Post on 23-Jan-2022
Corp2021F_Ch1n.doc
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Chapter 1
Goals and governance of the corporation
Investment and Financing Decisions
- the investment decision
investment decisions are often called capital budgeting or capital expenditure
(CAPEX) decisions
capital budgeting: long-term in nature
investments in tangible assets and intangible assets
examples of intangibles: patent, goodwill, research and development
(R&D), and advertising
not all capital investments succeed
- the financing decision
financing: the act of raising proceeds
it is about the form and the amount of financing
form of financing: internal financing (e.g., retain earnings) debt financing
and equity financing
Assets
Debt: Debtholders
Equity: Equityholders
CA
LA
CL
LL
Total Liabilities Total Assets
SE
Balance Sheet
Financing Investing
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- real (i.e. non-financial) assets versus financial assets
1. real assets: assets used to produce goods and services
examples: machine; equipment; plant; patent
2. financial assets: financial claims to the income generated by the firm’s real
assets
examples: IOU ("I Owe You"); notes; bonds; stocks
- some illustrations:
Which of the following are financial assets, and which are real assets?
a. A patent.
b. A share of stock issued by Bank of New York.
c. A blast(風) furnace(火爐) in a steel-making factory.
d. A loan your firm made to another firm to help pay for a new plant
e. After a successful advertising campaign, potential customers trust FedEx to
deliver packages promptly and reliably.
f. An IOU ("I owe you") from your brother-in-law.
- Table 1.1: examples of investment and financing decisions
- some illustrations:
Are the following capital budgeting or financing decisions?
a. Intel decides to spend $1 billion to develop a new microprocessor.
b. BMW borrows 350 million euros (€350 million) from Deutsche Bank.
c. Royal Dutch Shell constructs a pipeline to bring natural gas onshore from a
production platform in Australia.
d. Avon spends €200 million to launch a new range of cosmetics in European
markets.
e. Pfizer issues new shares to buy a small biotech company.
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The four types of firms
- the four major types of firms:
(1) sole proprietorships,
(2) partnerships,
(3) limited liability companies, and
(4) corporations
1. Sole Proprietorship
- a sole proprietorship is a business owned and run by one person
(1) very small with few employees
(2) the most common type of firm in the world
(3) not account for much sales revenue in the economy
- some statistics (Year 2011; source: www.bizstats.com)
- the advantage of a sole proprietorship: straightforward to set up
- the principal limitations of a sole proprietorship:
(1) the firm can have only one owner
(2) the owner has unlimited personal liability for any of the firm's debts
(3) the life of a sole proprietorship is limited to the life of the owner
(4) it is relatively difficult to transfer ownership of a sole proprietorship
2. Partnership
(1) a general partnership
a partnership is like a sole proprietorship but with more than one owner
all partners are liable for the firm's debt
the partnership normally ends on the death or withdrawal of any single partner
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(2) a limited partnership: a partnership with two kinds of owners
I. general partners
※ they have the same rights and privileges as partners in a (general)
partnership
* they are personally liable for the firm's debt obligations
II. limited partners
※ limited partners have limited liability
* their liability is limited to their investment
※ limited partners have no management authority and cannot legally be
involved in the managerial decision making for the business
3. Limited Liability Companies
- a limited liability company (LLC) is a limited partnership without a general
partner
all the owners have limited liability and they can also run the business
the LLC is a relatively new phenomenon in the United States
created in Wyoming in 1977
much older and established internationally; have existed for more than 100
years in Germany
- a variation of partnership: the professional corporation (PC)
some examples
(1) law firms
(2) groups of doctors, and
(3) accounting firms
limited liability, but the professionals can still be sued personally, for example,
for malpractice
4. Corporations
- it is a legally defined and artificial being (a judicial person or legal entity) separate
from its owners
it has many of the legal powers that people have
can enter into contracts, acquire assets, incur obligations
it enjoys protection under the U.S. Constitution against the seizure (奪取) of its
property
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the separation of the owner and the corporation
(1) shareholders have limited liability (only up to the invested capital)
(2) shareholders of a corporation (or its employees, customers, etc.) are not
liable for any obligations the corporation enters into
