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Chapter 1: Goals and Governance of the FirmWhat 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

firm). 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 financing is called the capital structure decision

Equity Finance

Through issuance of common stock

Through reinvestment of profits

The Role of the Financial Manager CFO: involved in the financial policy and financial 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 offinancial 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 returnthat 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 pricesplummet

Opportunity Cost of Capital is the expected return that investors can achieve in financial marketsat the same level of risk.

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Goals of the Corporation

Maximising shareholder value. Train of thought:1. Each shareholder wants three things:

1. Maximise current wealth2. Transform that wealth into the most desirable time pattern of consumption3. Manage the risk characteristics of the consumption plan

2. The financial manager cannot help with 1.2 or 1.33. Therefore, the financial manager can only help a firms shareholder by increasing his

wealth, i.e. increasing the market value of the firm and he current price of its shares .

What about Profit Maximisation? It is very misleading, because it is not a well defined objective.1. Which years profits are to be maximised? Should you improve short-term profits at the

expense of long-term ones?2. Increased profit 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 mutualfunds 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 reputationcan be enormous.

Putnam suffered a loss of $300 million per year because of this (excluding fines)

Should firms be managed for shareholders or all stakeholders?

Anglo-Saxons: For shareholders (i.e. value maximisation)

German/French/Japanese: harmonious, more prone to stakeholders (German workerselect 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 (satisficing, bureaucratic gambling)2. Costly state verification for shareholders

Agency Problems are mitigated by Good systems of Corporate Governance

A good coroporate governance ensures that agents (managers) and principals interestsare 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.