UNI OF Lecturer : FANGMING XU

    BRISTOL  
             
             
    QUESTIONS   NOTES    
 finance related decision corporates may face
 These decisions are classified into
o Investment
o Financing
o Payout
 Top management (directors CEO CFO) is in charge of these big
decisions
o where to invest money in what project for how long for how
much
o how you want to raise the capital needed for this investment:
do you want to sell your equity or do you want to borrow the
what is corporate finance money from the bond holders or found a bank so this is the
financing decision
o when the company has sufficient cash flow and cash reserved,
it is the right time to return the profits they have generated
due to those profitable projects to the shareholders
how they would like to return the capital:
– repurchase their shares
– issue dividends
 1 main objective that management should serve: maximizing
shareholders wealth
 Corporate finance is “common sense.” E.g. finance at 8% and invest at
10%.

under the rubric of  marketing, accounting, operations, strategy, etc.

corporate finance
 lists the firm’s assets and liabilities, providing a snapshot of the firm’s
financial position at a given point in time.
 It is backward looking. Some say the past is irrelevant, and only the
accounting balance sheet future matters. The value of an asset is determined by its capacity to
generate cash flows in the future.
 You can fund a business in two ways: borrow the money (debt) or use
your own money (equity).

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Components of S&P 500
market value


 The Investment Principle
Invest in assets/projects that yield a return greater than the minimum
acceptable cost of capital.
 The Financing Principle
Choose a capital structure (debt and equity) that maximizes the value
Core corporate finance of the investments made and match the financing to the nature of the
principles assets being financed.
 The Dividend Principle
If there are not enough investment opportunities that earn the
minimum cost of capital, return the cash, in the form of dividends or
stock repurchases, to the business owners.

the big picture

 “The value of a firm is the present value of its expected cash flows,
firm value discounted back at a rate that reflects both the riskiness of the
projects of the firm and the financing mix used to finance them.”

focus changes across the

life cycle


The objective of the firm  The objective in conventional corporate financial theory when making
decisions is to

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Why focus on stock price
maximization
Is stock price
maximization too
“narrow”?
Stockholders vs managers
Stockholders vs.
bondholders
Firms vs financial markets
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maximize the value of the business or firm.
• Maximize the assets in place and growth assets.
• Therefore, any decision (investment, financial, or payout) that
increase the value of a business is considered good.
 A narrower objective is to maximize stockholder wealth.
When the stock is traded and markets are viewed as efficient, the
objective is
to maximize the stock price.
• i.e. market estimate of the equity value
 These objectives vary in terms of the assumptions needed.
 Maximize the firm value (least restrictive)
 Maximize the stock price (most restrictive)
 1. Stock prices are the most observable of all measures that can be
used to judge the performance a publicly traded firm.
 2. If investors are rational and markets are efficient, stock prices will
reflect the long-term effects of decisions made by the firm.
 3. It allows us to make clear statements about the best approach to
choose projects and finance them (allocating resources, financing
investments, returning cash).
 Multiple stakeholders and conflicts of interest
• What is good for stockholders may not necessarily be good for
bondholders and managers.
• Employees may have little or no interest in stockholder wealth
maximization.
• Customers’ interests are not looked after.
 Potential side costs of value maximization
• Decisions that are good for the firm may create social costs.
• There is the potential for a conflict of interest between stockholders
and managerial interests.
• Inefficiencies in the financial markets may lead to the misallocation
of resources.
 In theory: The stockholders have significant control over management.
The two mechanisms for disciplining management are the annual
meeting and the board of directors. Specifically, we assume that
 • Stockholders who are dissatisfied with managers can not only
express their disapproval at the annual meeting, but can use their
voting power at the meeting to keep managers in check.
 • The board of directors plays its true role of representing
stockholders and acting as a check on management.
 In Practice: Neither mechanism is as effective in disciplining
management as theory posits.
o annual meeting : some stockholders do not attend, have
limited information to be actively involved in the annual
meeting, corporate charter give advantages to managers
o board of directors : usually chosen by managers instead of
stockholders, own only a few shares, lack of expertise to
question managers performance
 In theory: there is no conflict of interests between stockholders and
bondholders.
 In practice: Stockholders and bondholders have different objectives.
Bondholders are concerned most about safety and ensuring that they
get paid their claims.
 Stockholders are more likely to think about upside potential
 In theory: Financial markets are efficient. Managers convey information
honestly and in a timely manner to financial markets, and financial
markets make reasoned judgments of the effects of this information on
“true value”.
As a consequence:
A company that invests in good long term projects will be rewarded.
Short term accounting gimmicks will not lead to increases in market
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The objective in decision making

