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confirmingpagesPART1!!!!!CHAPTERVALUE1GoalsandGovernanceoftheFirm"Thisbookisabouthowcorporationsmakefinancialofthesethings,itdoescovertheconceptsthatgoverndecisions.Westartbyexplainingwhatthesedecisionsgoodfinancialdecisions,anditshowsyouhowtouseareandwhattheyareseekingtoaccomplish.thetoolsofthetradeofmodernfinance.Corporationsinvestinrealassets,whichgeneratecashWestartthischapterbylookingatafundamentalinflowsandincome.Someoftheassetsaretangibletrade-off.Thecorporationcaneitherinvestinnewassetssuchasplantandmachinery;othersareintangibleassetsoritcangivethecashbacktotheshareholders,assetssuchasbrandnamesandpatents.Corporationswhocantheninvestthatcashinthefinancialmarkets.financetheseassetsbyborrowing,byretainingandFinancialmanagersaddvaluewheneverthecompanyreinvestingcashflow,andbysellingadditionalsharescanearnahigherreturnthanshareholderscanearnforofstocktothecorporation’sshareholders.Thusthethemselves.Theshareholders’investmentopportunitiescorporation’sfinancialmanagerfacestwobroadfinancialoutsidethecorporationsetthestandardforinvestmentsquestions:First,whatinvestmentsshouldthecorporationinsidethecorporation.Financialmanagersthereforemake?Second,howshoulditpayforthoseinvestments?refertotheopportunitycostofthecapitalthatTheinvestmentdecisioninvolvesspendingmoney;theshareholderscontributetothefirm.financingdecisioninvolvesraisingit.ThesuccessofacorporationdependsonhowwellAlargecorporationmayhavehundredsofthousandsitharnessesallitsmanagersandemployeestoworkofshareholders.Theseshareholdersdifferinmanytoincreasevalue.Wethereforetakeafirstlookathowways,suchastheirwealth,risktolerance,andinvestmentgoodsystemsofcorporategovernance,combinedwithhorizon.Yetwewillseethattheyusuallyendorsetheappropriateincentivesandcompensationpackages,samefinancialgoal:theywantthefinancialmanagerencourageeveryonetopulltogethertoincreasevalue.toincreasethevalueofthecorporationanditscurrentGoodgovernanceandappropriateincentivesalsostockprice.helpblockouttemptationstoincreasestockpricebyThusthesecretofsuccessinfinancialmanagementillegalorunethicalmeans.Thoughtfulshareholdersdoistoincreasevalue.Thatiseasytosay,butnotverynotwantthemaximumpossiblestockprice.Theywanthelpful.Instructingthefinancialmanagertoincreasethemaximumhoneststockprice.valueislikeadvisinganinvestorinthestockmarkettoThischapterintroducesthreethemesthatreturn“buylow,sellhigh.”Theproblemishowtodoit.againandagain,invariousformsandcircumstances,Theremaybeafewactivitiesinwhichonecanthroughoutthebook:readatextbookandthenjust“doit,”butfinancial1.Maximizingvalue.managementisnotoneofthem.Thatiswhyfinanceis2.Theopportunitycostofcapital.worthstudying.Whowantstoworkinafieldwherethereisnoroomforjudgment,experience,creativity,anda3.Thecrucialimportanceofincentivesandpinchofluck?Althoughthisbookcannotguaranteeanygovernance.!!!!!1bbre30735_ch01_001-019.indd1re30735_ch01_001-019.indd1112/1/093:25:41PM2/1/093:25:41PM confirmingpages2PartOneValue1-1CorporateInvestmentandFinancingDecisionsTocarryonbusiness,acorporationneedsanalmostendlessvarietyofrealassets.Theseassetsdonotdropfreefromabluesky;theyneedtobepaidfor.Topayforrealassets,thecorporationsellsclaimsontheassetsandonthecashflowthattheywillgenerate.Theseclaimsarecalledfinancialassetsorsecurities.Takeabankloanasanexample.Thebankprovidesthecorporationwithcashinexchangeforafinancialasset,whichisthecorpora-tion’spromisetorepaytheloanwithinterest.Anordinarybankloanisnotasecurity,however,becauseitisheldbythebankandnotsoldortradedinfinancialmarkets.Takeacorporatebondasasecondexample.Thecorporationsellsthebondtoinvestorsinexchangeforthepromisetopayinterestonthebondandtopayoffthebondatitsmatu-rity.Thebondisafinancialasset,andalsoasecurity,becauseitcanbeheldbyandtradedamongmanyinvestorsinfinancialmarkets.Securitiesincludebonds,sharesofstock,andadizzyingvarietyofspecializedinstruments.WedescribebondsinChapter3,stocksinChapter4,andothersecuritiesinlaterchapters.Thissuggeststhefollowingdefinitions:Investmentdecision!purchaseofrealassetsFinancingdecision!saleoffinancialassetsButtheseequationsaretoosimple.Theinvestmentdecisionalsoinvolvesmanagingassetsalreadyinplaceanddecidingwhentoshutdownanddisposeofassetsifprofitsdecline.Thecorporationalsohastomanageandcontroltherisksofitsinvestments.Thefinancingdecisionincludesnotjustraisingcashtodaybutalsomeetingobligationstobanks,bondholders,andstockholdersthatcontributedfinancinginthepast.Forexample,thecorporationhastorepayitsdebtswhentheybecomedue.Ifitcannotdoso,itendsupinsolventandbankrupt.Soonerorlaterthecorporationwillalsowanttopayoutcashtoitsshareholders.1Let’sgotomorespecificexamples.Table1.1listsninecorporations.FourareU.S.corpo-rations.Fiveareforeign:GlaxoSmithKline’sheadquartersareinLondon,LVMH’sinParis,2Shell’sinTheHague,Toyota’sinNagoya,andLenovo’sinBeijing.Wehavechosenverylargepubliccorporationsthatyouareprobablyalreadyfamiliarwith.YouprobablyhavetraveledonaBoeingjet,shoppedatWal-Mart,orusedaWellsFargoATM,forexample.InvestmentDecisionsThesecondcolumnofTable1.1showsanimportantrecentinvestmentdecisionforeachcorporation.Theseinvestmentdecisionsareoftenreferredtoascapitalbudgetingorcapi-talexpenditure(CAPEX)decisions,becausemostlargecorporationsprepareanannualcapitalbudgetlistingthemajorprojectsapprovedforinvestment.SomeoftheinvestmentsinTable1.1,suchasWal-Mart’snewstoresorUnionPacific’snewlocomotives,involvethepurchaseoftangibleassets—assetsthatyoucantouchandkick.Corporationsalsoneedtoinvestinintangibleassets,however.Theseincluderesearchanddevelopment(R&D),advertising,andmarketing.Forexample,GlaxoSmithKlineandothermajorpharmaceu-ticalcompaniesinvestbillionseveryyearonR&Dfornewdrugs.Thesecompaniesalsoinvesttomarkettheirexistingproducts.1Wehavereferredtothecorporation’sownersas“shareholders”and“stockholders.”Thetwotermsmeanexactlythesamethingandareusedinterchangeably.Corporationsarealsoreferredtocasuallyas“companies,”“firms,”or“businesses.”Wealsousethesetermsinterchangeably.2LVMHMoëtHennessyLouisVuitton(usuallyabbreviatedtoLVMH)marketsperfumesandcosmetics,winesandspirits,watchesandotherfashionandluxurygoods.And,yes,weknowwhatyouarethinking,butLVMHreallyisshortforMoëtHennessyLouisVuitton.bbre30735_ch01_001-019.indd2re30735_ch01_001-019.indd2112/1/093:25:41PM2/1/093:25:41PM