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FINANCIAL ISSUES & INCENTIVES IN MODERN ORGANIZATIONS

Asso.Prof.Dr. NGUYEN THU THUY

Faculty of Business Administration

FOREIGN TRADE UNIVERSITY

Email: thuynguyen0202@gmail.com

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Finance?

A foremost concept in finance concerns how individuals interact in order to allocate resources (capital) and/or shift consumption across time by borrowing or investing.

If you receive $1 million today then what decision would you make regarding consumption and investment? Suppose you spend (consume) $100,000 now.

This leaves you with $900,000. You can postpone consumption to future time periods by investing the $900,000 today.

On the other hand, what if you have $20,000 but need to consume $30,000. You can borrow the $10,000 and pay it back in a future period along with the interest.

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Two examples of common corporate financial decisionsA firm must spend $100 million for the required assets if

a proposed project is approved. Important issues are: Should the project be accepted or rejected? What do investors

demand as a (minimum acceptable) project rate of return? What are the project’s forecasted future cash flows? How risky

are these forecasted cash flows? Where will the $100 million come from, i.e., what mix of equity

and debt financing should be used? If a firm has $200 million of cash flow, but needs reinvest

$120 million, what should be done with the remaining $80 million of cash. Pay it out as a dividend or repurchase some stock?

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Example of common investments type financial decisions

A mutual fund manager that manages a fund with $10 billion portfolio receives an additional $100 million in cash from new investors.Which stocks or bonds to purchase?How will any proposed new investments affect

the expected return and risk of the overall portfolio?

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Corporate finance vs. Investments

Board of Directors

CEO

AssetsEquity

Debt Issue Fixed Income Products (Bonds)

Issue Shares

Stock Holders

Debt Holders

Investors

CFO

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I: Corporate Finance

Imagine you are the CFO of a company with $2 billion in excess cash.

What can the firm do with the cash?1. Invest in a new project2. Find an acquisition candidate 3. Invest in financial assets4. Repay debt5. Repurchase shares of a stock6. Pay a dividend

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II: Investments

Investment theory tries to answer questions like:in which combination of securities should

investors put their money?what is the relation between risk &

return?what return can you expect on a

portfolio?is it possible to outperform the market?

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Corporate finance decisions - summary

Capital budgeting decision investment projects physical plants,

equipment brand building (intangible assets) R&D

Financing decision: Funding sources Long-term financing mix capital structure

decision

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Two Main Functions of Corporate Finance

Current AssetsCash

Marketable SecuritiesAccount Receivables

Inventory

Fixed AssetsBuildings

EquipmentLand

Intangible AssetsBrand Names

Trademarks and PatentsDistribution Networks

Customer LoyaltyLoyal and Skilled Work Force

Current LiabilitiesAccounts PayableShort-Term DebtProduct Warranties

Long-Term LiabilitiesLong-Term DebtPension ObligationsDeferred TaxesLeases

EquityProceeds from Stock SalesRetained EarningsValue Created by Investments

Intangible LiabilitiesNo-Layoff PolicyCommitment to QualityProducts and ServicesNeed to Advertise and Promote

The Investment/Capital budgeting Decision:

Assets

The Financing Decision:

Liabilities and Equity

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Check: Capital budgeting or Financing decisions? Intel decides to spend $500 mil to develop a new

microprocessorVolkswagen decides to raise 350 mil euros through a

bank loanExxon constructs a pipeline to bring natural gas on shore

from the Gulf of MexicoPierre Lapin sells shares to finance expansion of his

newly formed securities trading firm.Norvatis buys a license to produce and sell a new drug

developed by a biotech companyMaersk issues new shares to help pay for the purchase

of two new vessels.

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Managerial Issues

How to measure the project’s worth for the company?

Are companies' market prices justified? Example: dot-coms

How to choose among the projects given the budget constraint and externalities?

How to account for risks associated with the project?

Are risks always bad? Is it good to have volatile oil prices?

Should we invest now in an unprofitable project?Should we invest now in a profitable project?

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Managerial Issues (cont.)

Does it matter how to finance the project: by debt or by equity?

Would you like the company to have much debt?Should the company borrow more money from

banks or issue bonds?Would you like the company to pay high

dividends?Example: Microsoft

How will the market react to the share buyback?How will the market react to the new equity

issue?

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Managerial Issues (cont.)

Should we give managers higher salaries or higher bonuses?

How should the company communicate with the market?

What drives the company’s decision to go public?

Would you like the company to grow via acquisitions?