(3) the corporation is not liable for any personal obligations of its owners
- formation of a corporation
must be legally formed through the state’s consent and charter
setting up a corporation is considerably more costly than setting up a sole
proprietorship
- ownership of a corporation
there is no limit on the number of owners a corporation can have
many owners with only a small fraction of the corporation
the entire ownership is represented by shares known as stock
the equity of the corporation: the collection of all the outstanding shares of a
corporation
the owner of the shares of stock in the corporation is known as a
(1) shareholder
(2) stockholder
(3) equityholder
is entitled to dividend payments and a voice in firm’s operation
there is no limitation on who can own its stock this allows free trade in
the shares of the corporation
one of the most important advantages of organizing a firm as a corporation
rather than as sole proprietorship, partnership, or LLC
corporations can raise substantial amounts of capital by selling ownership
shares to anonymous outside investors
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Tax Implications for Corporate Entities
- a corporation is a separate legal entity a corporation's profits are subject to
taxation separate from its owners' tax obligations shareholders of a
corporation pay taxes twice
double taxation:
the corporation pays tax on its profits the remaining profits are distributed
to the shareholders the shareholders pay their own personal income tax
on this income
taxable income of the firm paying taxes Net income Net
income distributed to stock holders in the form of
(taxes) incomeordinary Dividends(2)
(taxes) gains capital earnings Retained(1)
the sequence of the events:
NI↑ Price↑
$5 :income dividend
$150)-($175
$25:gain capital no)(or smaller
Taxes
$175 toprice dividends cash (2)
$150)-($180 $30 gain capitalTaxes
unchanged Pricedividends cash no (1)
Revenues
- Costs
- Depreciation and Amortization
Operating Income (EBIT)
- Interests
- Taxes
Net Income (Dividends; Retained Earnings)
current T1
Net income↑
Stock prices↑
(say, to $180)
(1) the firm retains the NI
the stock price stay at $180
(2) the firm pays out $5 as dividends
the stock price drops to $175
T0
Buy a share at $150
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the corporate organizational structure is the only organizational structure
subject to double taxation
- examples of relief from double taxation
(1) the United States: a lower tax rate on dividend income than on other sources of
income
as of 2005, dividend income is taxed at 15%
(2) Australia, Finland, Mexico, New Zealand, and Norway, offer complete relief
by effectively not taxing dividend income
- a summary:
Goals of the Corporation
- why not "maximize profits (i.e., Net Income)"?
Reason #1: Which year's profits?
※ maximize the tth
year's Et! But how about other years' profits?
sole proprietorship partnership
Limited liability company
corporation
ownership
liability
fund-raising
concentrated dispersed
unlimited
tax
limited
difficult easy
single double
none
high Cost to set up low
high Agency problem
current 1 2 t 30
... ... ...
Et
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Reason #2: maximize short-term profits or long-term profits
a. increase current profits at the expense of future profits
※ shareholders will not welcome higher short-term profits if long-term
profits are damaged
b. increase long-term profits by cutting short-term profits
※ this is not in the shareholders' best interest if the company earns only a
very low rate of return on the extra investment.
- shareholders want managers to Maximize Market Value of shareholders’ interest
The goal: Maximize the current market value of shareholders' investment in
the firm. (i.e., maximize the stock price!)
current 1 2 10 ∞
... ...
D1 D2 D10 D∞
Present value (the stock price)
current 1 2 10 30
... ... ...
E0 E1 E2 E10 E30
short-term long-term
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- a concern for the goal:
Can "shareholders have different needs and risk attitudes" make the goal
infeasible?
No! This can be resolved by a well-functioned capital market
1. risk-averse investors versus risk-tolerant investors
I. Risk-averse investors:
a. those with the shares:
stockrisky lessanother buy toswitch
and/or
stock theSell
b. those without the shares: do not buy the stock
II. Risk-tolerant investors:
a. those with the shares: keep the stock
b. those without the shares: buy the stock
2. short-term needs for cash versus long-term needs for cash
I. Investors with short-term cash needs
(1) currently holding a high-dividend stock
* do nothing
(2) currently holding a low-dividend stock
Approach #1: sell part of the shares
Approach #2: sell all the current shares and switch to buy another
high-dividend stock
An announcement of a good but quite risky new investment It increases the stock price by
$3.0 but makes the stock riskier
New stock price = $23.0
Current stock price = $20.0
current 1 t
...