confirmingpagesChapter1GoalsandGovernanceoftheFirm3Company(revenueinbillionsfor2008)RecentInvestmentDecisionRecentFinancingDecisionBoeing($61billion)Beganproductionofits787DreamlinerThecashflowfromBoeing’soperationsaircraft,ataforecastedcostofmorethanallowedittorepaysomeofitsdebtand$10billion.repurchase$2.8billionofstock.RoyalDutchShell($458billion)Investedina$1.5billiondeepwateroilandIn2008returned$13.1billionofcashgasfieldintheGulfofMexico.toitsstockholdersbybuyingbacktheirshares.Toyota(¥26,289billion)In2008openednewengineeringandsafetyReturned¥431billiontoshareholderstestingfacilitiesinMichigan.intheformofdividends.GlaxoSmithKline(£24billion)Spent£3.7billionin2008onresearchandFinancedR&Dexpenditureslargelywithdevelopmentofnewdrugs.reinvestedcashflowgeneratedbysalesofpharmaceuticalproducts.Wal-Mart($406billion)In2008announcedplanstoinvestoveraIn2008raised$2.5billionbyanissuebilliondollarsin90newstoresinBrazil.of5-yearand30-yearbonds.UnionPacific($18billion)Acquired315newlocomotivesin2007.Largelyfinanceditsinvestmentinlocomotivesbylong-termleases.WellsFargo($52billion)AcquiredWachoviaBankin2008forFinancedtheacquisitionbyanexchange$15.1billion.ofshares.LVMH(€17billion)AcquiredtheSpanishwineryBodegaIssuedasix-yearbondin2007,raisingNumanthiaTermes.300millionSwissfrancs.Lenovo($16billion)ExpandeditschainofretailstorestocoverBorrowed$400millionfor5yearsfromover2,000cities.agroupofbanks."TABLE1.1Examplesofrecentinvestmentandfinancingdecisionsbymajorpubliccorporations.Today’scapitalinvestmentsgeneratefuturereturns.Oftenthereturnscomeinthedis-tantfuture.Boeingcommittedover$10billiontodesign,test,andmanufacturetheDream-liner.Itdidsobecauseitexpectsthattheplanewillgeneratecashreturnsfor30yearsormoreafteritfirstenterscommercialservice.ThosecashreturnsmustrecoverBoeing’shugeinitialinvestmentandprovideatleastanadequateprofitonthatinvestment.ThelongerBoeingmustwaitforcashtoflowback,thegreatertheprofitthatitrequires.Thusthefinancialmanagermustpayattentiontothetimingofprojectreturns,notjusttheircumula-tiveamount.Inaddition,thesereturnsarerarelycertain.Anewprojectcouldbeasmashingsuccessoradismalfailure.Ofcourse,noteveryinvestmenthassuchdistantpayoffsasBoeing’sDreamliner.Someinvestmentshaveonlyshort-termconsequences.Forexample,withtheapproachoftheChristmasholidays,Wal-Martspendsabout$40billiontostockupitswarehousesandretailstores.Asthegoodsaresoldoverthefollowingmonths,thecompanyrecoversthisinvestmentininventories.Financialmanagersdonotmakemajorinvestmentdecisionsinsolitaryconfinement.Theymayworkaspartofateamofengineersandmanagersfrommanufacturing,market-ing,andotherbusinessfunctions.Also,donotthinkofthefinancialmanagerasmakingbillion-dollarinvestmentsonadailybasis.Mostinvestmentdecisionsaresmallerandsim-pler,suchasthepurchaseofatruck,machinetool,orcomputersystem.Corporationsmakethousandsofthesesmallerinvestmentdecisionseveryyear.Thecumulativeamountofsmallinvestmentscanbejustaslargeasthatoftheoccasionalbiginvestments,suchasthoseshowninTable1.1.bbre30735_ch01_001-019.indd3re30735_ch01_001-019.indd3112/1/093:25:41PM2/1/093:25:41PM confirmingpages4PartOneValueFinancingDecisionsThethirdcolumnofTable1.1listsarecentfinancingdecisionbyeachcorporation.Acorpo-rationcanraisemoney(cash)fromlendersorfromshareholders.Ifitborrows,thelenderscon-tributethecash,andthecorporationpromisestopaybackthedebtplusafixedrateofinterest.Iftheshareholdersputupthecash,theygetnofixedreturn,buttheyholdsharesofstockandthereforegetafractionoffutureprofitsandcashflow.Theshareholdersareequityinvestors,whocontributeequityfinancing.Thechoicebetweendebtandequityfinancingiscalledthecapitalstructuredecision.Capitalreferstothefirm’ssourcesoflong-termfinancing.Thefinancingchoicesavailabletolargecorporationsseemalmostendless.Supposethefirmdecidestoborrow.Shoulditborrowfromabankorborrowbyissuingbondsthatcanbetradedbyinvestors?Shoulditborrowfor1yearor20years?Ifitborrowsfor20years,shoulditreservetherighttopayoffthedebtearlyifinterestratesfall?ShoulditborrowinParis,receivingandpromisingtorepayeuros,orshoulditborrowdollarsinNewYork?AsTable1.1shows,theFrenchcompanyLVMHborrowedSwissfrancs,butitcouldhaveborroweddollarsoreurosinstead.Corporationsraiseequityfinancingintwoways.First,theycanissuenewsharesofstock.Theinvestorswhobuythenewsharesputupcashinexchangeforafractionofthecorporation’sfuturecashflowandprofits.Second,thecorporationcantakethecashflowgeneratedbyitsexistingassetsandreinvestthecashinnewassets.Inthiscasethecorpora-tionisreinvestingonbehalfofexistingstockholders.Nonewsharesareissued.Whathappenswhenacorporationdoesnotreinvestallofthecashflowgeneratedbyitsexistingassets?Itmayholdthecashinreserveforfutureinvestment,oritmaypaythecashbacktoitsshareholders.Table1.1showsthatin2008Toyotapaidcashdividendsof¥431billion,equivalenttoabout$4.3billion.InthesameyearShellpaidback$13.1billiontoitsstockholdersbyrepurchasingshares.Thiswasinadditionto$9.8billionpaidoutascashdividends.Thedecisiontopaydividendsorrepurchasesharesiscalledthepayoutdecision.WecoverpayoutdecisionsinChapter16.Insomewaysfinancingdecisionsarelessimportantthaninvestmentdecisions.Finan-cialmanagerssaythat“valuecomesmainlyfromtheassetsideofthebalancesheet.”Infactthemostsuccessfulcorporationssometimeshavethesimplestfinancingstrategies.TakeMicrosoftasanexample.Itisoneoftheworld’smostvaluablecorporations.Attheendof2008,Microsoftsharestradedfor$19.44each.Therewereabout8.9billionsharesoutstanding.ThereforeMicrosoft’soverallmarketvalue—itsmarketcapitalizationormarketcap"was$19.44#8.9!$173billion.Wheredidthismarketvaluecomefrom?ItcamefromMicrosoft’sproductdevelopment,fromitsbrandnameandworldwidecustomerbase,fromitsresearchanddevelopment,andfromitsabilitytomakeprofitablefutureinvestments.Thevaluedidnotcomefromsophisticatedfinancing.Microsoft’sfinancingstrategyisverysimple:itcarriesnodebttospeakofandfinancesalmostallinvestmentbyretainingandreinvestingcashflow.Financingdecisionsmaynotaddmuchvalue,comparedwithgoodinvestmentdeci-sions,buttheycandestroyvalueiftheyarestupidoriftheyareambushedbybadnews.Forexample,whenrealestatemogulSamZellledabuyoutoftheChicagoTribunein2007,thenewspapertookonabout$8billionofadditionaldebt.Thiswasnotastupiddecision,butitdidprovefatal.Asadvertisingrevenuesfellawayintherecessionof2008,theTribunecouldnolongerserviceitsdebt.InDecember2008itfiledforbankruptcywithassetsof$7.6billionanddebtsof$12.9billion.Businessisinherentlyrisky.Thefinancialmanagerneedstoidentifytherisksandmakesuretheyaremanagedproperly.Forexample,debthasitsadvantages,buttoomuchdebtcanlandthecompanyinbankruptcy,astheChicagoTribunediscovered.Companiescanalsobeknockedoffcoursebyrecessions,bychangesincommodityprices,interestratesandexchangerates,orbyadversepoliticaldevelopments.Someoftheseriskscanbehedgedorinsured,however,asweexplaininChapters26and27.bbre30735_ch01_001-019.indd4re30735_ch01_001-019.indd4112/1/093:25:42PM2/1/093:25:42PM