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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

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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)