The Objective in Financial Management 1 “If you don’t know where you are going, it doesn’t matter how you get there”

Introduction An objective can be explained as a specific result that a person aims to achieve within a time frame and with available resources. The objective of a financial manager is to maximize the value of the business. Financial managers should focus on stock price maximization while also considering the rights of all stakeholders when making decisions.

The Objective in Decision Making 3 Maximiz e firm value Maximize equity value Maximize market estimate of equity value

Why focus on maximizing stockholder wealth? Stock price is easy to see and constantly updated. Profits are updated once every quarter while stock prices are updated constantly depending on changes in the firm. If investors are rational then stock prices show the results of decisions immediately. Many investors think in the long term, therefore stock prices should show the long-term effects of decisions made by the firm. An estimate of long- term value is still better than just looking at a firms current profits to decide the value of the firm. 4

Market Share Maximize Market Share (Market share is the percentage of a market controlled by a particular firm). Higher market share does not mean higher pricing, and the increase in market share can be accompanied by lower profits or even losses meaning that firms that concentrate on increasing market share could fail.

Profits Maximize profits If we focus on short-term profitability we may make poor decisions that maximize profits now at the expense of long-term profits, value and reputation. Also depending on what kind of accounting we use profits can be “moved” from one year to the next meaning their measurements can be misunderstood

The Classical Objective Function STOCKHOLDERS Maximize stockholder wealth Hire & fire managers - Board - Annual Meeting BONDHOLDERS/ LENDERS Lend Money Protect bondholder Interests FINANCIAL MARKETS SOCIETY Managers Reveal information honestly and on time Markets are efficient and assess effect on value No Social Costs All costs can be linked to firm

What can go wrong? STOCKHOLDERS Managers put their interests above stockholders Have little control over managers BONDHOLDERS Lend Money Bondholders can be cheated FINANCIAL MARKETS SOCIETY Managers Delay bad news or provide misleading information Markets make mistakes and can over react Significant Social Costs Some costs cannot be linked to firm

Corporate Governance Corporate governance is the system of rules, practices and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of the many stakeholders in a firm, and is the system by which the owners exercise control over the managers. Stockholders control managers using the Annual General meeting and board of directors

The Annual Meeting as a control The power of stockholders at annual meetings is small because –Most small stockholders do not go to meetings –Institutional investors (institutional investor is a person or organization that trades a large amount of securities) own stocks in many firms and so if they are not happy with the firm they may just sell the stock rather than push for change. –Annual meetings are run by management.

And institutional investors go along with incumbent managers…

Board of Directors as a control Many directors do not spend much time on this work, mainly because they are already very busy people. Directors may not be qualified in the area and may not understand enough about the business to look after the interests of the stockholders properly. Some directors are “insiders” which means they have a personal connection or network with the managers, such as a family member or friend.

Board of Directors as a control In most boards, the CEO is the chairperson. Communication failures. Directors at the top of the organization may be unable to recognize important risks which start from the bottom of the organization and make correct decisions to manage this risk. For example, Lehman’s brothers. The search for consensus means that there is not much confrontation - Group think.

Vocabulary Groupthink: A mode of thinking that occurs in highly cohesive, high status groups in which the desire to reach unanimous agreement overrides the motivation to adopt proper, rational decision-making procedures.

Improving corporate governance 1.Managers own stock If managers own a reasonable amount of stock in the firm it is more in their interest to think about maximizing the stock price. 2. Improve the performance of the Boards of Directors Boards should include more independent directors and fewer insiders. There should be more direct input from groups such as employees, suppliers and customers 3. More “activist” investors

Conflicts of interests between stakeholders - Stockholders and Bondholders 1.Risky Projects Bondholders do not like high risk investments which have a higher risk of failure. 2. Debt to Equity ratio (leverage) The more debt a firm has the higher its risk of not repaying the debt is. 3. Dividend policy Bondholders would simply prefer that the cash is kept in the firm.

Stockholders and Bondholders Bondholders can protect themselves by writing in covenants (covenant is a legal agreement making restrictions on what stockholders can do). Additionally firms can lose their reputation if they treat bondholders too unfairly and find it challenging to borrow money in the markets in future.

III. Firms and Financial Markets  In theory: Financial markets are efficient. A company that invests in good long term projects will be rewarded.  In practice: There are some holes in the 'Efficient Markets' theory

Managers control the release of information Information is sometimes suppressed or delayed by managers seeking a better time to release it. In some cases, firms release intentionally misleading information about their current conditions and future prospects to financial markets.

Evidence that managers delay bad news?