confirmingpagesChapter1GoalsandGovernanceoftheFirm5WhatIsaCorporation?Wehavebeenreferringto“corporations.”Beforegoingtoofarortoofast,weoffersomebasicdefinitions.Detailsfollowasneededinlaterchapters.Acorporationisalegalentity.Intheviewofthelaw,itisalegalpersonthatisownedbyitsshareholders.Asalegalperson,thecorporationcanmakecontracts,carryonabusiness,borroworlendmoney,andsueorbesued.Onecorporationcanmakeatakeoverbidforanotherandthenmergethetwobusinesses.Corporationspaytaxes—butcannotvote!IntheU.S.,corporationsareformedunderstatelaw,basedonarticlesofincorporationthatsetoutthepurposeofthebusinessandhowitistobegovernedandoperated.3Forexample,thearticlesofincorporationspecifythecompositionandroleoftheboardofdirectors.Acorporation’sdirectorschooseandadvisetopmanagementandarerequiredtosignoffonsomecorporateactions,suchasmergersandthepaymentofdividendstoshareholders.Acorporationisownedbyitsshareholdersbutislegallydistinctfromthem.Thereforetheshareholdershavelimitedliability,whichmeansthatshareholderscannotbeheldpersonallyresponsibleforthecorporation’sdebts.WhentheU.S.financialcorporationLehmanBrothersfailedin2008,noonedemandedthatitsstockholdersputupmoremoneytocoverLehman’smassivedebts.Shareholderscanlosetheirentireinvestmentinacorporation,butnomore.Corporationsdonothavetobeprominent,multinationalbusinesseslikethoselistedinTable1.1.Youcanorganizealocalplumbingcontractororbarbershopasacorporationifyouwanttotakethetrouble.4Butusuallycorporationsarelargerbusinessesorbusinessesthataspiretogrow.Whenacorporationisfirstestablished,itssharesmaybeprivatelyheldbyasmallgroupofinvestors,perhapsthecompany’smanagersandafewbackers.Inthiscasethesharesarenotpubliclytradedandthecompanyiscloselyheld.Eventually,whenthefirmgrowsandnewsharesareissuedtoraiseadditionalcapital,itssharesaretradedinpublicmarketssuchastheNewYorkStockExchange.Suchcorporationsareknownaspubliccompanies.Mostwell-knowncorporationsintheU.S.arepubliccompanieswithwidelydispersedsharehold-ings.Inothercountries,itismorecommonforlargecorporationstoremaininprivatehands,andmanypubliccompaniesmaybecontrolledbyjustahandfulofinvestors.Thelattercategoryincludessuchwell-knownnamesasFiat,Porsche,Benetton,Bosch,IKEA,andtheSwatchGroup.Alargepubliccorporationmayhavehundredsofthousandsofshareholders,whoownthebusinessbutcannotpossiblymanageorcontrolitdirectly.Thisseparationofownershipandcontrolgivescorporationspermanence.Evenifmanagersquitoraredismissedandreplaced,thecorporationsurvives.Today’sstockholderscansellalltheirsharestonewinvestorswithoutdisruptingtheoperationsofthebusiness.Corporationscan,inprinciple,liveforever,andinpracticetheymaysurvivemanyhumanlifetimes.OneoftheoldestcorporationsistheHudson’sBayCompany,whichwasformedin1670toprofitfromthefurtradebetweennorthernCanadaandEngland.ThecompanystilloperatesasoneofCanada’sleadingretailchains.Theseparationofownershipandcontrolcanalsohaveadownside,foritcanopenthedoorformanagersanddirectorstoactintheirowninterestsratherthaninthestockholders’interest.Wereturntothisproblemlaterinthechapter.3IntheU.S.,corporationsareidentifiedbythelabel“Corporation,”“Incorporated,”or“Inc.,”asinUSAirwaysGroup,Inc.TheU.K.identifiespubliccorporationsby“plc”(shortfor“PublicLimitedCorporation”).Frenchcorporationshavethesuffix“SA”(“SociétéAnonyme”).ThecorrespondinglabelsinGermanyare“GmbH”(“GesellschaftmitbeschränkterHaftung”)or“AG”(“Aktiengesellschaft”).4Singleindividualsdoingbusinessontheirownbehalfarecalledsoleproprietorships.Smaller,localbusinessescanalsobeorganizedaspartnershipsorprofessionalcorporations(PCs).WecoverthesealternativeformsofbusinessorganizationinChapter14.bbre30735_ch01_001-019.indd5re30735_ch01_001-019.indd5112/1/093:25:42PM2/1/093:25:42PM confirmingpages6PartOneValue1-2TheRoleoftheFinancialManagerandtheOpportunityCostofCapitalWhatdofinancialmanagersdoforaliving?Thatsimplequestioncanbeansweredinseveralways.Wecanstartwithfinancialmanagers’jobtitles.Mostlargecorporationshaveachieffinancialofficer(CFO),whooverseestheworkofallfinancialstaff.TheCFOisdeeplyinvolvedinfinancialpolicyandfinancialplanningandisinconstantcontactwiththeChiefExecutiveOfficer(CEO)andothertopmanagement.TheCFOisthemostimportantfinancialvoiceofthecorporation,andexplainsearningsresultsandforecaststoinvestorsandthemedia.BelowtheCFOareusuallyatreasurerandacontroller.Thetreasurerisresponsibleforshort-termcashmanagement,currencytrading,financingtransactions,andbankrelation-ships.Thecontrollermanagesthecompany’sinternalaccountingsystemsandoverseespreparationofitsfinancialstatementsandtaxreturns.Thelargestcorporationshavedozensofmorespecializedfinancialmanagers,includingtaxlawyersandaccountants,expertsinplanningandforecasting,andmanagersresponsibleforinvestingthemoneysetasideforemployeeretirementplans.Financialdecisionsarenotrestrictedtofinancialspecialists.Topmanagementmustsignoffonmajorinvestmentprojects,forexample.Buttheengineerwhodesignsanewproduc-tionlineisalsoinvolved,becausethedesigndeterminestherealassetsthatthecorporationholds.Theengineeralsorejectsmanydesignsbeforeproposingwhatheorshethinksisthebestone.Thoserejectionsarealsoinvestmentdecisions,becausetheyamounttodecisionsnottoinvestinothertypesofrealassets.Inthisbookweusethetermfinancialmanagertorefertoanyoneresponsibleforaninvestmentorfinancingdecision.Oftenweusethetermcollectivelyforallthemanagersdrawnintosuchdecisions.Let’sgobeyondjobtitles.Whatistheessentialroleofthefinancialmanager?Figure1.1givesoneanswer.Thefiguretraceshowmoneyflowsfrominvestorstothecorporationandbacktoinvestorsagain.Theflowstartswhencashisraisedfrominvestors(arrow1inthefigure).Thecashcouldcomefrombanksorfromsecuritiessoldtoinvestorsinfinancialmarkets.Thecashisthenusedtopayfortherealassets(investmentprojects)neededforthecorporation’sbusiness(arrow2).Later,asthebusinessoperates,theassetsgeneratecashinflows(arrow3).Thatcashiseitherreinvested(arrow4a)orreturnedtotheinvestorswhofurnishedthemoneyinthefirstplace(arrow4b).Ofcourse,thechoicebetweenarrows4aand4bisconstrainedbythepromisesmadewhencashwasraisedatarrow1.Forexample,ifthefirmborrowsmoneyfromabankatarrow1,itmustrepaythismoneyplusinterestatarrow4b."FIGURE1.1(2)(1)FlowofcashbetweenfinancialmarketsandFirm’sFinancialthefirm’soperations.Key:(1)CashraisedbyoperationsFinancialmarketssellingfinancialassetstoinvestors;(2)cash(abundlemanager(4a)(investorsinvestedinthefirm’soperationsandusedtoofrealholdingpurchaserealassets;(3)cashgeneratedbytheassets)financialfirm’soperations;(4a)cashreinvested;(4b)assets)cashreturnedtoinvestors.