Low-dividend
sell some shares
Low-dividend
sell some shares
...
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II. Investors with long-term cash needs
(1) currently holding a low-dividend stock
* do nothing
(2) currently holding a high-dividend stock
Approach #1: buy more of the shares (i.e., reinvest the dividends)
Approach #2: sell all the current shares and switch to buy another
low-dividend stock
an example (based on Self-Test 1.4)
Rhonda and Reggie Hotspur are working hard to save for their childrens'
college education. They don't need more cash for current consumption but
will face big tuition bills in 2030. Should they therefore avoid investing in
stocks that pay generous current cash dividends? Explain briefly.
current, 2017 1 2030
...
no cash needs
1. buy shares with low- or no-dividend payments
2. buy shares with high-dividend payments & reinvest part of the dividends
high cash
needs ...
current 1 t
...
High-dividend
buy some shares
High-dividend
buy some shares
...
Net effect:
reasonable dividends; more shares
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The Ethics of Maximizing Value
- What is ethical behavior
1. Should the firm be prepared to do business with a corrupt or repressive ((法規)
嚴苛的) government?
2. Should it employ child labor in countries where that is the norm?
3. Recent examples of unethical behavior in the financial area (I.e., financial
scandals)
(1) Enron
(2) WorldCom
(3) Bernard Madoff
- Does a focus on enriching the shareholders mean that managers must act as
greedy (貪婪) mercenaries(傭兵)riding roughshod over (輕蔑地對待某人/某
事)the weak and helpless?
※ suppose that managers do maximize shareholders' value:
(1) Maximize E but Damage D
(2) Maximize E and Maximize D
Which of (1) & (2) is more adequate?
Assets (A)
Debt: Debtholders (D)
Priority claim
Equity: Equityholders (E)
Residual claim
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Do managers really maximize shareholders' value?
- for a corporation, how is the management team appointed?
1. the shareholders
in most corporations, each share of stock gives a shareholder one vote in
the election of the board of directors
※ investors with more shares have more influence
2. the board of directors:
a group of people who have the ultimate decision-making authority in the
corporation
(1) makes rules on how the corporation should be run (including how the
top managers in the corporation are compensated),
(2) sets policy, and
(3) monitors the performance of the company
3. the management team
in charge of day-to-day running of the corporation
headed by the chief executive officer (or CEO)
※ the separation of powers within corporations is not always distinct
* not uncommon for the CEO also to be the chairman of the board of
directors
BOD (Board of Directors)
The goal of the firm (i.e.,
the goal of the owners)
establish
Delegated to
The management team
(i.e., managers)
The goal of
managers
May not equal
Shareholders
elect
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4. the goal of a firm with multiple owners and the goal of the managers
the multiple owners the mangers
the goal of the multiple owners the goal of the mangers
5. A note for a firm with a sole owner:
(1) A sole proprietorship only one owner of a firm
(2) If the owner is the manager
the goal of the sole owner the goal of the manger
The agency problem (i.e., the principal-agent problem):
- it exists whenever someone (the principal) hires another (the agent) to represent
his or her interests
a possibility of a conflict of interest between the principal and the agent an
agency problem (also the principal-agent problem)agency costs
- the agency cost:
1. Costs (i.e., monitoring and bonding costs)from the cost of mitigating agency
problems
2. Deadweight loss (i.e., the residual loss) from agency problems
- stakeholders (利害關係人) of the firm and the agency problem
they all contribute to and share the firm's revenues the agency problem
The direction of the
agent’s goal
The direction of
the principal’s goal
disparity
Revenues
of the firm
suppliers
debtholders
shareholders
employees
Government
Other claimants
:contributing
:sharing
Contributing & sharing do not match the agency problem
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two important agency relationships within a firm
Case #1:
Case #2:
- the agency problem between managers and shareholders
examples of selfish conducts of managers, particularly when they earn only a
fixed salary
(1) Reduced effort
※ finding and implementing investment in truly valuable projects is a
high-effort, high-pressure activity
* the financial manager will be tempted to slack off
(2) Perks (short for perquisites: 工資以外之非金錢收入)
※ luxurious corporate jets , expense-account dinners (由公司支付食宿
費 的 費 用 帳 戶 ), tickets to sporting events, lavish office
accommodations(昂貴的工作場所), planning meetings scheduled at
luxury resorts, and so on
※ economists refer to these nonpecuniary (非金錢的) rewards as private
benefits
* ordinary people call them perks (short for perquisites)
Shareholders The management
team Agency problem
Shareholders The management
team
Debtholders
Agency problem
Agency problem
These two parties are now tied together
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3. Empire building
※ other things equal, managers prefer to run large businesses rather than
small ones
※ adding unnecessary capacity or employees
※ getting from small to large may not be a positive-NPV undertaking (i.e.,
positive NPV: profitable)
* an example: conducting Merges & Acquisitions
※ this is an example of overinvestment
4. Entrenching investment
Suppose manager Q considers two expansion plans:
(1) One plan will require a manager with special skills that
manager Q just happens to have.
