Learning objectives Explain why corporations dominate economic activity. Identify the proper goal of the corporation Value a business firm Define corporate governance structures in different economies. Explain the agency conflict. Describe how agency control devices mitigate the agency conflict.
Consumer
*ar"ets
Business Business
Business
Business
B. Businesses
Business firm: n economic organi!ation that draw on mar"ets for resources that it can reconfigure to sell as goods and services in mar"ets at a profit.
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Resource markets
Business +irm
Product markets
Profit
profitable firm. (esources cost ,%'. -hey are converted into a product that is sold for ,%#. )toc"holders get a profit of ,# .rofit accrues to the company/s owners only if the business efficiently satisfies customers/ needs. non$profitable firm. (esources cost ,%'. -hey are converted into a product that is sold for ,0. )toc"holders suffer a loss of ,#. 1osses will drive a company to change or go out of business. .rofit is a residual2 .rofitable companies must:
Resources
3btain and use only recourses necessary. 4se these resources in the most efficient manner.
Business +irm
Profit
In competitive mar"ets only the efficient earn profits and survive. Business firm: In competitive mar"ets only the efficient survive.
ccess to capital:
%$%' (aise funds from investors
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.rop
3ne person
3ne person
4nlimited
3wner/s
Collective effort
ccess to capital
.art
)everal partners
4nlimited
ny partners
Collective effort
ccess to capital
Corporations were not natural persons. -hey were persons before the law: legal entities that can ma"e contracts separate from their owners. *odern corporations are chartered by governments. 5hat types of companies are organi!ed as corporations6
3wnership Control 1iability 1ife ccess -o Capital 4nlimited
Corp
)hareholders
Entrusted to managers
1imited to investment
4nlimited
Collective effort
). Collective e%%ort
*odern production is a complex activity. 5almart -oyota B3 AE #?%''?''' employees >#'?@7' employees #0>?=%= employees >'B?''' employees
ccess to capital
Could a single individual design? manufacture? mar"et and service a car6 Could a single owner manage this process6 .roprietor: 3wnerC*anagerC5or"er Corporation: 3wner is separate from *anager and wor"er Collective effort: )peciali!ation22 *ost productive efforts reDuire a complex mix of talent guided by a sophisticated management structure in which ownership is separated from management.
F. !ccess to capital
5almart -oyota #?%''?''' employees ,%='?B''?'''?''' assets >#'?@7' employees ,>#>?B''?'''?''' assets #$B
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B3 AE
Could a plumber raise ,>#>?'''?'''?'''6 -he plumber is limited to the capital he can raise as an individual. -he plumber faces: 4nlimited liability: <eCshe is completely responsible for the debts of the company. 1imited life: -he death of the plumber is the death of the company. -he plumber has limited funds and is not li"ely to attract others to his endeavor. -o raise large amounts of capital a company needs to issue financial securities that represent claims on the company/s cash flows. -hese securities must possess: 1imited liability: n investor cannot lose more than the amount invested. -he investor is not responsible for debts of the company in the event of default. 4nlimited life: -he life of the company is independent from the life of the owner. -he death of any owner does not affect the ability of the company to satisfy the claims against it. -hese characteristics appear only in corporations.
Resources
Corporation
Profit
-he goal: *aximi!e stoc"holder wealth fiduciary responsibility of managers. +iduciary: person legally appointed and authori!ed to hold assets in trust for another person. -he fiduciary manages the assets for the benefit of the other person rather than for his or her own profit.
E E
5ithout profit? no one has a sta"e in efficiency. (esources are wasted reducing the value society gets from its scarce resources. company will profit only if it produces products that consumers actually want.
E E
2. Efficient capital allocation Businesses that produce profits will attract investorsF businesses that produce losses will lose investors. Aovernment investment: Earmar"s$$,B?7B7?''' government program on wood utili!ation research.
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-his system will truly wor" for the benefit of all members of society only if there are three controls on business activity. %. Aovernment regulation. E Aovernments must protect wor"ers? consumers and the general welfare of society. Child labor 5arranties )afety regulations <ours and conditions for wor"ers. #. Competition E Economic choice leads to a higher standard of living E *onopolies and oligopolies limit choice. E Aovernments should ensure that competitive mar"ets exist. >. (estriction on managerial behavior. E *anagers may see" to benefit themselves at the expense of the stoc"holders and other sta"eholders in the company. E Issues of corporate control.
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-he value of a firm is the sum of its present and proposed pro:ects. firm can only invest in a pro:ect if it raises funds from investors? who in return for giving money to a company get promises of future payments. Every asset of the firm thus has a financial mar"et claim against it in the form of financial securities.
+inancial securities are promises of future benefits in return for a payment today.
+inancial mar"ets are where financial securities are issued and traded.