Some critiques of market efficiency.  Investors are irrational – Herding, Bubbles.  Investors overreact to news, both good and bad.  Financial markets are manipulated by insiders; Prices do not have any relationship to value.  Investors are short-sighted, and do not consider the long-term implications of actions taken by the firm

Question Following and worrying about daily stock prices in the market will lead companies towards short term decisions at the expense of long term value. a.I agree b.I do not agree

Are Markets short term? Some evidence that they are not.  There are hundreds of start-up and small firms, with no earnings expected in the near future, that raise money on financial markets.  Studies suggest that low P/E stocks are under priced relative to high P/E stocks  The market response to research and development and investment expenditures is generally positive.

Vocabulary P/E RATIO – Market Value per Share / Earnings per Share (EPS) For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be ($43/$1.95).

If markets are so short term, why do they react to big investments (that potentially lower short term earnings) so positively?

IV. Firms and Society In theory: All costs and benefits associated with a firm’s decisions can be traced back to the firm. In practice: Financial decisions can create social costs and benefits. Environmental costs (pollution, health costs, etc..) creating employment in areas with high unemployment

Social Costs and Benefits are difficult to quantify A firm may think that it is delivering a product that enhances society, at the time it delivers the product but discover afterwards that there are very large costs. E.g. Asbestos They are ‘person-specific’, since different decision makers can look at the same social cost and weight them very differently – e.g. different scientific opinions on climate change.

A test of your social consciousness  Assume that you work for Disney and that you have an opportunity to open a store in an inner-city neighborhood. The store is expected to lose about a million dollars a year, but it will create much-needed employment in the area, and may help revitalize it.  Would you open the store?  Yes  No  If yes, would you tell your stockholders and let them vote on the issue?  Yes  No  If no, how would you respond to a stockholder query on why you were not living up to your social responsibilities?

Question What can go wrong when we use stock price as our only objective function? For stockholders? For Society? For Bondholders? For Financial Markets?

So this is what can go wrong STOCKHOLDERS Managers put their interests above stockholders Have little control over managers BONDHOLDERS Lend Money Bondholders can get cheated FINANCIAL MARKETS SOCIETY Managers Delay bad news or provide misleading information Markets make mistakes and can over react Significant Social Costs Some costs cannot be traced to firm

Traditional corporate financial theory can be wrong The interests/objectives of the decision makers in the firm conflict with the interests of stockholders. Bondholders (Lenders) are not protected against stockholders. Financial markets do not operate efficiently, and stock prices do not reflect the underlying value of the firm. Significant social costs can be created by stock price maximization.

Possible solutions  To choose a different way of corporate governance.  To choose a different objective for the firm.  To maximize stock price, but reduce the conflict:  Making managers (decision makers) and employees into stockholders  Protect lenders  By providing information honestly and quickly to financial markets  Minimize social costs

An Alternative Corporate Governance System Germany and Japan developed a different way of corporate governance, based upon corporate cross holdings. Pro - the stronger firms in the group work at improving the weaker firms. Con - the weaker and poorly run firms in the group pull down the stronger firms. The nature of the cross holdings makes its very difficult for outsiders to figure out how well or badly the group is doing. China – government owned companies with centralized power structure.

Maximize Stock Price, Reduce Conflict Counter actions to reduce or eliminate problems. –managers taking advantage of stockholders has led to a much more active market for corporate control. –stockholders taking advantage of bondholders has led to bondholders protecting themselves at the time of the issue. –firms revealing incorrect or delayed information to markets has led to markets becoming more “skeptical” and “punitive” –firms creating social costs has led to more regulations, as well as investor and customer backlashes.

The Bondholders’ Defense Against Stockholder Excesses More restrictive agreements on investment, financing and dividend policy have been introduced into both private lending agreements and into bond issues. New types of bonds have been created to protect bondholders against sudden increases in leverage or other actions that increase lender risk substantially. Two examples of such bonds –“Puttable Bonds”, where the bondholder can put the bond back to the firm and get face value, if the firm takes actions that hurt bondholders –Ratings Sensitive Notes, where the interest rate on the notes adjusts to that appropriate for the rating of the firm

The Financial Market Response  As investor access to information improves, it is becoming much more difficult for firms to control when and how information gets out to markets.  It has become much easier to trade on bad news. In the process, it is revealed to the rest of the market.  When firms mislead markets, the punishment is quick and strong.

The Societal Response If firms create large social costs, the governmental response is for laws and regulations to be passed against such behavior. For firms catering to a more socially conscious clientele, the failure to meet societal norms (even if it is legal) can lead to loss of business and value. Socially responsible investing is growing.

The Counter Reaction STOCKHOLDERS Managers of poorly run firms are put on notice. 1. More activist investors 2. Hostile takeovers BONDHOLDERS Protect themselves 1. Covenants 2. New Types FINANCIAL MARKETS SOCIETY Managers Firms are punished for misleading markets Investors and analysts become more skeptical Corporate Good Citizen Constraints 1. More laws 2. Investor/Customer Backlash

Question What can managers do to make less the problems of conflict with Stockholders? Society? Bondholders? Financial Markets?