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Forms of Business Organization impact on financial decisions

Sole proprietorshipPartnershipCorporation

Evaluate byThe owners' liabilityThe life of the entityThe ability to raise capital

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Sole Proprietorship

AdvantagesEase of organizationSubject to fewer government regulations

DisadvantagesUnlimited personal liabilityInability to raise large amounts of moneyLife of the business is limited to the life of the

proprietor

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Partnership

AdvantagesEase of organizationAble to raise more money than the sole

proprietorDisadvantages

Unlimited personal liabilityDifficult to transfer ownershipAbility to raise capital is limited by the

partner’s personal wealth

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Corporation

AdvantagesLimited liabilityEasy transfer of ownershipUnlimited lifeAbility to raise large amounts of money

DisadvantagesStart-up can be costlyEarnings subject to double taxationSeparation of control and ownership

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Characteristics of business organizations

  Sole Proprietorship Partnership Corporation

Who owns the business? The manager Partners Shareholders

Are managers and owner(s) separate? No No Usually

What is the owner's liability? Unlimited Unlimited Limited

Are the owner and business taxed separately? No No Yes

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Check: Which form of business organization might best suit the following? Why?

A consulting firm with several senior consultants and support staff.

A pharmaceutical company with sales of $ 300 mil and 1,500 employees.

An advertisement design firm owned and operated by a (industrial design) college student who occasionally hires friends for manual help.

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About corporations:Book versus Market values

The book value of an asset is determined based on accounting rules.

The book value is at best a rough approximation of the asset’s replacement cost.

The market value of an asset is that investors are willing to pay today for stocks and bonds in order to receive a risky stream of future expected cash flows.Market values are forward looking.Stocks and bonds represent claims on the future cash

flows that a firm’s assets generate.

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Book versus market values

Market value of a firm

Mkt. value of equity

Mkt. value of debtMarket value of the asset’s earning power (as a going concern)

Liabilities + EquityAssets

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Book versus market values

The Book value of a firm often contrasts sharply with the Market value.

Book equity

Book debtPhysical assets at historical book value

Liabilities + EquityAssets

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Book versus market values: a hypothetical exampleA firm begins with $2000 of debt and $4000 of

equity in order to purchase $6000 of assets. These become the original accounting book values.

In contrast, Market values are based on today’s expectations of future performance, i.e., what cash amounts are expected to be paid out and the perception of risk. Assume the following: Investors are willing to pay $2000 for the bonds. Investors are willing to pay $10,000 for the equity.

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Book versus market values for the hypothetical example

Book values of firm:

Market values of firm: $4,000 Book equity

$2,000 Book debt$6,000 physical assets

Liabilities + EquityAssets

$10,000 M.V. equity

$2,000 M.V. debt$12,000 M.V. as a going concern

Liabilities + EquityAssets

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A question:

What can you tell from a market-to-book ratio? large/small ratios > 1 < 1

What shall you do if you observe/think that your shares are undervalued?

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Intrinsic (fundamental) values

Market values are what investors are willing to either buy or sell an asset for, based on investors’ expectations of future performance.Market values are very often publicly observed, e.g., the

transactions in the stock markets.In contrast, intrinsic values are usually

considered as private estimates of what something, e.g., a common stock, is actually worth. Intrinsic value is not something that you can prove. If ten analysts are asked to value IBM stock, then there

will likely be ten different intrinsic value estimates!

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Intrinsic (fundamental) values

Assume that a New York Stock Exchange listed firm has an equity market value of $10 billion.

However, those that manage the firm (insiders) believe the firm is actually worth $12 billion (intrinsic value), based on their private or inside forecasts of future cash flow performance.

For the most part, market prices are driven by public expectations and consensus, while intrinsic values represent private forecasts.

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Financial goals of the corporation

The primary financial goal is shareholder wealth maximization — a function of future cash flow and risk.

In reality, this is maximizing intrinsic value For now we will assume that this is

synonymous with maximizing the market value, i.e., stock price maximization.

Warren Buffett states that his goal is to maximize Berkshire Hathaway’s intrinsic value, and hopefully, the stock’s market value will be close to the intrinsic value.

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Stock price maximization is NOT profit or earnings maximization?

Market (and intrinsic) values are driven by risk and expectations (forecasts) of future cash flows.

Earnings and other accounting profitability measures are not cash flows and have limited use in estimating financial values.

Some actions may cause an increase in reported earnings, yet cause the stock price to decrease (and vice versa).

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Wealth maximization and societal welfare

Is the general welfare of society advanced when individual agents pursue wealth maximization? Is intrinsic or market value maximization good or bad for

society. Should firms behave ethically?The following slide contains a quote is from

Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations, 1776. Adam Smith believed that an economic system in which

individual agents strive to increase their market value results in the most efficient level of general welfare, as it facilitates the allocation of resources to their most productive use.

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Wealth maximization and societal welfare (Adam Smith, 1776)

“As every individual, endeavours as much as he can both to employ his capital in the industry, and to direct that industry that its produce may be of the greatest value, every individual necessarily labours to render the annual revenue of the society as great as he can. In doing so he generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Thus, by pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who pretended to trade for the public good.”

