Chapter 2: The Objective of corporate finance
Top ten companies by sales:
ExxonMobil United States Oil & gas operations 328.21
Wal-Mart Stores United States Retailing 312.43
Royal
Dutch/Shell Group
BP
General Motors United States Consumer durables 192.60
Chevron United States Oil & gas operations 184.92
Ford Motor United States Consumer durables 178.10
DaimlerChrysler Germany Consumer durables 177.04
Toyota Motor Japan Consumer durables 173.09
ConocoPhillips United States Oil & gas operations 162.41
Top ten companies by profits:
ExxonMobil United States Oil & gas operations
Royal
Dutch/Shell Group
Citigroup
BP
Bank
of America
General Electric United States Conglomerates
Total
Chevron United States Oil & gas operations
ConocoPhillips United States Oil & gas operations
Microsoft United States Software & services
Source: Forbes
http://www.forbes.com/forbes/2006/0417/111.html
What you can find from the above rankings? Who are the top sales? Who are the top earners?
The fundamental dilemma in corporate governance: If managers reveal too little information, they may screw shareholders. If managers reveal too much information, they may be screwed by competitors. Information is always valuable. This tradeoff can never be resolved. Society will determine where the balance lies.
Why we need a unique objective? The advantage of unique objective
is its simplicity. The disadvantage is that it inevitably ignores the competing
and conflicting interests that are related to a firm. The objectives of a firm
is not determined by a theory, but by the relative political powers of
different stake holders. The dominance of shareholder maximization theory in
the textbooks is a result of dominant power of shareholders over employees in the
To
understand firm behaviours, it will be much better to directly assess the power
structure of various stakeholders in a firm. For example, wage differentials in
different industries, wage differential in firms with or without unions. Why
Wal-Mart spend so much effort to discourage union organizations?
The characteristics of the right
objectives
Comments: Many people like to play video games because
the rules are clear and unambiguous. These people often resent the real world
because there does not exist clear and unambiguous
rules. We have to learn to handle with ambiguity.
Timely
measure is often difficult for an inherently long term process. For example,
your long term success in the future has little to do with your grades in this
or other courses. But you care about them anyway. Compared with other animals,
human being have extremely long juvenile period, when people cannot live
independently. The measurement of success for people at juvenile stage is
extremely difficult. That is the main problem for parents raising kids. The
same is true for businesses. Businesses can only measure short term results.
That is why most long term researches are carried out by universities, where
measurement is less clear and less timely.
It is
impossible any conventional objective of a firm will not create costs for other
entities or groups. Becoming more competitive will make your competitors
closing their doors. The zero inventory policy of Dell will force supplies to
provide large amount of inventories because they never know what Dell needs and
Dell needs them urgently. High economic growth today, which will consume more
resources, will inevitably reduce the amount of resources available to future
generations. From the second law of thermodynamics, any economic progress is
accompanied by environmental degradation. From the ecological theory, the earth
is always fully occupied. The expansion of human space is inevitably
accompanied by the reduction of habitats of other species.
Why corporate finance focuses on stock price
maximization
When is stock price maximization the only
objective a firm needs?
Comments: Boards are generally unwilling to
replace inept managers for this reveal their earlier mistakes in selecting managers.
A manager who is harmful to shareholders may be very helpful to board members.
Board members and CEOs are in general in the same
league. They don’t want to promote the culture of replacement.
Even managers are major shareholders themselves, they may opt for
privilege maximizing instead of wealth maximizing. For example, many major
shareholders reject wealth increasing merger deals to keep their firms
independent.
Comments: Can you find this kind of lenders?
Comments: In AOL-Time Warner deal, Goldman
Sachs bought 0.5% of AOL’s European subsidiary, which made AOL’s stake to be
49.5%. It avoided the need to consolidate European subsidiary’s financial
results into the parent company’s book. In general, managers will always
attempt to mislead financial market when it is to their advantage. They don’t
actually lie. It is just their predictions didn’t come true.
Comments: Higher quality works are always
more stressful. Video game companies, fast food companies will try to get
people addicted. Fashion companies will try to convince you that image is
everything. Military contractors will try to generate wars or tension.
Commodity companies will try to control governments with rich minerals. For
example,
http://www.globalresearch.ca/articles/CHO309A.html
Iran-Iraq war, Iraqi wars.
CT(Critical Thinking Question) 2.1: Al Dunlup has argued that CEOs of
firms should focus solely on maximizing stock prices and that the actions they
take in the process enrich society as well.
The following link is about Dunlup’s
disastrous manoeuvre at
Sunbeam
http://www.businessweek.com/1999/99_42/b3651099.htm
Stock price maximization and agency costs
Stockholders and managers
Annual meeting
The board of directors
The consequence of
stockholder powerlessness
Stockholders and bondholders
Stockholders may want to take
risky actions. Bondholders don’t.
The Firm and Financial
Markets
The information problem
Are market
inefficient?
The Firm and Society
To be fair, conflicts between the interests of the firm and the
interests of society are not restricted to the objective of maximizing
stockholder wealth. They may be endemic to a system of private enterprise, and
there may never be a solution to satisfy the purists who would like to see a
complete congruence between social interests and firm interests. (p. 27)
Stock Price
maximization with Lower agency Costs
Stockholders and
Managers
Making Managers think more like stockholders:
Problem: Offering stocks or stock options dilute ownership for original
owners.
CC 2.4: The interests of institutional investors and individual
investors may sometimes diverge. Can you think of a scenario in which the two
groups might have conflicting interests?
Dividends are not taxed for institutional investors and are taxed for
individual investors. Any other conflicting interests?
