Fundamentals of Corporate Finance 1: Goals and Governance of the Corporation
Based on the questions at the end of chapter 1 of Fundamentals of Corporate Finance International Edition (11th edition) by Brealey, Myers, Marcus.
A security is a tradeable financial instrument, such as a stock, bond, option, future, or mutual fund.
Companies usually buy real assets. These include both tangible assets (such as trademarks, trucks, lands, and labour) and intangible assets (such as brand names). The decision about which assets to buy is usually termed the capital budgeting or investment decision. Stocking up on inventory, developing new software, and selling a warehouse, are all investment decisions.
To pay for these assets, companies sell financial assets such as bonds. Shares, IOUs, cash in a bank account, and a bank loan, are all financial assets. Decisions relating to financial assets are financial decisions. Increasing dividends or repaying debt from profits are financial decisions.
The decision about how to raise the money is usually termed the capital structure or financing decision. Capital structure refers to how an investment is paid for, i.e. debt vs equity.
Partnerships do not pay income tax (the owners do) but face unlimited liability.
Private corporations are owned by a small group of investors. They are not publicly traded; they are closely held.
Public corporations are owned by shareholders. Shareholders can sell their shares (i.e. ownership can be transferred) without disrupting the business, and managers can be fired with no effect on ownership (the corporation survives even if managers leave to organisation).
The owners of corporations (investors if a private corporation and shareholders if a public corporation) have limited liability, meaning they are not personally liable for debts or legal issues. This reduces the risk of investing in a business. Limited liability can be a disadvantage; external finance may require collateral, and a corporation with limited assets may have less to offer than a group of persons who are individually liable, therefore it may be more difficult to access finance.
Corporations are subject to double taxation, as there is both corporation tax (paid by the corporation) and capital gains tax (paid by the shareholders).
The CFO is responsibly for the overall financial strategy for the organisation.
The treasurer is responsible for investing the firm’s spare cash (investment decisions) and for arranging any issue of common stock. They are also involved in cash management and maintaining relationships with financial institutions.
The controller is responsible for the company’s tax affairs and monitors capital expenditures to make sure that they are not misappropriated. They are involved in reporting, accounting, and compliance.
Fundamentally, a corporation tries to make shareholders as wealthy as possible by investing in real assets.
Shareholders want managers to maximize the market value of their investments. The firm faces a trade-off. Either it can invest its cash in real assets or it can give the cash back to shareholders in the form of a dividend and they can invest it in financial assets. Shareholders want the company to invest in real assets only if the expected return is higher than they could earn for themselves in equivalent risk investments. The return that shareholders could earn for themselves is therefore the opportunity cost of capital for the firm.
A firm that is trying to maximise current market value might reduce its dividend payment, choose to reinvest more earnings in the business, or drill for oil in a remote jungle. It would not add a cost-of-living adjustment to the pensions of its retired employees or buy a corporate jet for its executives.
A firm that strives to maximise stock price should be less subject to an overemphasis on short-term results than one that simply maximizes profits. Actions taken to maximise short-term profits may come at the expense of long-term profits, resulting in a decreased stock price. For example, reducing quality controls to lower costs (and therefore prices) may result in more sales and higher profits, but in the long term, liabilities (due to warranty claims or legal action) and reputational damage may damage the company. Investors fear of this happening could cause them to sell, reducing the stock price before the event itself occurs.
Trying to increase market share may come from aggressive pricing strategies that reduce profits. Also, if they become too large (a monopoly), there is a threat from regulators.
Trying to minimise costs may come at the expense of product quality, employee morale, or customer satisfaction.
Trying to under-price competitors could damage any premium brand positioning or cause a rase to the bottom.
Trying to maximise profits could involve short-term measures that damage long-term value.