(2) The other plan requires only a general-purpose manager.
※ which plan will Manager Q favor?
※ projects designed to require or reward the skills of existing managers
are called Entrenching investment
※ this is an example of overinvestment
5. Avoiding risk
Shy away from attractive but risky projects because they are worried more
about the safety of their jobs than the potential for superior profits
※ the manager receives only a fixed salary cannot share in the upside
of risky projects
※ reject risky projects with large positive NPVs (i.e., positive NPV:
profitable) underinvestment
Expected value
better outcome
worse outcome
downside risk
Upside risk
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the consequence
A manager on a fixed salary could hardly avoid all these temptations all of the
time. The agency problem occurs. The resulting loss in value is an agency
cost.
The ownership structure of a corporation and the agency problem
1. a corporation many owners difficult to have direct control of the firm
the free-rider problem serious agency problem
2. a sole proprietorship only one owner of a firm direct control of the
firm less serious agency problem
Mechanisms to reduce the agency problem:
1. Legal and Regulatory Requirements
2. Independence of Board of Directors
require corporations to place more independent directors on the board
delegated monitoring is especially important when ownership is widely
dispersed
one drawback: the free rider problem
BOD (Board of Directors)
Delegated monitoring
The management team
(i.e., managers)
Shareholders
elect
a free rider problem
a free rider problem
The direction of the
agent’s goal
Incentives
The direction of
the principal’s goal
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3. Blockholders
investors that hold 5%, 10%, or more of the corporation's shares
examples of blockholders: wealthy individuals and families, other corporations,
institutional investors, pension funds, or foundations
when a 5% blockholder calls the CFO, the CFO answers
4. Specialist Monitoring
examples of specialists
(1) institutional shareholders
(2) security analysts
(3) larger lenders (e.g., bankers)
5. Compensation Plans
providing incentives for managers
compensation can be based on
(1) input (for example, the manager's effort)
※ input is difficult to measure
(2) output (actual return or value added as a result of the manager's decisions)
incentives are almost always based on output
the trouble is that output depends not just on the manager's decisions, but
also on many other factors outside his or her control
the result is a compromise
※ firms do link managers' pay to performance (i.e., firm value)
* managers bear some of the risks that are beyond their control
* shareholders bear some of the agency costs if managers shirk,
empire build, or otherwise fail to maximize firm value
※ an example: stock options
1. Factors can be controlled by managers
2. Factors cannot be controlled by managers
The firm value
Managers' compensation
based on (1), (2), & (3)
affect
affect
3. Agency costs resulting from the management team
affect
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A Digression on Options
- an option: it is a contract that gives its owner the right to buy or sell some asset at
a fixed price on or before a given date
the asset could be a financial or physical asset
an example: stock; wheat; gold
seller and buyer
(1) the seller of an option receives money up front and has the obligation to
meet the request of the option holder
(2) the buyer of an option pays money up front and has the right to buy or sell
the asset
- calls and puts
options come in two basic types: puts and calls.
a call option gives the owner the right to buy an asset at a fixed price during a
particular time period
0 T (maturity)
the right to buy an asset at a fixed price
Get an American
call option
0 T (maturity)
Get a European
option the right to sell or
buy an asset at a
fixed price
0 T (maturity)
the right to sell or buy an asset at a fixed price
Get an American
option
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a put option gives the holder the right to sell that asset for a fixed exercise
price
an illustration
Suppose that you just bought a put option on one IBM share expiring in 3
months at 20 $/share. The price you paid was $2.00 per contract.