(3)(4b)bbre30735_ch01_001-019.indd6re30735_ch01_001-019.indd6112/1/093:25:42PM2/1/093:25:42PM confirmingpagesChapter1GoalsandGovernanceoftheFirm7Youcanseeexamplesofarrows4aand4binTable1.1.GlaxoSmithKlinefinanceditsdrugresearchanddevelopmentbyreinvestingearnings(arrow4a).Shelldecidedtoreturncashtoshareholdersbybuyingbackitsstock(arrow4b).Shellcouldhavechoseninsteadtopaythemoneyoutasadditionalcashdividends.Noticehowthefinancialmanagerstandsbetweenthefirmandoutsideinvestors.Ontheonehand,thefinancialmanagerhelpsmanagethefirm’soperations,particularlybyhelp-ingtomakegoodinvestmentdecisions.Ontheotherhand,thefinancialmanagerdealswithinvestors—notjustwithshareholdersbutalsowithfinancialinstitutionssuchasbanksandwithfinancialmarketssuchastheNewYorkStockExchange.TheInvestmentTrade-offNowlookatFigure1.2,whichsetsoutthefundamentaltrade-offforcorporateinvestmentdecisions.Thecorporationhasaproposedinvestmentproject(arealasset).Supposeithascashonhandsufficienttofinancetheproject.Thefinancialmanageristryingtodecidewhethertoinvestintheproject.Ifthefinancialmanagerdecidesnottoinvest,thecorpora-tioncanpayoutthecashtoshareholders,sayasanextradividend.(TheinvestmentanddividendarrowsinFigure1.2arearrows2and4binFigure1.1.)Assumethatthefinancialmanagerisactingintheinterestsofthecorporation’sowners,itsstockholders.Whatdothesestockholderswantthefinancialmanagertodo?Theanswerdependsontherateofreturnontheinvestmentprojectandontherateofreturnthatthestockholderscanearnbyinvestinginfinancialmarkets.Ifthereturnofferedbytheinvest-mentprojectishigherthantherateofreturnthatshareholderscangetbyinvestingontheirown,thentheshareholderswouldvotefortheinvestmentproject.Iftheinvestmentprojectoffersalowerreturnthanshareholderscanachieveontheirown,theshareholderswouldvotetocanceltheprojectandtakethecashinstead.Figure1.2couldapplytoWal-Mart’sdecisionstoinvestinnewretailstores,forexample.SupposeWal-Marthascashsetasidetobuild10newstoresin2012.Itcouldgoaheadwiththenewstores,oritcouldchoosetocanceltheinvestmentprojectandinsteadpaythecashouttoitsstockholders.Ifitpaysoutthecash,thestockholderscouldtheninvestforthemselves.SupposethatWal-Mart’snew-storesprojectisjustaboutasriskyastheU.S.stockmar-ketandthatinvestmentinthestockmarketoffersa10%expectedrateofreturn.Ifthenewstoresofferasuperiorrateofreturn,say20%,thenWal-Mart’sstockholderswouldbe"FIGURE1.2ThefirmcaneitherCashkeepandreinvestcashorreturnittoinves-tors.(Arrowsrepresentpossiblecashflowsortransfers.)IfcashisInvestmentInvestmentreinvested,theopportu-FinancialopportunityShareholdersopportunitynitycostistheexpectedmanager(realasset)(financialasset)rateofreturnthatshareholderscouldhaveobtainedbyinvestinginInvestAlternative:Shareholdersfinancialassets.paydividendinvestforthemselvestoshareholdersbbre30735_ch01_001-019.indd7re30735_ch01_001-019.indd7112/1/093:25:42PM2/1/093:25:42PM confirmingpages8PartOneValuehappytoletWal-Martkeepthecashandinvestitinthenewstores.Ifthenewstoresofferonlya5%return,thenthestockholdersarebetteroffwiththecashandwithoutthenewstores;inthatcase,thefinancialmanagershouldturndowntheinvestmentproject.Aslongasacorporation’sproposedinvestmentsofferhigherratesofreturnthanitsshareholderscanearnforthemselvesinthestockmarket(orinotherfinancialmarkets),itsshareholderswillapplaudtheinvestmentsanditsstockpricewillincrease.Butifthecom-panyearnsaninferiorreturn,shareholdersboo,stockpricefalls,andstockholdersdemandtheirmoneybacksothattheycaninvestontheirown.Inourexample,theminimumacceptablerateofreturnonWal-Mart’snewstoresis10%.Thisminimumrateofreturniscalledahurdlerateorcostofcapital.Itisreallyanopportunitycostofcapital,becauseitdependsontheinvestmentopportunitiesavailabletoinvestorsinfinancialmarkets.Wheneveracorporationinvestscashinanewproj-ect,itsshareholderslosetheopportunitytoinvestthecashontheirown.Corporationsincreasevaluebyacceptingallinvestmentprojectsthatearnmorethantheopportunitycostofcapital.Noticethattheopportunitycostofcapitaldependsontheriskoftheproposedinvest-mentproject.Why?It’snotjustbecauseshareholdersarerisk-averse.It’salsobecauseshare-holdershavetotradeoffriskagainstreturnwhentheyinvestontheirown.Thesafestinvestments,suchasU.S.governmentdebt,offerlowratesofreturn.Investmentswithhigherexpectedratesofreturn—thestockmarket,forexample—areriskierandsometimesdeliverpainfullosses.(TheU.S.stockmarketwasdown38%in2008,forexample.)Otherinvestmentsareriskierstill.Forexample,high-techgrowthstocksoffertheprospectofhigherratesofreturn,butareevenmorevolatile.Noticetoothattheopportunitycostofcapitalisgenerallynottheinterestratethatthecompanypaysonaloanfromabankoronabond.Ifthecompanyismakingariskyinvest-ment,theopportunitycostistheexpectedreturnthatinvestorscanachieveinfinancialmarketsatthesamelevelofrisk.Theexpectedreturnonriskysecuritiesisnormallywellabovetheinterestrateoncorporateborrowing.Managerslooktothefinancialmarketstomeasuretheopportunitycostofcapitalforthefirm’sinvestmentprojects.Theycanobservetheopportunitycostofcapitalforsafeinvest-mentsbylookingupcurrentinterestratesonsafedebtsecurities.Forriskyinvestments,theopportunitycostofcapitalhastobeestimated.WestarttotacklethistaskinChapter7.Estimatingtheopportunitycostofcapitalisoneofthehardesttasksinfinancialman-agement,evenwhenthestock,bond,andotherfinancialmarketsarebehavingnormally.Whenthesemarketsaremisbehaving,preciseestimatesofthecostofcapitalcanbetempo-rarilyoutofthequestion.FinancialmarketsintheU.S.andmostdevelopedcountriesworkwellmostofthetimebutjustlikethelittlegirlinthepoem,“Whentheyaregood,theyareverygoodindeed,butwhentheyarebadtheyarehorrid.”5In2008financialmarketswerehorrid.SecuritypricesbouncedaroundlikeTiggeronstimulants,andforsometypesofinvestmentthemarkettemporarilydisappeared.Financialmarketsnolongerofferedagoodyardstickforaproj-ect’svalueortheopportunitycostofcapital.Thatwasayearinwhichfinancialmanagersreallyearnedtheirkeep.Wegivemorespecificexamplesofinvestmentdecisionsandtheopportunitycostofcapitalatthestartofthenextchapter.5ThepoemisattributedtoLongfellow:Therewasalittlegirl,Whohadalittlecurl,Rightinthemiddleofherforehead.Whenshewasgood,Shewasverygoodindeed,Butwhenshewasbadshewashorrid.bbre30735_ch01_001-019.indd8re30735_ch01_001-019.indd8112/1/093:25:42PM2/1/093:25:42PM