BA385 Chapter 1 Introduction to Corporate Finance

4. "Ethics and Firm Goals" Can the goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer.

An argument can be made either way. At the one extreme, we could argue that in a market economy, all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: "A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?"

Three main areas of concern (Corporate Finance)

Capital Budgeting, Capital Structure, Working Capital Management.

9. "Executive Compensation" Critics have charged that compensation to top managers in the U.S. is simply too high and should be cut back. For example, focusing on large corporations, Larry Ellison of Oracle has been one of the best-compensated CEOs in the US, earning about $130 million in 2010 alone and over $1 billion during the 2006-2010 period. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as Tiger Woods, top earners in the entertainment field such as James Cameron and Oprah Winfrey, and many others at the top of their respective field earn at least as much, if not a great deal more.

How much is too much? Who is worth more, Larry Ellsion or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases.

Working Capital Management

How should the firm manage its everyday financial activities?

1. "Agency Problems" Who owns a corporation? Describe the process whereby the owner control the firm's management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problem arise?

In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm's management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else's best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

10. "Goal of Financial Management" Why is the goal of financial management to maximize the current share price of the company's stock? in other words, why isn't the goal to maximize the future share price?

Maximizing the current share price is the same as maximizing the future share price at any future period. The value of a share of stock depends on all of the future cash flows of company. Another way to look at this is that, barring large cash payments to shareholders, the expected price of the stock must be higher in the future than it is today. Who would buy a stock for $100 today when the share price in one year is expected to be $80?

of the topic we've discussed thus far, the most important is the goal of financial management:

Maximizing the value of the stock. Throughout the text we will be analyzing many different financial decisions, but we will always ask the same question: How does the decision under consideration affect the value of the stock?

3. "Goal of the Firm" Evaluate the following statement: Manager should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

2. "Not-for-Profit Firm Goals" Suppose you were the financial manager of not-for-profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate?

Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity.

6. "Agency Problems" Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company's management immediately begins fighting off this hostile bid. Is management acting in the shareholder's best interests? Why or why not?

The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.

5. "International Firm Goal" Would the goal of maximizing the value of the stock differ for financial management in a foreign country? Why or why not?

The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions.

8. "Agency Problems and Corporate Ownership" In recent years, large financial institutions such as mutual funds and pension funds have become the dominant owner of stock in the U.S., and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control?

The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate control. However, this may not always be the case. If the managers of the mutual fund or pension plan are not concerned with the interests of the investors, the agency problem could potentially remain the same, or even increase since there is the possibility of agency problems between the fund and its investors.

There is the possibility of conflicts between stockholders and management in a large corporation.

We called these conflict "Agency Problems" an discussed how they might be controlled and reduced.

7. "Agency Problems and Corporate Ownership" Corporate ownership varies around the world. Historically, individuals have owned the majority of shares in public corporations in the U.S. In Germany and Japan, however, banks, other large financial institutions, and other companies own most of the stock in public corporations. Do you think agency problems are likely to be more or less severe in Germany and Japan than in the U.S.?

We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions' deeper resources and experiences with their own management.

Capital Budgeting

What long-term investment should the firm take?

Capital Structure

Where will the firm get the long term financing to pay for its investment? Also, what mixture of debt and equity should it use to fund operation?

The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests,

but it has the significant disadvantage of double taxation.

The advantage of the corporate form are...

enhanced by the existence of financial markets.

The goal of financial management in a for-profit business is...

to make decisions that increase the value of the stock, or, more generally, increase the market value of the equity.