Chapter 1: Goals and Governance of the Firm

What is a Corporation? A legal person that is owned by its shareholders As a legal person it can make contracts, borrow, lend and pay taxes Shareholders have limited liability Separation of ownership and control (shareholders usually not active in the running of the rm). This gives the corporation permanence. Corporate Investment and Financing Decisions Investment Decisions (known as capital budgeting or capital expenditure (CAPEX)) Investment decision = purchase of real assets + meeting of past obligations Financing Decisions The choice between debt and equity nancing is called the capital structure decision Equity Finance Through issuance of common stock Through reinvestment of prots The Role of the Financial Manager CFO: involved in the nancial policy and nancial planning, explains result to the media Treasurer: responsible for short-term cash management, currency trading and bank relationships Controller: manages the companys internal accounting systems and oversees preparation of nancial statements and tax returns.

Opportunity Cost of Capital Tradeoff: should the corporation reinvest its retained earnings or should it pay dividends? If the return offered by the corporations investment project is higher than the rate of return that shareholders can get on their own, it shouldnt pay dividends If the corporation carries through with its plan despite lower corporations returns Stockholders want their money back so they can invest on their own, and stock prices plummet Opportunity Cost of Capital is the expected return that investors can achieve in nancial markets at the same level of risk.

Goals of the Corporation Maximising shareholder value. Train of thought: 1. Each shareholder wants three things: 1. Maximise current wealth 2. Transform that wealth into the most desirable time pattern of consumption 3. Manage the risk characteristics of the consumption plan 2. The nancial manager cannot help with 1.2 or 1.3 3. Therefore, the nancial manager can only help a rms shareholder by increasing his wealth, i.e. increasing the market value of the rm and he current price of its shares. What about Prot Maximisation? It is very misleading, because it is not a well dened objective. 1. Which years prots are to be maximised? Should you improve short-term prots at the expense of long-term ones? 2. Increased prot is possible by not paying out dividends; as shown above this may not be in the interest of shareholders if the company earns less than the opportunity cost of capital Contentious issues: Scandals such as the 2003 Market Timing Scandal (where investors could buy frozen mutual funds shares valued at the previous days NAV even if news that occurred after the closing of the exchange has increased the real price of the share) shows that damages to reputation can be enormous. Putnam suffered a loss of $300 million per year because of this (excluding nes) Should rms be managed for shareholders or all stakeholders? Anglo-Saxons: For shareholders (i.e. value maximisation) German/French/Japanese: harmonious, more prone to stakeholders (German workers elect board representatives) Globalisation suggests diffusion of preponderance of shareholder interest Agency Problems and Corporate Governance Agency Costs are incurred when: 1. Managers do not attempt to maximise future value (satiscing, bureaucratic gambling) 2. Costly state verication for shareholders Agency Problems are mitigated by Good systems of Corporate Governance A good coroporate governance ensures that agents (managers) and principals interests are aligned Legal and Regulatory Requirement (SECs ban on insider trading) Compensation Plans (pay boni in form of stock and option grants) Board of Directors: More than half have to be independent (Sarbanes-Oxley) Monitoring The threat of takeovers and raiders Shareholder pressure Wall Street Walk (i.e. moving onto other investments) sends a powerful message since if enough people do it, stock prices will fall.