confirmingpagesChapter1GoalsandGovernanceoftheFirm91-3GoalsoftheCorporationShareholdersWantManagerstoMaximizeMarketValueWal-Marthasover300,000shareholders.ThereisnowaythatWal-Mart’sshareholderscanbeactivelyinvolvedinmanagement;itwouldbeliketryingtorunNewYorkCitybytownmeetings.Authorityhastobedelegatedtoprofessionalmanagers.ButhowcanWal-Mart’smanagersmakedecisionsthatsatisfyalltheshareholders?Notwoshareholdersareexactlythesame.Theydifferinage,tastes,wealth,timehorizon,risktolerance,andinvestmentstrategy.Delegatingtheoperationofthefirmtoprofessionalmanagerscanworkonlyiftheshareholdershaveacommonobjective.Fortunatelythereisanaturalfinancialobjectiveonwhichalmostallshareholdersagree:Maximizethecurrentmarketvalueofshareholders’investmentinthefirm.Asmartandeffectivemanagermakesdecisionsthatincreasethecurrentvalueofthecompany’ssharesandthewealthofitsstockholders.Thisincreasedwealthcanthenbeputtowhateverpurposestheshareholderswant.Theycangivetheirmoneytocharityorspenditinglitzynightclubs;theycansaveitorspenditnow.Whatevertheirpersonaltastesorobjectives,theycanalldomorewhentheirsharesareworthmore.Maximizingshareholderwealthisasensiblegoalwhentheshareholdershaveaccesstowell-functioningfinancialmarkets.6Financialmarketsallowthemtosharerisksandtrans-portsavingsacrosstime.Financialmarketsgivethemtheflexibilitytomanagetheirownsavingsandinvestmentplans,leavingthecorporation’sfinancialmanagerswithonlyonetask:toincreasemarketvalue.Acorporation’srosterofshareholdersusuallyincludesbothrisk-averseandrisk-tolerantinvestors.Youmightexpecttherisk-aversetosay,“Sure,maximizevalue,butdon’ttouchtoomanyhigh-riskprojects.”Instead,theysay,“RiskyprojectsareOK,providedthatexpectedprofitsaremorethanenoughtooffsettherisks.Ifthisfirmendsuptooriskyformytaste,I’lladjustmyinvestmentportfoliotomakeitsafer.”Forexample,therisk-averseshareholderscanshiftmoreoftheirportfoliostosafeassets,suchasU.S.governmentbonds.Theycanalsojustsaygood-bye,sellingsharesoftheriskyfirmandbuyingsharesinasaferone.Iftheriskyinvestmentsincreasemarketvalue,thedepartingshareholdersarebetteroffthaniftheriskyinvestmentswereturneddown.AFundamentalResultThegoalofmaximizingshareholdervalueiswidelyacceptedinboththeoryandpractice.It’simportanttounderstandwhy.Let’swalkthroughtheargumentstepbystep,assumingthatthefinancialmanagershouldactintheinterestsofthefirm’sowners,itsstockholders.1.Eachstockholderwantsthreethings:a.Tobeasrichaspossible,thatis,tomaximizehisorhercurrentwealth.b.Totransformthatwealthintothemostdesirabletimepatternofconsumptioneitherbyborrowingtospendnoworinvestingtospendlater.c.Tomanagetheriskcharacteristicsofthatconsumptionplan.2.Butstockholdersdonotneedthefinancialmanager’shelptoachievethebesttimepatternofconsumption.Theycandothatontheirown,providedtheyhavefree6Hereweuse“financialmarkets”asshorthandforthefinancialsectoroftheeconomy.Strictlyspeaking,weshouldsay“accesstowell-functioningfinancialmarketsandinstitutions.”Manyinvestorsdealmostlywithfinancialinstitutions,forexample,banks,insurancecompanies,ormutualfunds.Thefinancialinstitutionsthenengageinfinancialmarkets,includingthestockandbondmarkets.Theinstitutionsactasfinancialintermediariesonbehalfofindividualinvestors.bbre30735_ch01_001-019.indd9re30735_ch01_001-019.indd9112/1/093:25:43PM2/1/093:25:43PM confirmingpages10PartOneValueaccesstocompetitivefinancialmarkets.Theycanalsochoosetheriskcharacteristicsoftheirconsumptionplanbyinvestinginmore-orless-riskysecurities.3.Howthencanthefinancialmanagerhelpthefirm’sstockholders?Thereisonlyoneway:byincreasingtheirwealth.Thatmeansincreasingthemarketvalueofthefirmandthecurrentpriceofitsshares.Economistshaveprovedthisvalue-maximizationprinciplewithgreatrigorandgeneral-ity.Afteryouhaveabsorbedthischapter,takealookatitsAppendix,whichcontainsafurtherexample.Theexample,thoughsimple,illustrateshowtheprincipleofvaluemaxi-mizationfollowsfromformaleconomicreasoning.Wehavesuggestedthatshareholderswanttobericherratherthanpoorer.Butsome-timesyouhearmanagersspeakasifshareholdershavedifferentgoals.Forexample,manag-ersmaysaythattheirjobisto“maximizeprofits.”Thatsoundsreasonable.Afterall,don’tshareholderswanttheircompanytobeprofitable?Buttakenliterally,profitmaximizationisnotawell-definedfinancialobjectiveforatleasttworeasons:1.Maximizeprofits?Whichyear’sprofits?Acorporationmaybeabletoincreasecurrentprofitsbycuttingbackonoutlaysformaintenanceorstafftraining,butthoseoutlaysmayhaveaddedlong-termvalue.Shareholderswillnotwelcomehighershort-termprofitsiflong-termprofitsaredamaged.2.Acompanymaybeabletoincreasefutureprofitsbycuttingthisyear’sdividendandinvestingthefreed-upcashinthefirm.Thatisnotintheshareholders’bestinterestifthecompanyearnslessthantheopportunitycostofcapital.ShouldManagersLookAftertheInterestsofTheirShareholders?Wehavedescribedmanagersastheagentofshareholders,whowantthemtomaximizetheirwealth.Butperhapsthisbegsthequestion,Isitdesirableformanagerstoactintheselfishinterestsoftheirshareholders?Doesafocusonenrichingtheshareholdersmeanthatmanagersmustactasgreedymercenariesridingroughshodovertheweakandhelpless?Mostofthisbookisdevotedtofinancialpoliciesthatincreasevalue.Noneofthesepoli-ciesrequiresgallopsovertheweakandhelpless.Inmostinstances,thereislittleconflictbetweendoingwell(maximizingvalue)anddoinggood.Profitablefirmsarethosewithsatisfiedcustomersandloyalemployees;firmswithdissatisfiedcustomersandadisgruntledworkforcewillprobablyendupwithdecliningprofitsandalowstockprice.Mostestablishedcorporationscanaddvaluebybuildinglong-termrelationshipswiththeircustomersandestablishingareputationforfairdealingandfinancialintegrity.Whensomethinghappenstounderminethatreputation,thecostscanbeenormous.Hereisanexample.TheMarket-TimingScandalIn2003themutualfundindustryconfrontedamarket-timingscandal.Markettimingexploitsthefactthatstockmarketsindifferentpartsoftheworldcloseatdifferenttimes.Forexample,ifthereisastrongsurgeinU.S.stockpriceswhiletheJapanesemarketisclosed,itislikelythatJapanesepriceswillincreasewhenmarketsopeninAsiathenextday.TraderswhocanbuymutualfundsinvestedinJapanesestockswhiletheirpricesarefrozenwillbeabletomakesubstantialprofits.U.S.mutualfundswerenotsup-posedtoallowsuchtrading,butsomedid.AfteritwasdisclosedthatmanagersatPutnamInvestmentshadallowedmarket-timingtradesforsomeofitsinvestors,thecompanywasfined$100millionandobligedtopay$10millionincompensation.ButthelargercostbyfarwasPutnam’slossofreputation.Whenthescandalcametolight,Putnamsufferedhugewithdrawalsoffunds.Putnammutualfundssufferedoutflowsof$30billioninjusttwobbre30735_ch01_001-019.indd10re30735_ch01_001-019.indd10112/1/093:25:43PM2/1/093:25:43PM