Stockholders and
bonder holders
Security innovation
One way in which bondholders
can protect themselves is to attach a provision (called a protective put) to
their bonds, giving them the right to sell their bonds back to the firm at face
value, in the event of such actions.
Comments: A more valuable bond will be more expensive, which will lower
yield. A complex new security needs extra expertise with extra cost, making
clear analysis more difficult.
Equity stake
Bondholders take bond for good reasons. Otherwise they will hold stocks
from the beginning, e.g., retired people prefer bond over stocks.
Firms and financial markets
Improving
the quality of information
Analysts
are often from investment banks whose major source of income are
deals with companies they cover. They have vested interests to please their
clients. Buy side analyst may provide less biased analysis, at a cost.
Firms and societies
The legal
system can also provide a partial, if costly, solution to the social cost problem.
Comments:
However, we are not sure if legal costs are lower than original social cost?
Summary:
The objectives of firms are to serve the interests of those who control the
firms, which include shareholders, managers, employees, debt holders, customers,
government and the general society. The actions they make reflection the
relative power of different stakeholders.
Discuss
conflicts and compromises of stakeholders, for whom a firm exists. Analyse
human body as well. Sneeze for whom, diarrhoea for whom, wound is going to
cure, itching, scratch for whom?
Homework
Problems 8, 11, 13, 14.
Some notes
related to home work problems.
Problem 8.
Executive
stock option, share repurchase and market efficiency
In recent
years, top managers have been given large packages of options, giving them the
right to buy stock in the firm at a fixed price. These
packages often worth hundreds of millions of dollars a year if share prices
rise substantially. The value of stock options often dwarf life long’s
salary income of the managers, which gives top managers strong incentive to
push up share prices over short term. Share repurchase by a firm is a simple
and effective way to push up share prices. From value perspective, companies
will buy back their own shares if they believe their share prices are
undervalued by the market. Therefore the action of share repurchase, which can
be observed easily, is often associated with the under-valuation of a company,
which can be much more difficult to assess, especially by the general public.
As a result, share repurchases are often used by top managers to induce share
purchasing by the general public to push up share prices, which will increase
the value of the executive stock options. Since a good year’s stock option value
far exceed the total value of life long salary income, there is little
incentive for long term view. Because of the mixed role played by share
repurchase, the pattern of share repurchase is very complicated compare with
other corporate activities, such as IPO, SEO and M&A (Rau and Stouraitis, 2006).
While it is
generally thought that offering stock options make managers more responsive to
shareholders, there are many costs. First, it dilutes the ownership of original
shareholders. Although it is suggested that managers are paid only when share
prices go up, the short term gain may not cover the long term dilution. Second,
it encourages managers to take more risky projects because of asymmetric
payoff. Third, it encourages managers to perform financial actions that may be
harmful to company operations. For example, share repurchase may dry up cash
reserves, making a company less able to cushion unexpected downturns or to take
potential profitable projects.
Reference:
Rau, Raghavendra and Stouraitis,
Aris, 2006, Corporate Event Waves, Working paper.
Problem 11.
Answer of
Problem 11, “If a firm were large enough in the country’s economy that socially
irresponsible actions would also affect its share price, it would try to act socially
responsible.” However, businesses are often international in scope. For
example, from the very beginning, Nike adopted a policy to produce overseas,
which minimize production cost and leaves more money for promotion.
Answer of
problem 11, “Also,
if the company were majority-owned by the government, there would be a greater
convergence between social goals and shareholder goals.” However, government does not necessarily
represent society. It more represents government itself. For example, most government
related companies are famous for low efficiency, because low efficiency work is
less stressful than high efficiency works. Government, as a social system, has
its goals. One of its goals is to maximize cash flows through itself, which may
not be beneficial to the whole society. For example, people working for paid
salaries will have to pay taxes, while people working at home, such as
housewives, will not pay taxes. Mainstream media often portray the increase of
women in the paid jobs as a sign of social progress, although the increase of
professional women is often linked to decrease in fertility at great social
cost. Although trades people nowadays earn the same amount or more than
university educated people and the cost of training is much less, there are
often long waiting lists for training at trades while universities often have
difficulty recruiting enough students. This is the case probably due to the
fact that it is more difficult to collect taxes from trades
people, who are often independent contractors, than from salaried people who
work for companies.
Answer of
11, “Finally, if there are laws penalizing socially irresponsible actions, the
firm will act responsibly in social matters as well.” Legal matters are costly
by itself. The complication of legal system will shift
more power to lawyer.
Problem 13.
Convertible
bonds, by carrying conversion right, have lower yields than straight bonds.
Convertible bonds are more complex and hence more difficult to price and
understand. The complexity of CB may make it easy for experts to expropriate
others, e.g., China Travel CB.
Problem 14.
More
specialized laws, more specialized experts are needed, which by itself, a
social cost. There is always a balance between more legal enforcement and its
cost. When the threat of legal action is high, people generally document
everything and proceed slowly to avoid possible lawsuits. This is also one reason
why large companies, which have accumulated large amount of wealth, are less
willing to explore uncharted areas for possible legal liabilities. Have you
ever heard a poor person been sued for financial wrong doings? Large firms,
such as Microsoft and big car companies, are favourite targets in law suits. For
example, in many car accidents, drivers were rarely sued because they don’t
have much money. Instead it is often the car companies that were get sued on
the reason that cars were not safe enough.
For
ordinary persons like us, we don’t know what specific laws are there. How can
we know if certain actions we take are against laws? The safest way is not to
do anything or get authorization before doing anything. This creates a lot of
red tape.