Session 3: The Objective in Corporate Finance - Reality

Introduction

In this session, the speaker discusses the objective of corporate finance and explores alternatives to maximizing stock prices. The speaker also highlights potential issues with corporate finance and how to protect against them.

Maximizing Stock Prices as an Objective

• The central objective of corporate finance is to maximize the value of the business by maximizing stock prices.

• However, there are many things that can go wrong with this objective, such as managers prioritizing their interests over those of shareholders or financial markets being irrational.

• Large social costs can also result from focusing solely on maximizing stock prices.

Alternatives to Maximizing Stock Prices

• Three potential alternatives are presented: a different approach to corporate governance, picking a different objective (e.g., maximizing revenues or growth), or fixing/maximizing stock prices while reducing associated costs.

• A different corporate governance mechanism could involve someone other than shareholders taking on the responsibility of keeping managers in line.

• Japan and Germany provide examples of cross-holding systems where companies hold shares in each other and work together to replace poorly performing managers without involving shareholders.

Cross-Holding Systems in Japan and Germany

This section explores cross-holding systems used in Japan and Germany as an alternative to traditional shareholder-focused corporate governance mechanisms.

Carrots in Japan

• In Japan's cross-holding system, companies hold shares in each other and work together to replace poorly performing managers without involving shareholders.

• This system is known as "carrots" because it incentivizes good behavior through positive reinforcement rather than punishment.

Banks in Germany

• In Germany's cross-holding system, banks play a central role by holding shares in multiple companies and monitoring their behavior.

• This system is more elitist than Japan's carrots system since it relies on well-equipped managers replacing poorly performing ones.

Conclusion

The speaker concludes by summarizing the alternatives to maximizing stock prices and highlighting the importance of finding a corporate finance objective that balances shareholder interests with those of other stakeholders.

Balancing Shareholder Interests

• While maximizing stock prices is an important objective, it's crucial to balance this with the interests of other stakeholders.

• Finding a corporate governance mechanism that achieves this balance is key to avoiding potential issues with traditional shareholder-focused systems.

Corporate Governance Mechanisms

In this section, the speaker discusses the problem with corporate governance mechanisms that are elitist-based and proposes a different system where committees or groups of people decide which companies are well-run and badly run.

Elitist-Based Corporate Governance Mechanisms

• If one company out of fifty has made good loans while the remaining forty-nine have made bad real estate loans, the one company that made good loans will replace the other forty-nine.

• Companies with elitist-based corporate governance mechanisms tend to circle their wagons and get rid of people who make good decisions instead of addressing systemic problems in the economy.

• Elitists make mistakes but hate to admit them.

Alternative Objectives for Corporate Governance

• Committees or groups of people should decide which companies are well-run and badly run.

• Maximizing growth, earnings, market share, and margins are intermediate objectives that need to be recognized as such.

• Focusing on alternative objectives can cause managers to forget about larger objectives.

Maximizing Stock Prices

In this section, the speaker argues that maximizing stock prices is still the best solution despite its flaws. He explains why markets are self-correcting and how they correct their mistakes quickly.

Market-Based Mechanism

• Markets make mistakes but correct them quickly because they have no ego.

• The self-correcting nature of markets makes it a better option than other alternatives.

• Four linkages discussed include stockholders having little power over managers, lenders lending money without protecting themselves, managers revealing information to financial markets not that well and sometimes lying, and markets not being efficient.

Social Costs

• If stockholders are taken advantage of too much, they will eventually get mad enough to do something about it.

• Hostile acquisitions and activist investors can emerge when stockholders are unhappy with managers.

• Bondholders learned from the Nabisco case and started putting special clauses into bonds to protect themselves against LBO-like activities.

Conclusion

In this section, the speaker concludes his argument for maximizing stock prices as the best solution despite its flaws.

Final Thoughts

• Maximizing stock prices is still the best option because markets are self-correcting.

• The flaws in market-based mechanisms can be addressed by recognizing intermediate objectives and understanding their linkages to the larger objective.

• Alternative corporate governance mechanisms should be considered but must be carried through to their logical conclusions.

Why Mature Companies Sometimes Lie

In this section, the speaker discusses why mature companies sometimes lie and why growth companies should avoid playing accounting games that can damage their credibility.

Reasons for Lying

• The speaker cannot understand why growth companies want to fudge the facts.

• Playing accounting games can mess with a company's credibility.

• Social costs can arise if a company becomes a ripe target for taxes or lawsuits.

Market-Based Solutions

• Mechanisms in market-based solutions allow the system to get back to steady-state.

• Corrective mechanisms within markets make them more effective.

Example of Disney

• Michael Eisner made decisions that made stockholders worse off, causing discontent among stockholders.

• Stockholders became mad enough to consider a hostile acquisition bid for Disney, leading Eisner to resign as chairman from the board.

• Bob Iger replaced Eisner and did everything differently from him, creating a much more independent board.

The Importance of Corporate Governance

In this section, the speaker discusses corporate governance and how even well-intentioned CEOs can acquire Imperial CEO characteristics over time.

Disney's Board Improvement

• By 2008, Disney's board was considered one of the better governed companies in the US under Bob Iger's leadership.

Bad Habits Return

• In 2013, it looked like Bob Iger was acquiring some bad habits.

• Pressure from below was starting to build up again because Disney seemed to be going back to bad habits from old days.

Term Limits for CEOs

• The speaker suggests that just as legislators have term limits, CEOs should also have them because the longer a CEO stays on, the more they acquire the trappings of power and the more captive the board becomes.