confirmingpagesChapter1GoalsandGovernanceoftheFirm11months.IfPutnam’sfundschargedroughly1%ofinvestedassetsasanannualmanagementfee(abouttheindustryaverage),thislossofassetscostthecompany$300millionofrevenueperyear.Whenwesaythattheobjectiveofthefirmistomaximizeshareholderwealth,wedonotmeanthatanythinggoes.Thelawdetersmanagersfrommakingblatantlydishonestdecisions,butmostmanagersarenotsimplyconcernedwithobservingtheletterofthelaworwithkeepingtowrittencontracts.Inbusinessandfinance,asinotherday-to-dayaffairs,thereareunwrittenrulesofbehavior.Theserulesmakeroutinefinancialtransactionsfeasible,becauseeachpartytothetransactionhastotrusttheothertokeeptohisorhersideofthebargain.7Ofcoursetrustissometimesmisplaced.Charlatansandswindlersareoftenabletohidebehindboomingmarkets.Itisonly“whenthetidegoesoutthatyoulearnwho’sbeenswimmingnaked.”8Thetidewentoutin2008andanumberoffraudswereexposed.OnenotoriousexamplewasthePonzischemerunbytheNewYorkfinancierBernardMadoff.9Individualsandinstitutionsputabout$65billionintheschemebeforeitcollapsedin2008.(It’snotclearwhatMadoffdidwithallthismoney,butmuchofitwasapparentlypaidouttoearlyinvestorsintheschemetocreateanimpressionofsuperiorinvestmentper-formance.)Withhindsight,theinvestorsshouldnothavetrustedMadofforthefinancialadviserswhosteeredmoneytoMadoff.Madoff’sPonzischemewas(wehope)aonce-in-a-lifetimeevent.10Mostofthemoneylostbyinvestorsinthecrisisof’08waslosthonestly.Fewinvestorsorinvestmentmanagerssawthecrisiscoming.Whenitarrived,therewaslittletheycoulddotogetoutoftheway.ShouldFirmsBeManagedforShareholdersorAllStakeholders?Itisoftensuggestedthatcompaniesshouldbemanagedonbehalfofallstakeholders,notjustshareholders.Otherstakeholdersincludeemployees,customers,suppliers,andthecom-munitieswherethefirm’splantsandofficesarelocated.Differentcountriestakeverydifferentviewsonthisquestion.IntheU.S.,U.K,andother“Anglo-Saxon”economies,theideaofmaximizingshareholdervalueiswidelyacceptedasthechieffinancialgoalofthefirm.Inothercountries,workers’interestsareputforwardmuchmorestrongly.InGermany,forexample,workersinlargecompanieshavetherighttoelectuptohalfthedirectorstothecompanies’supervisoryboards.Asaresulttheyhaveasignificantroleinthegover-nanceofthefirmandlessattentionispaidtotheshareholders.11InJapanmanagersusuallyputtheinterestsofemployeesandcustomersonaparwith,orevenaheadof,theinterestsofshareholders.Forexample,Toyota’sbusinessphilosophyis“torealizestable,long-termgrowthbyworkinghardtostrikeabalancebetweentherequirementsofpeopleandsociety,theglobalenvironmentandtheworldeconomy...togrowwithallofourstakeholders,includingourcustomers,shareholders,employees,andbusinesspartners.”127SeeL.Guiso,L.Zingales,andP.Sapienza,“TrustingtheStockMarket,”JournalofFinance63(December2008),pp.2557–600.Theauthorsshowthatanindividual’slackoftrustisasignificantimpedimenttoparticipationinthestockmarket.“Lackoftrust”meansasubjectivefearofbeingcheated.8ThequotationisfromWarrenBuffett’sannuallettertotheshareholdersofBerkshireHathaway,March2008.9PonzischemesarenamedafterCharlesPonziwhofoundedaninvestmentcompanyin1920thatpromisedinvestorsunbelievablyhighreturns.HewassoondelugedwithfundsfrominvestorsinNewEngland,takingin$1millionduringonethree-hourperiod.Ponziinvestedonlyabout$30ofthemoneythatheraised,butusedpartofthecashprovidedbylaterinvestorstopaygenerousdividendstotheoriginalinvestors.WithinmonthstheschemecollapsedandPonzistartedafive-yearprisonsentence.10Ponzischemespopupfrequently,butnonehasapproachedthescopeanddurationofMadoff’s.11ThefollowingquotefromtheGermanbankerCarlFürstenberg(1850–1933)offersanextremeversionofhowshareholderswereonceregardedbyGermanmanagers:“Shareholdersarestupidandimpertinent—stupidbecausetheygivetheirmoneytosomebodyelsewithoutanyeffectivecontroloverwhatthepersonisdoingwithitandimpertinentbecausetheyaskforadividendasarewardfortheirstupidity.”QuotedbyM.Hellwig,“OntheEconomicsandPoliticsofCorporateFinanceandCorporateControl,”inCorporateGovernance,ed.X.Vives(Cambridge,U.K.:CambridgeUniversityPress,2000),p.109.12ToyotaAnnualReport,2003,p.10.bbre30735_ch01_001-019.indd11re30735_ch01_001-019.indd11112/1/093:25:43PM2/1/093:25:43PM confirmingpages12PartOneValue"FIGURE1.3(a)Theshareholders(a)WhosecompanyAllstakeholdersJapan3isit?Theviewsof37897managersfromfivecountries.Germany1783(b)WhichismoreFrance22important—jobsecurity78foremployeesorshare-United71holderdividends?The29Kingdomviewsof399managersfromfivecountries.United76States24Source:M.Yoshimori,“WhoseCompanyIsIt?The020406080100ConceptoftheCorporationPercentageofresponsesinJapanandtheWest,”LongRangePlanning,28(August(b)Dividends1995),pp.33–44.CopyrightJobsecurity©1995withpermissionfromJapan3ElsevierScience.97France4060Germany4159United89Kingdom11United89States11020406080100PercentageofresponsesFigure1.3summarizestheresultsofinterviewswithexecutivesfromlargecompaniesinfivecountries.Japanese,German,andFrenchexecutivesthinkthattheirfirmsshouldberunforallstakeholders,whileU.S.andU.K.executivessaythatshareholderscomefirst.Whenaskedaboutthetrade-offbetweenjobsecurityanddividends,mostU.S.andU.K.execu-tivesbelievedividendsshouldcomefirst.Bycontrast,almostallJapaneseexecutivesandthemajorityofGermanandFrenchexecutivesbelievethatjobsecurityshouldcomefirst.Ascapitalmarketshavebecomemoreglobal,therehasbeengreaterpressureforcom-paniesinallcountriestoadoptwealthcreationforshareholdersasaprimarygoal.SomeGermancompanies,includingDaimlerandDeutscheBank,haveannouncedtheirprimarygoalaswealthcreationforshareholders.InJapantherehasbeenlessmovementinthisdirection.Forexample,thechairmanofToyotahassuggestedthatitwouldbeirresponsibletopursueshareholders’interests.Ontheotherhand,theaggregatemarketvalueofToyota’ssharesissignificantlygreaterthanthemarketvaluesofGM’sandFord’s.Soperhapsthereisnottoomuchconflictbetweenthesegoalsinpractice.1-4AgencyProblemsandCorporateGovernanceWehaveemphasizedtheseparationofownershipandcontrolinpubliccorporations.Theowners(shareholders)cannotcontrolwhatthemanagersdo,exceptindirectlythroughtheboardofdirectors.Thisseparationisnecessarybutalsodangerous.Youcanseethedan-gers.Managersmaybetemptedtobuysumptuouscorporatejetsortoschedulebusinessmeetingsattonyresorts.Theymayshyawayfromattractivebutriskyprojectsbecausetheybbre30735_ch01_001-019.indd12re30735_ch01_001-019.indd12112/1/093:25:43PM2/1/093:25:43PM