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What is the Objective of the Firm?Van Horne: "In this book, we assume that the

objective of the firm is to maximize its value to its stockholders"

Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value."

Copeland & Weston: The objective of the firm is to maximize the wealth of its stockholders."

Brigham and Gapenski: we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.

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Why Focus on Maximizing Stockholder Wealth?

Shareholders are the legal owners of the business, management has a responsibility to act in their best interest

Stockholders provide the risk capital that serves as a “shock absorber” to the claims of other stakeholders

Focusing on shareholder value avoids value gaps Undervalued firms are prime targets for a takeover

Profit or earnings per share maximization is inferior:Shareholders don’t really get profits; the only direct returns

are dividends and stock price appreciationAccounting measures ignore shareholder opportunity costsFocusing on expected profits ignores risks

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Why Focus on Maximizing Stock Price?

Stock price is easily observable and constantly updated

If investors are rational, stock prices reflect the risks, short term and long term

Maximizing stock price is not incompatible with meeting other stakeholders' needs/objectives

The objective of stock price performance provides some elegant theory on:how to pick projectshow to finance themhow much to pay in dividends

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The Classical Objective Function

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What Can Go Wrong?

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Solutions

Choose a different mechanism for corporate governance

Choose a different objectiveMaximizing earnings / revenues / firm size / market shareThe key thing to remember is that these are intermediate

objective functions

Maximize stock price, but reduce the potential for conflict and breakdown:Making managers and employees into stockholdersProviding information honestly and promptly to financial

markets

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Counter Reaction

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The Modified Objective Function For publicly traded firms in reasonably efficient markets,

where bondholders (lenders) are protected: Maximize stock price: this will also maximize firm value

For publicly traded firms in inefficient markets, where bondholders are protected: Maximize stockholder wealth: this will also maximize firm

value, but might not maximize the stock price

For publicly traded firms in inefficient markets, where bondholders are not fully protected Maximize firm value, though stockholder wealth and stock

prices may not be maximized at the same point.

For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not)

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Agency relationships — the separation of ownership and controlAn agency relationship exists whenever a

principal (owner of a resource) hires an agent to act on their behalf. Examples are:Citizen (principal) and elected official (agent)

Stockholder (principal) and corporate manager (agent)

Within a corporation, agency relationships exist between:Shareholders and managers

Shareholders and creditors

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Shareholders versus Managers

Managers are naturally inclined to act in their own best interests.

But the following factors affect managerial behavior:Managerial compensation plansDirect intervention by shareholdersThe threat of firingThe threat of corporate takeover

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Shareholders versus Creditors

Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors, i.e., actions that result in a wealth transfer from creditors to stockholders.

In the long run, such actions will raise the cost of debt and ultimately lower the stock price.

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Case study

Michael Eisner – CEO of The Walt Disney Company (Sep 1984 – Sep 2005)

Discuss the paper by Stephen F. O’Byrne “What pay for performance looks like: the case of Michael Eisner", Journal of Applied Corporate Finance 5 (summer 1992), pp. 135-136

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Another example:

The compensation for Mr. Palmisano, Chairman and CEO of IBM Corp., during 2003-2005 (Source: IBM Notice of 2006 Annual Meeting and Proxy Statement)

Year Annual compensation (US$) Long-term compensation (US$)

Salary Bonus OthersRestricted

stock award

Stock option

Others

2005 1,680,000 5,175,000 103,302 990,674 230,325 4,241,981

2004 1,660,000 5,175,000 104,406 250,000 1,676,480

2003 1,550,000 5,400,000 11,037 250,000 769,095

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To mitigate the agency problems in practice (1)

Compensation schemes (to tie the fortune of the manager to that of the firm)

Example: Walt Disney offers its CEO with a package that includesA base annual salaryAn annual bonus (2% of Disney’s net income above

a threshold of “normal” profitability)A (10-year) option that allows the CEO to purchase

stocks (e.g., 2 mils shares for $14 per share)

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To mitigate the agency problems in practice (2)

Monitoring by lenders, stock market analysts, and investors

Independent board membersTakeover threats Labor market forces:

Threat that poor performance will result in the removal of the manager

Bad reputation/remuneration for managers if badly performing

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Summary – Keep in mind the differences between:

Real vs. financial assets Capital budgeting and financing decision Closely held vs. public corporations Limited and unlimited liability

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Đoc case study va tra lơi cac câu hoi sau đây:

1. Đai y cua bai la gi? Tac gia muôn ca ngơi cai gi?

2. Phân tich tinh hinh Walt Disney Co. trươc khi M.Eisner trơ thanh CEO.

3. Cac đăc điêm nao trong hơp đông 6 năm cua M.Eisner co tinh chât khuyên khich ngươi lao đông lam viêc hiêu qua nhât?

4. So sanh cac điêm khac biêt cua HĐ 10 năm vơi HĐ 6 năm.