:200 K the strike (exercise) price
:20 P the price of the put option
:TS the IBM price at time T (T 3 months)
(A) if ).,.(20 0KeiST :
Not exercise the put option
let it expire!
(B) if 20TS :
Exercise the put option
sell a IBM share to the option seller at $20 ( 0.,. Kei )
An illustration:
20$
16$
0
K
ST
I. Buy the stock at the market price: -$16
II. Sell the stock to the put option seller: +$20
0 3 months
(maturity of the IBM option)
buy a IBM put option at
K0 = $20 for $2.00
0 T (maturity)
the right to sell an asset at a fixed price
Get an American
put option
Corp2021F_Ch1n.doc
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another direction
:200 K the strike (exercise) price
:2.30 C the price of the call option
:TS the IBM price at time T
(A) if ).,.(20 0KeiST :
Exercise the option
buy a IBM share from the option seller at $20 ).,.( 0Kei
An illustration:
20$
25$
0
K
ST
I. Buy the stock from the call option seller: -$20
II. Sell the stock in the market: +$25
(B) if 20TS :
Not exercise the option
let it expire!
$
Spot price (ST) -C0 = -$3.2
K0
Payoff of the call option
$
Spot price (ST) -$2
K0=20
Payoff of the put option
K0-P0
0 3 months
( maturity of the IBM call option)
buy a IBM call option at
K0 = $20
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- an example of a stock option
management compensation
13- 7
CEO Compensation (2005)
Th
ou
sa
nd
s o
f D
olla
rs
※ some unusual features of the United States
(1) it has unusually high levels of executive pay
(2) the base salary of CEOs forms a relatively small proportion of their
total compensation
0 7 years
Get an American call option to
buy up to 200,000 shares of the
firm at $20 per share between
the beginning of the 4th year
and the end of the 7th year
3 years
the call option can be exercised P0 = $17.00
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6. Shareholder Pressure and Takeovers
shareholders are unhappy with the CEO's performance
(1) pressure the board to oust the CEO
※ rarely occurred
(2) choose to sell their shares
※ this is often the case
※ A required condition: somebody must be willing to buy the shares from
the dissatisfied shareholders; they will do so if the price is low enough
the mechanism of “a market for corporate control”
the idea:
The stock price of the corporation is a barometer for corporate managers
(1) enough shareholders are dissatisfied with a bad-managed
corporation the price is lowered
(2) enough shareholders are satisfied with a well-managed corporation
the stock price is driven up
the attitude of the BOD
When the stock performs poorly, the board of directors
(1) might react by replacing the CEO
(2) might not have the will(意志) to replace them
* the board is comprised of people who are close friends of the
CEO and lack objectivity
corporations in which
(1) the CEO is entrenched
and
(2) the CEO is doing a poor job
※ the stock price will be low
* these provide a hostile takeover opportunity
An individual or organization (sometimes known as a corporate
raider) purchases a large fraction of the stock get enough votes
to replace the board of directors and the CEO appoint a new
superior management team the stock becomes a much more
attractive investment a price rise a profit for the
corporate raider and the other shareholders
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two concluding remarks
(1) the threat of being removed as a result of a hostile takeover can
I. discipline bad managers
and
II. motivate boards of directors to make difficult decisions
(2) a corporation's shares are publicly traded the stock market serves as
"a market for corporate control” managers and boards of directors
will be forced to act in the interests of their shareholders (the agency
problem is mitigated!)
The Goal of the Firm (revisited):
MV(A) = MV(D) + MV(E)
(1) if there is an agency problem between debtholders and equityholders
Case #1:
Maximize the shareholder’s claim Maximize the debtholders’ claim
Case #2:
Maximize the value of the firm
D & E are also maximized
(2) if there is no agency problem between debtholders and equityholders
Case #1:
Maximize the shareholder’s claim
the debtholders’ claim is also maximized (due to the priority claim)
Case #2:
Maximize the value of the firm
D & E are also maximize
A: Assets D: Debtholders
E: Equityholders
(with ownership)
B/S (market value)