There can be a conflict between maximising shareholder value and maximising the welfare of all its stakeholders (e.g. employees, customers, community). Maximising shareholder value can be done through the creation of negative externalities (e.g. pollution), or at the cost of stakeholders (for example, if there are few repeat customers or low staff onboarding costs, shareholder value could be maximised by bad customer service and bad treatment of staff). If a company focusses on maximising the welfare of all its stakeholders, investors may shift to other organisations that do prioritise the maximisation of shareholder value instead. Government interventions and customer (investor) education can combat this, as negative externalities can be fined, and investors can realise long-term value may require ethical management. However, in the short term, investing in an ethical organisation may come with lower returns, as the investor pays for the externalities
Both national and local brands could be damaged by unethical actions. If a national company was caught, it could damage the brand’s reputation; given it’s size, in absolute terms, it has more to lose, from fines to customers. However, they might be able to overcome it with PR. If a local company was caught, the owner might lose their entire livelihood, a huge loss in relative terms; however, the overall impact (on the economy, on jobs, etc) would be smaller.
The opportunity cost of capital is the rate of return for an alternative investment. A safe investment (risk-free rate), for comparison, is typically a treasury bond.
For a shareholder to be satisfied, the rate of return of an investment by a corporation into a real asset must be higher than an investment into a financial asset. This includes the shareholder selling their shares in the corporation to invest in a different corporation with a higher rate of return.
An attractive rate of return is one that is satisfactory given the risk level. Even a risk-averse investor may support a high-risk investment if the opportunity cost of capital is low and the expected rate of return significantly outweighs the alternative.
The opportunity cost of capital is generally not the interest rate that the firm pays on a loan from a bank or insurance company, due to the risk of the investment. For example, a company can get a bank loan at 7%. and it has the opportunity to invest in an average-risk project with a 9.5% rate of return. This might be a good investment (9.5 > 7), but the total WACC (including cost of equity) needs to be considered (to ensure shareholders are also satisfied), and a higher return might be required if it was a high-risk project. It should also be considered if there is a better alternative investment (e.g. higher return or lower risk).
If there is an investment opportunity with a guaranteed return above the risk-free rate, it is typically a good investment. If funding is limited, the highest guaranteed return should be invested in first. If the return is not guaranteed (i.e. it is variable, such as correlating to a commodity price), a risk analysis should be done to determine against this opportunity and alternatives to understand the expected rates of return and risk profiles.
Agency costs are costs incurred due to misaligned incentives between managers and shareholders, where the latter prioritise personal objectives over those of the organisation. Mitigations include tying compensation to performance, Boards of Directors (part of corporate governance), and legal requirements. Firms with defences that make it more costly or difficult for other firms to take them over might increase the likelihood of agency problems, as managers feel their positions are more secure, and therefore may be more likely to act in their personal interests. However, when compensation is tied to performance (either in company shares or a salary linked to company profits), the manager is incentivised to improve company performance, which would reduce conflicts of interest and agency costs. Similarly, lawyers paid a percentage-based fee are encouraged to push better settlement, rather than simply bill additional hours. However, traders rewarded by a percentage of the profits, not the success of the trade over the long term, may encourage short-term risk taking and unauthorised/unethical trades, hoping they leave with their gains before they are caught. An individual shareholder has limited power over the operation of the organisation; they can only choose to sell. A bank that has made a large loan to the company may be able to pressure large shareholders if they feel the organisation will default on their debt; they also have contractual arrangements to leverage.
Clear and comprehensive financial reports promote effective corporate governance as nothing can be hidden or missed; this builds trust and accountability. It also provides compliance and supports effective decision-making.
A long-term relationship between a corporation and a bank could lead to more cronyism; however, competition between banks for the custom of a corporations could lead to unethical tactics and bribes.
- Corporate finance is about adding value.
- The opportunity cost of capital sets the standard for investments.
- A safe dollar is worth more than a risky one, and a dollar today is worth more than a future one.
- Smart investment decisions create more value than smart financing decisions.
- Good governance matters.