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5hile the firm receives no funds? secondary mar"et transactions are important. Crucial to the functioning of our economic system. o 1iDuidity: -he degree to which an asset or security can be bought or sold in the mar"et without affecting the assetJs price. -he ability to convert an asset to cash Duic"ly. lso "nown as Kmar"etabilityK.
August 2007 is far more significant because it provides the first piece of evidence that problems in one corner of the financial system - possibly the sub-prime mortgage andrelated credit markets - can spill over so directly to a completely unrelated corner: long short e!uity strategies" L5hat happened to the Duants in ugust #''=6/ mir 9handani and ndrew 1o? *I-
.roduce security prices that are the ma:or source of guidance for managers. o -he 5all )treet wal": Dissatisfied investors sell stoc"? causing price to drop. o Institutional investors: 3rgani!ations which pool large sums of money and invest those sums in securities? real property securities and other investment assets. -heir role in the economy is to act as highly speciali!ed investors on behalf of others.
-ypes of institutional investors Commercial and investment ban"s *utual funds <edge funds .ension funds Insurance companies
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Based on the firm/s assets: %MO Based on the claims on those assets: OM#N$ O&%&#N$ -wo ma:or points. 1. First point: A major economic relationship #'$&%&A )ecurity holders$$stoc"holders and bondholders$$determine values for the firm/s securities by evaluating the wealth$creating decisions that managers ma"e. +inancial mar"ets develop crucial information that managers can use to evaluate pro:ects they are considering. (inancial markets provide the key to the return-risk relationship that is crucial for managerial )ealth-increasing decisions" 2. Second point: Defining Stoc holder !ealth #'$&%&O )hareholders play an especially crucial role in this return$ris" relationship. E-hey are the residual holders.
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Investors value the firm/s stoc" by evaluating: E-he firm/s existing assets E-he wealth the firm/s assets are expected to create E-he firm/s use of debt to finance existing and proposed pro:ects. $&O*#
+iduciary (esponsibility
+iduciary (esponsibility
*anagers
Chief Executive 3fficer C33 C+I CI3
Inside Directors: ny member of a companyJs board of directors who is either an employee or sta"eholder in the company.
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3utside Directors: ny member of a companyJs board of directors who is not an employee or sta"eholder in the company. 3utside directors are paid an annual retainer fee in the form of cash? benefits andCor stoc" options.
B. !gency proble"s
-he agency relationship produces an inherent incentive misalignment. 5hat managerial actions might be inconsistent with the welfare of the stoc"holders6 E Excessive perDuisites E E <ori!on problem +ocus on si!e E .restige E (educe managers/ ris" E Cash cushion
C. !gency costs
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gency cost: -he cash flows of the firm are reduced by the existence of agency problems. gency costs are controlled by a complex interaction of legalCadministrativeCmar"et devices that constrain managerial actions. External control devices: -hese are controls placed on corporate managers by individuals and organi!ations outside of the corporation. Aovernment. Aovernments provide substantial regulation and oversight of corporate activity in general and managerial actions in particular. (e: Enron. External audits. )ecurity laws reDuire public companies to undergo an annual audit by an outside auditor who must report to the stoc"holders. -his reDuirement in its current form is not as effective a control device as it could be. 1awsuits. )toc"holders who feel that managers have violated their fiduciary responsibility can sue managers and directors of the corporation. 1arge institutional investors: Investors who have a substantial ownership share in the corporation can place pressure on managers to improve performance. -hese large institutions may even have a seat on the board? which further increases their influence. -a"e$overs. n outside group may feel that a corporation is badly managed. -hey may offer existing stoc"holders a premium for their stoc"? obtain sufficient shares to control the firm? and then replace the board and existing managers and reconfigure the corporation/s assets. Internal control devices: -hese are internal to the firm in that they are created and run by the firm/s managers and owners themselves in order to assure the stoc"holders that the managers will loo" after the stoc"holders/ interests.
Carefully designed compensation contracts for managers. 5hile these contracts involve a straight salary? their ma:or component is often extra compensation connected to the performance of the firm? such as stoc" options. -he board of directors. -he board is directly elected by stoc"holders and is responsible to set the broad direction of the firm and hire managers? oversee their performance and set their compensation. -he corporation/s charter and by$laws. In the 4) corporations are chartered by state governments. -he corporation must file documents with the state that set forth its purpose? how it is organi!ed and how it will raise capital. *anagers who monitor each other. *anagers formally oversee other managers and ensure that they are performing as reDuired. mbitious managers may also identify and OoutP other managers who are not performing in an acceptable manner.
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2ur points
-he corporation see"s to maximi!e stoc"holder wealth. Corporations are efficient and dominate economic activity. -he corporation see"s to maximi!e stoc"holder wealth. -he value of the firm/s assets should eDual the value of the financial claims on those assets. Corporate governance forms and goals differ throughout the world. In corporations an agency conflict exists between managers and stoc"holders. gency control devices control agency costs.
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