Firms vs society
social responsibility and
firm value go hand in hand
Traditional Theory versus
reality
Traditional corporate
financial theory breaks
down when
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value.
Stock price performance is a good measure of company performance.
 In practice: There are some holes in the “Efficient Markets” assumption
and information (especially negative) is sometimes suppressed or
delayed by managers.
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.
 A social cost or benefit is a cost or benefit that accrues to society as a
whole and not to the firm making the decision.
o o Environmental costs (pollution, health costs, etc.)
o o Quality of life costs (traffic, housing, safety, etc.)
 Examples of social benefits include:
o o creating employment in areas with high unemployment
o o supporting development in inner cities
o o creating access to goods in areas where such access does
not exist
two factors have come to play
 the consumers mass factor social responsibility when deciding what to buy
and whom to buy it from
 investors must direct the money to socially responsible companies
thus the firm may market its products on that basis and be successful both in
attracting consumers and achieve higher stock price


 • Managerial self-interest: The interests/objectives of the decision
makers in the firm conflict with the interests of stockholders.
 • Unprotected debt holders: Bondholders (lenders) are not protected
against expropriation by stockholders.
o Dividend increase: constraining dividend policy
o leverage buyout: protective inputs to bond charter
o acquiring risky business: restricting investment policy
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  • Inefficient markets: Financial markets do not operate efficiently, and
stock prices do not reflect the underlying value of the firm.
 • Large social side costs: Significant social costs can be created as a
byproduct of stock price maximization.

The solutions are?


 • In the 1950s and 1960s, the stakeholder was king. CEOs saw their
role as one balancing the interests of various groups that touched
their companies – customers, employees, suppliers, shareholders, and
the community at large.
The raise of shareholder  • In 1970, Nobel Prize-winning economist Milton Friedman wrote an
capitalism article in the New York Times in which he famously argued that the
only “social responsibility of business is to increase its profit.”
 • In 1976, economist Michael Jensen and William Meckling published
a paper saying that shareholders were “principals” who hired
executives and board members as “agents.”
The “fall” of shareholder  • In the 1990s, many companies introduced stock options as a major
component of executive compensation. But the initial design of
capitalism options is flawed, which encouraged executives to focus on short-
term performance.
 • The climate changed dramatically in the new millennium as
accounting scandals and a steep stock market decline triggered a
series of corporate collapses.
 • In 2002, The Sarbanes-Oxley Act (SOX) was passed, which requires
companies to institute elaborate internal controls and mark corporate
executives directly accountable for the accuracy of financial
statements.
 • The 2008 financial crisis and its aftermaths triggered further debates.
 Some even call “maximizing shareholder's value” the world's dumbest
idea
 • The problem with the term “maximize shareholder value” is that it
has been hijacked by those who incorrectly believe that the goal is to
maximize shortterm earnings to boost today’s stock price.
 • Properly stated, maximizing shareholder value means allocating
resources to maximize long-term cash flow.

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market share profits vs
market value
Effective corporate
governance structure
executive compensation
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
Work:
- higher market share leads to higher profits and cash flow in the long
term
doesn't work:
- Higher market share is obtained by cutting prices and sacrificing long
term profitability. Short term decision that maximizes profits now at
the expense of long term profits
Notion Profit can be measured easier and more precise then value is incorrect.
accountants can be called on to make earnings assessment.
First, corporate boards must select a clear governing objective.
 • Choosing shareholder or stakeholder value; the time horizon used in
its planning and decision-making processes; how it will resolve trade-
offs among stakeholder interests
 • Common law countries (US, UK) lean to maximize shareholder value;
Civil law countries (France, Germany, Japan) lean to balancing the
interest of stakeholders.
Second, companies need to adopt a set of policies that encourage behaviours
consistent with the governing objective.
 • Includes non-financial and financial performance metrics as well as
incentive compensation plans.
Third, companies must communicate with all of their stakeholders.
 • This communication allows all stakeholders, including shareholders,
to opt-in or opt-out given a company’s objectives.
 by linking wealth of managers to the value of firm stock price, the granting
of options increases the incentive for managers to make value maximizing
decisions.
 However, this also increase the incentive for managers to take risky
projects that they might not have taken, because the value of options
increases with the variance of returns of underlying assets. this also
reduced the market value of bonds issue by the company.
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 

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 

 you're going to discount future cash flows using the appropriate discount
 out the no arbitrage and also the law of one price based on low arbitrage
Three fundamental
principles that underlie
corporate finance
The time value of money
rate to get the present value and therefore you can get the present
representative in terms of the total value of the project given everything
has been considered including the risk including the time value of money
we can have a new evaluation method which is called a checking portfolio
the idea of the checking portfolio is that if you want to give a find the
value or find the price of an asset you don't need to know the discounts
rate as long as you can find a portfolio that match and mimic the exact
cash flow you can get from holding this asset and also they have the same
risk as long as you can find some asset or portfolio like this you can quite
easily to get the accurate or say the appropriate pricing for the asset and if
there's a difference internal pricing that would be the net present value of
your project or investment OK still
 Decision-making objectives of stock price maximization
 Assumptions that must hold for the objective of stock price
maximization
 Real-world conflicts of interest
 Potential alternatives to stock price maximization
 Compound interest and compounding frequencies
 Annuities, perpetuities, growing annuities, and growing perpetuities
 Present value of cash flow streams
 Net present value (NPV) and its decision rule
 Absence of arbitrage and tracking portfolios

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    SUMMARY    

   

   

29 – FUNDAMENTALS OF
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The objective in decision making