge funds .ension funds Insurance companies

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&. Fir" value

-he Economic Balance )heet
Value of assets HOI *ar"et value of debt H#I *ar"et value of eDuity H$I

Based on the firm/s assets: %MO Based on the claims on those assets: OM#N$ O&%&#N$ -wo ma:or points. 1. First point: A major economic relationship #'$&%&A )ecurity holders$$stoc"holders and bondholders$$determine values for the firm/s securities by evaluating the wealth$creating decisions that managers ma"e. +inancial mar"ets develop crucial information that managers can use to evaluate pro:ects they are considering. (inancial markets provide the key to the return-risk relationship that is crucial for managerial )ealth-increasing decisions" 2. Second point: Defining Stoc holder !ealth #'$&%&O )hareholders play an especially crucial role in this return$ris" relationship. E-hey are the residual holders.

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Investors value the firm/s stoc" by evaluating: E-he firm/s existing assets E-he wealth the firm/s assets are expected to create E-he firm/s use of debt to finance existing and proposed pro:ects. $&O*#

I,.Corporate *overnance !. &e%ining Corporate *overnance

Corporate governance: -he organi!ational structure and process by which the stoc"holders control the managers of the corporation. -wo topics: Aovernance structure: -he structure of the corporation/s process for developing and implementing strategic decisions and controlling the operations of the firm. gency relationship: <ow does the firm prevent opportunistic behavior on the part of managers6

B. !nglo0.a1on governance structure

)toc"holders Board of Directors

Chairman Inside Directors 3utside Directors

+iduciary (esponsibility

+iduciary (esponsibility

*anagers
Chief Executive 3fficer C33 C+I CI3

Inside Directors: ny member of a companyJs board of directors who is either an employee or sta"eholder in the company.

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3utside Directors: ny member of a companyJs board of directors who is not an employee or sta"eholder in the company. 3utside directors are paid an annual retainer fee in the form of cash? benefits andCor stoc" options.

,. The agency relationship !. The !gency relationship

gency: relationship between an agent and a principal in which the agent acts for and represents the principal on the basis of the principal/s instructions. Corporations raise a large amount of capital from investors in the form of shares of ownership. )toc"holders hire professional managers to ma"e decisions in the stoc"holders/ interests. n agency relationship is thus created.

B. !gency proble"s
-he agency relationship produces an inherent incentive misalignment. 5hat managerial actions might be inconsistent with the welfare of the stoc"holders6 E Excessive perDuisites E E <ori!on problem +ocus on si!e E .restige E (educe managers/ ris" E Cash cushion

*anagerial goal: *aximi!e corporate wealth

C. !gency costs

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gency cost: -he cash flows of the firm are reduced by the existence of agency problems. gency costs are controlled by a complex interaction of legalCadministrativeCmar"et devices that constrain managerial actions. External control devices: -hese are controls placed on corporate managers by individuals and organi!ations outside of the corporation. Aovernment. Aovernments provide substantial regulation and oversight of corporate activity in general and managerial actions in particular. (e: Enron. External audits. )ecurity laws reDuire public companies to undergo an annual audit by an outside auditor who must report to the stoc"holders. -his reDuirement in its current form is not as effective a control device as it could be. 1awsuits. )toc"holders who feel that managers have violated their fiduciary responsibility can sue managers and directors of the corporation. 1arge institutional investors: Investors who have a substantial ownership share in the corporation can place pressure on managers to improve performance. -hese large institutions may even have a seat on the board? which further increases their influence. -a"e$overs. n outside group may feel that a corporation is badly managed. -hey may offer existing stoc"holders a premium for their stoc"? obtain sufficient shares to control the firm? and then replace the board and existing managers and reconfigure the corporation/s assets. Internal control devices: -hese are internal to the firm in that they are created and run by the firm/s managers and owners themselves in order to assure the stoc"holders that the managers will loo" after the stoc"holders/ interests.

Carefully designed compensation contracts for managers. 5hile these contracts involve a straight salary? their ma:or component is often extra compensation connected to the performance of the firm? such as stoc" options. -he board of directors. -he board is directly elected by stoc"holders and is responsible to set the broad direction of the firm and hire managers? oversee their performance and set their compensation. -he corporation/s charter and by$laws. In the 4) corporations are chartered by state governments. -he corporation must file documents with the state that set forth its purpose? how it is organi!ed and how it will raise capital. *anagers who monitor each other. *anagers formally oversee other managers and ensure that they are performing as reDuired. mbitious managers may also identify and OoutP other managers who are not performing in an acceptable manner.

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,I.

2ur points

-he corporation see"s to maximi!e stoc"holder wealth. Corporations are efficient and dominate economic activity. -he corporation see"s to maximi!e stoc"holder wealth. -he value of the firm/s assets should eDual the value of the financial claims on those assets. Corporate governance forms and goals differ throughout the world. In corporations an agency conflict exists between managers and stoc"holders. gency control devices control agency costs.

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