Session 2: The Objective in Corporate Finance

Corporate Finance Objective

In this session, the speaker talks about the objective in corporate finance and why it is important. The objective is to maximize the value of the business, but in practice, it becomes maximizing stockholder wealth.

The Financial Balance Sheet

• The financial balance sheet has two items on each side: assets in place and growth assets on one side, and debt and equity on the other.

• To maximize the value of a business, you need to maximize the value of both assets in place and growth assets.

Maximizing Stockholder Wealth

• If you're managing a publicly traded company, your focus becomes maximizing stockholder wealth because you want to keep them happy.

• You need an objective measure to show that you are increasing their wealth. Stock prices provide an objective third-party estimate of stockholder wealth.

• If your stock price goes up, you can argue that stockholder wealth has gone up and implicitly that the value of the business also went up.

Utopian Conditions for Maximizing Stock Prices

• To have maximizing stock prices as the only objective for a company requires utopian conditions.

• Four linkages must be perfect: between managers and stockholders; between firms and lenders/bondholders; between firms and financial markets; between firms and society.

• These assumptions are unrealistic because utopia never existed.

Conclusion

• While maximizing stock prices may not be realistic as a sole objective for companies due to pragmatic considerations, it remains an important consideration for publicly traded companies.

Assumptions and Linkages in Corporate Finance

In this section, the speaker discusses the assumptions made in traditional corporate finance and the linkages between firms and financial markets.

Assumptions Made in Traditional Corporate Finance

• Companies reveal news about themselves honestly and in a timely manner.

• Markets are rational and cool-headed.

• There are no social costs.

What Can Go Wrong?

• Stockholders have complete power over managers, but annual meetings and boards of directors are not very effective at keeping managers in line.

• Most stockholders don't show up at annual meetings, so they get proxies to vote for them. Unfortunately, most stockholders don't return their proxies, effectively giving incumbent managers an advantage.

• The people who serve on boards of directors are often connected to top management or even the CEO themselves.

• Disney's Board in 1997 is an example of a bad board:

• There were too many members (17).

• Eight of the 17 members were insiders who worked for or used to work for Disney.

• The chairman of the board was also the CEO of Disney.

• Even the nine outside members had connections to Michael Eisner (the CEO).

The Role of the Board of Directors

In this section, the speaker discusses the role of the board of directors in overseeing top management and ensuring that they act in the best interests of shareholders.

Rubber-Stamp Board

• The board is often a rubber-stamp board, meaning it acts as a mere formality for top management rather than actively overseeing their actions.

• As a result, managers may prioritize their own interests over those of shareholders since they have little accountability to them.

Managerial Interests vs. Shareholder Interests

• Managers may prioritize their own interests over those of shareholders through tactics such as greenmail, golden parachutes, poison pills, shark repellents, and ego-driven acquisitions.

• This is due to the fundamental problem that stockholders have little power over managers.

Lenders' Protection

In this section, the speaker discusses how lenders can protect themselves from exploitative behavior by firms.

RJR Nabisco Example

• Lenders who do not protect themselves are vulnerable to exploitative behavior by firms.

• The example of RJR Nabisco shows how bondholders were impoverished when KKR quadrupled Nabisco's debt during a leveraged buyout.

Firms' Information Disclosure

In this section, the speaker discusses how firms reveal information to financial markets.

Importance of Information Disclosure

• Firms must disclose information to financial markets in order to attract investors and maintain credibility.

• Failure to disclose relevant information can lead to legal consequences and loss of investor trust.

The Power in a Company

In this section, the speaker discusses the power dynamics within companies and how it affects stockholders.

Financial Markets and Companies

• Markets are not rational or cool.

• Companies create social costs that cannot be avoided.

• Maximizing stock prices can lead to terrible consequences for both companies and people.

Where Does Power Lie?

• It is important to identify where power lies within a company.

• Power can lie with managers, stockholders (inside or outside), government, lenders, or employees.

• As a stockholder, it is important to determine if any of these groups will watch out for your interests.

Examples of Power Dynamics

Disney

• In 2003, 16 out of the top 17 stockholders in Disney were institutional investors who tend to sell and move on rather than fight for change.

• The only individual on the list was Roy Disney who was part of Disney's top management at the time.

Vale

• Vale has two classes of shares with different voting rights. Stockholders with lower voting rights have little power in the company.

• Seven entities control Vale through higher voting right shares. One entity appoints most of Vale's directors effectively running the company.

• The Brazilian government owns a golden share which gives them veto power over big decisions.

Other Companies

• It is important to analyze each company individually to determine where power lies and if there are any potential issues with corporate governance.

Corporate Finance and Stockholders

In this section, the speaker discusses the role of stockholders in corporate finance decisions and how they can influence change in a company.

The Importance of Stockholders

• Outsiders can influence the way companies are run.

• As a stockholder, decisions made by a company may not always be in your best interest.

• When looking at corporate finance decisions, consider whether any managers can be forced to make changes.

Case Studies: Tata Motors and Baidu

Tata Motors

• Decisions made by Tata Motors may not always be in the best interest of stockholders.

Baidu

• When buying shares in Baidu, you're actually buying shares in a Cayman Islands shell company with a legal arrangement with the operating company in China.

• This legal arrangement might be subject to oversight by the Chinese government.

Importance of Activist Stockholders

• Steve Jobs became the largest stockholder in Disney after owning 60% of Pixar when Disney bought it.

• Having an activist stockholder like Steve Jobs can push for change within a company.

• Existing management is often stuck with inertia, so having someone pushing for change is important.

Final Thoughts

• The objective of corporate finance is to maximize stock prices, but there are multiple interests at play in modern corporations.

• As a stockholder, you want someone pushing for your interests because you don't have the power to make changes yourself.