confirmingpagesChapter1GoalsandGovernanceoftheFirm13areworriedmoreaboutthesafetyoftheirjobsthanaboutmaximizingshareholdervalue.Theymayworkjusttomaximizetheirownbonuses,andthereforeredoubletheireffortstomakeandresellflawedsubprimemortgages.Conflictsbetweenshareholders’andmanagers’objectivescreateagencyproblems.Agencyproblemsarisewhenagentsworkforprincipals.Theshareholdersaretheprincipals;themanagersaretheiragents.Agencycostsareincurredwhen(1)managersdonotattempttomaximizefirmvalueand(2)shareholdersincurcoststomonitorthemanagersandcon-straintheiractions.Agencyproblemscansometimesleadtooutrageousbehavior.Forexample,whenDennisKozlowski,theCEOofTyco,threwa$2million40thbirthdaybashforhiswife,hechargedhalfofthecosttothecompany.Thisofcoursewasanextremeconflictofinterest,aswellasillegal.Butmoresubtleandmoderateagencyproblemsarisewhenevermanagersthinkjustalittlelesshardaboutspendingmoneywhenitisnottheirown.PushingSubprimeMortgages:ValueMaximizationRunAmok,oranAgencyProblem?Theeconomiccrisisof2007–200913startedasasubprimecrisis.“Subprime”referstomortgageloansmadetohomebuyerswithweakcredit.Someoftheseloansweremadetonaïvebuyerswhofacedseveredifficultiesinmakinginterestandprincipalpayments.Someloansweremadetoopportunisticbuyerswhowerewillingtogamblethatrealestatepriceswouldkeepincreas-ing.Butrealestatepricesdeclinedsharply,andmanyofthesebuyerswereforcedtodefault.Whydidmanybanksandmortgagecompaniesmaketheseloansinthefirstplace?Onereasonisthattheycouldrepackagetheloansasmortgage-backedsecuritiesandsellthemataprofittootherbanksandtoinstitutionalinvestors.(Wecovermortgage-backedandotherasset-backedsecuritiesinChapter24.)It’sclearwithhindsightthatbuyersofthesesubprimemortgage-backedsecuritieswereinturnnaïveandpaidtoomuch.Whenhous-ingpricesfellanddefaultsincreasedin2007,thepricesofthesesecuritiesfelldrastically.MerrillLynchwroteoff$50billionoflossesonmortgage-backedsecurities,andthecom-panyhadtobesoldunderduresstoBankofAmerica.Othermajorfinancialinstitutions,suchasCitigroupandWachoviaBank,alsorecordedenormouslosses.There’slotsmoretosayaboutthesubprimecrisis,whichwediscussfurtherinChapters13and14.Butfornowjustthinkaboutthebanksandmortgagecompaniesthatoriginatedthesubprimeloansandmadeaprofitbyresellingthem.Withhindsightweseethattheyweresellingdefectiveproductsthatwouldgeneratepainfullossesfortheircustomers.Werethesecompaniesreallypursuingvaluemaximization?Perhapstheyweretryingtomaximizevalueandjustmadeadisastrousmisjudgmentaboutthecourseofhouseprices.Butwethinkitismorelikelythatthecompanieswereawarethatastrategyoforiginatingmassiveamountsofsubprimewaslikelytoendbadly.WashingtonMutual,oneofthemostaggres-siveplayersinthesubprimemarket,quicklyfailedwhenthetruerisksofthesubprimeloanswererevealed.WashingtonMutual’sshareholderswouldsurelynothaveendorsedthecompany’sstrategyiftheyhadunderstoodit.Althoughthereisplentyofblametopassaroundinthesubprimecrisis,someofitmustgotothemanagerswhoactuallypromotedandresoldthesubprimemortgages.Weretheyactinginshareholders’interests,orweretheyactingintheirowninterests,tryingtosqueezeinonemore,fatbonusbeforethegameended?Wethinkthatthemanagerswouldhavethoughtmuchharderabouttheiractionsiftheyhadnothadashort-termselfishinterestinpromotingsubprimemortgages.Ifso,themesswaslargelyanagencyproblem,notvaluemax-imizationrunamok.Agencyproblemsoccurwhenmanagersdonotactinshareholders’interests,butintheirowninterests.13Wewritethischapterinearly2009.Wehopethatthenexteditionofthisbookdoesnotrefertothefinancialcrisisof2007–2010or2007–2011.bbre30735_ch01_001-019.indd13re30735_ch01_001-019.indd13112/1/093:25:43PM2/1/093:25:43PM Rev.confirmingPages14PartOneValueAgencyProblemsAreMitigatedbyGoodSystemsofCorporateGovernanceWereturntoagencyproblemsandtohowtheproblemsaremitigatedinpracticelaterinthetext.Forexample,Chapter12coverscompensationschemesfortopmanagement,whichcanbedesignedtohelpalignmanagers’andshareholders’interests.Fornowwelistsomeofthecharacteristicsofagoodsystemofcorporategovernance,whichensuresthattheshareholders’pocketsareclosetothemanagers’hearts.LegalandRegulatoryRequirementsManagershavealegaldutytoactresponsiblyandintheinterestsofinvestors.Forexample,theU.S.SecuritiesandExchangeCommission(SEC)setsaccountingandreportingstandardsforpubliccompaniestoensureconsistencyandtransparency.TheSECalsoprohibitsinsidertrading,thatis,thepurchaseorsaleofsharesbasedoninformationthatisnotavailabletopublicinvestors.CompensationPlansManagersarespurredonbyincentiveschemesthatproducebigreturnsifshareholdersgainbutarevaluelessiftheydonot.Forexample,LarryEllison,CEOofthebusinesssoftwaregiantOracleCorporation,receivedtotalcompensationfor2007estimatedatbetween$60and$70million.Onlyasmallfraction(amere$1million)ofthatamountwassalary.Alargeramount,abitmorethan$6million,wasbonusandincen-tivepay,andthelion’ssharewasintheformofstockandoptiongrants.ThoseoptionswillbeworthlessifOracle’ssharepricefallsbelowits2007level,butwillbehighlyvalu-ableifthepricerises.Moreover,asfounderofOracle,Ellisonholdsover1billionsharesinthefirm.NoonecansayforcertainhowhardEllisonwouldhaveworkedwithadifferentcompensationpackage.Butonethingisclear:Hehasahugepersonalstakeinthesuccessofthefirm—andinincreasingitsmarketvalue.BoardofDirectorsAcompany’sboardofdirectorsiselectedbytheshareholdersandhasadutytorepresentthem.Boardsofdirectorsaresometimesportrayedaspassivestoogeswhoalwayschampiontheincumbentmanagement.Butresponsetopastcorporatescandalshastippedthebalancetowardgreaterindependence.TheSarbanes-OxleyAct(commonlyknownas“SOX”)requiresthatcorporationsplacemoreindependentdirectorsontheboard,thatis,moredirectorswhoarenotmanagersorarenotaffiliatedwithmanagement.Morethanhalfofalldirectorsarenowindependent.Boardsalsonowmeetinsessionswith-outtheCEOpresent.Inaddition,institutionalshareholders,particularlypensionfundsandhedgefunds,havebecomemoreactiveinmonitoringfirmperformanceandproposingchangestocorporategovernance.Notsurprisingly,morechiefexecutiveshavebeenforcedoutinrecentyears,amongthemtheCEOsofGeneralMotors,MerrillLynch,Starbucks,Yahoo!,AIG,FannieMae,andMotorola.BoardsoutsidetheUnitedStates,whichtraditionallyhavebeenmoremanagement-friendly,havealsobecomemorewillingtoreplaceunderperformingmanag-ers.ThelistofrecentdeparturesincludestheheadsofRoyalBankofScotland,UBS,PSAPeugeotCitroen,Lenovo,Samsung,OldMutual,andSwissRe.MonitoringThecompany’sdirectorsarenottheonlyonestobescrutinizingmanage-ment’sactions.Managersarealsomonitoredbysecurityanalysts,whoadviseinvestorstobuy,hold,orsellthecompany’sshares,andbybanks,whichkeepaneagleeyeonthesafetyoftheirloans.TakeoversCompaniesthatconsistentlyfailtomaximizevaluearenaturaltargetsfortake-oversbyanothercompanyorbycorporateraiders.