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THE OBJECTIVE IN CORPORATE

FINANCE

“If you don’t know where you are going, it does’nt

maCer how you get there”

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First Principles

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The ObjecKve in Decision Making

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¨ In tradiKonal corporate finance, the objecKve in decision making is to

maximize the value of the firm.

¨ A narrower objecKve is to maximize stockholder wealth. When the stock

is traded and markets are viewed to be efficient, the objecKve is to

maximize the stock price.

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible

Residual Claim on cash flows Significant Role in management Perpetual Lives

Growth Assets

Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets

Expected Value that will be created by future investments

Maximize

firm value

Maximize equity

value

Maximize market

estimate of equity

value

Maximizing Stock Prices is too “narrow” an

objecKve: A preliminary response

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¨ Maximizing stock price is not incompaKble with

meeKng employee needs/objecKves. In parKcular:

¤ -­‐ Employees are o\en stockholders in many firms

¤ -­‐ Firms that maximize stock price generally are profitable firms that can afford to treat employees well.

¨ Maximizing stock price does not mean that

customers are not criKcal to success. In most

businesses, keeping customers happy is the route to

stock price maximizaKon.

¨ Maximizing stock price does not imply that a

company has to be a social outlaw.

The Classical ObjecKve FuncKon

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STOCKHOLDERS

Maximize stockholder wealth

Hire & fire managers

• Board
• Annual Meeting

BONDHOLDERS/

LENDERS

Lend Money

Protect bondholder Interests

FINANCIAL MARKETS

Managers^ SOCIETY

Reveal information honestly and on time

Markets are efficient and assess effect on value

No Social Costs

All costs can be traced to firm

What can go wrong?

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STOCKHOLDERS

Managers put their interests above stockholders

Have little control over managers

BONDHOLDERS

Lend Money

Bondholders can get ripped off

FINANCIAL MARKETS

Managers^ SOCIETY

Delay bad news or provide misleading information

Markets make mistakes and can over react

Significant Social Costs

Some costs cannot be traced to firm

The Annual MeeKng as a disciplinary venue

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¨ The power of stockholders to act at annual meeKngs is diluted by three factors ¤ Most small stockholders do not go to meeKngs because the cost of going to the meeKng exceeds the value of their holdings. ¤ Incumbent management starts off with a clear advantage when it comes to the exercise of proxies. Proxies that are not voted becomes votes for incumbent management. ¤ For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.

¨ Annual meeKngs are also Kghtly scripted and controlled events, making it difficult for outsiders and rebels to bring up issues that are not to the management’s liking.

And insKtuKonal investors go along with

incumbent managers…

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