“Raiders”areprivateinvestmentfundsthatspecializeinbuyingoutandreformingpoorlyperformingcompanies.Takeoversarecommoninindustrieswithslowgrowthandexcesscapacity.Forexample,attheendoftheColdWarin1990,itwasclearthatthedefenseindustrywouldhavebre30735_ch01_001-019.indd141/5/1011:25:26AM confirmingpagesChapter1GoalsandGovernanceoftheFirm15toshrinkdrastically.Awaveofconsolidatingmergersfollowed.WecovertakeoversinChapter31andbuyoutsinChapter32.ShareholderPressureIfshareholdersbelievethatthecorporationisunderperform-ingandthattheboardofdirectorsisnotholdingmanagerstotask,theycanattempttoelectrepresentativestotheboardtomaketheirvoicesheard.Forexample,in2008billionaireshareholderactivistCarlIcahnfeltthatthedirectorsofYahoo!werenotactinginshareholders’interestwhentheyrejectedabidfromMicrosoft.Hethereforeinvested$67millioninYahoo!stock,andmuscledhimselfandtwolike-mindedfriendsontotheYahoo!board.Disgruntledstockholdersalsotakethe“WallStreetWalk”bysellingoutandmovingontootherinvestments.TheWallStreetWalkcansendapowerfulmessage.Ifenoughshare-holdersbailout,thestockpricetumbles.Thisdamagestopmanagement’sreputationandcompensation.Alargepartoftopmanagers’paycheckscomesfromstockoptions,whichpayoffifthestockpricerisesbutareworthlessifthepricefallsbelowastatedthreshold.Thusafallingstockpricehasadirectimpactonmanagers’personalwealth.Arisingstockpriceisgoodformanagersaswellasstockholders.Wedonotwanttoleavetheimpressionthatcorporatelifeisaseriesofsquabblesandendlessmicromanagement.Itisn’t,becausepracticalcorporatefinancehasevolvedtorec-oncilepersonalandcorporateinterests—tokeepeveryoneworkingtogethertoincreasethevalueofthewholepie,notmerelythesizeofeachperson’sslice.FewmanagersatthetopofmajorU.S.corporationsarelazyorinattentivetostockholders’interests.Onthecontrary,thepressuretoperformcanbeintense.WehavegivenabriefoverviewofcorporategovernanceintheU.S.,U.K.,andother“Anglo-Saxon”economies.Governanceworksdifferentlyinothercountries,butwewillnotattemptaworldwidesurveyuntilChapter33.Wewillreturntoagencyproblemsandgovernancemanytimesinintermediatechapters,however.!!!!!Corporationsfacetwoprincipalfinancialdecisions.First,whatinvestmentsshouldtheSUMMARYcorporationmake?Second,howshoulditpayfortheinvestments?Thefirstdecisionistheinvestmentdecision;thesecondisthefinancingdecision.Thestockholderswhoownthecorporationwantitsmanagerstomaximizeitsoverallvalueandthecurrentpriceofitsshares.Thestockholderscanallagreeonthegoalofvaluemaximization,solongasfinancialmarketsgivethemtheflexibilitytomanagetheirownsavingsandinvestmentplans.Ofcourse,theobjectiveofwealthmaximizationdoesnotjustifyunethicalbehavior.Shareholdersdonotwantthemaximumpossiblestockprice.Theywantthemaximumhonestshareprice.Howcanfinancialmanagersincreasethevalueofthefirm?Mostlybymakinggoodinvestmentdecisions.Financingdecisionscanalsoaddvalue,andtheycansurelydestroyvalueifyouscrewthemup.Butit’susuallytheprofitabilityofcorporateinvestmentsthatseparatesvaluewinnersfromtherestofthepack.Investmentdecisionsforceatrade-off.Thefirmcaneitherinvestcashorreturnittoshareholders,forexample,asanextradividend.Whenthefirminvestscashratherthanpayingitout,shareholdersforgotheopportunitytoinvestitforthemselvesinfinancialmarkets.Thereturnthattheyaregivingupisthereforecalledtheopportunitycostofcapi-tal.Ifthefirm’sinvestmentscanearnareturnhigherthantheopportunitycostofcapital,shareholderscheerandstockpriceincreases.Ifthefirminvestsatareturnlowerthantheopportunitycostofcapital,shareholdersbooandstockpricefalls.Visitusatwww.mhhe.com/bmabbre30735_ch01_001-019.indd15re30735_ch01_001-019.indd15112/1/093:25:44PM2/1/093:25:44PM confirmingpages16PartOneValueManagersarenotendowedwithaspecialvalue-maximizinggene.Theywillconsidertheirownpersonalinterests,whichcreatesapotentialconflictofinterestwithoutsideshare-holders.Thisconflictiscalledaprincipal–agentproblem.Anylossofvaluethatresultsiscalledanagencycost.Corporategovernancehelpstoalignmanagers’andshareholders’interests,sothatman-agerspaycloseattentiontothevalueofthefirm.Forexample,managersareappointedby,andsometimesfiredby,theboardofdirectors,whoaresupposedtorepresentshareholders.Themanagersarespurredonbyincentiveschemes,suchasgrantsofstockoptions,whichpayoffbigonlyifthestockpriceincreases.Ifthecompanyperformspoorly,itismorelikelytobetakenover.Thetakeovertypicallybringsinafreshmanagementteam.Rememberthefollowingthreethemes,foryouwillseethemagainandagainthroughoutthisbook:1.Maximizingvalue.2.Theopportunitycostofcapital.3.Thecrucialimportanceofincentivesandgovernance.!!!!!SelectproblemsareavailableinMcGraw-HillConnect.Pleaseseetheprefaceformoreinformation.PROBLEMSETSBASIC1.Readthefollowingpassage:“Companiesusuallybuy(a)assets.Theseincludebothtangibleassetssuchas(b)andintangibleassetssuchas(c).Topayfortheseassets,theysell(d)assetssuchas(e).Thedecisionaboutwhichassetstobuyisusuallytermedthe(f)or(g)decision.Thedecisionabouthowtoraisethemoneyisusuallytermedthe(h)decision.”Nowfiteachofthefollowingtermsintothemostappropriatespace:financing,real,bonds,investment,executiveairplanes,financial,capitalbudgeting,brandnames.2.Whichofthefollowingarerealassets,andwhicharefinancial?a.Ashareofstock.b.ApersonalIOU.c.Atrademark.d.Afactory.e.Undevelopedland.f.Thebalanceinthefirm’scheckingaccount.g.Anexperiencedandhardworkingsalesforce.h.Acorporatebond.3.Vocabularytest.Explainthedifferencesbetween:a.Realandfinancialassets.b.Capitalbudgetingandfinancingdecisions.c.Closelyheldandpubliccorporations.d.Limitedandunlimitedliability.4.Whichofthefollowingstatementsalwaysapplytocorporations?a.Unlimitedliability.b.Limitedlife.c.Ownershipcanbetransferredwithoutaffectingoperations.d.Managerscanbefiredwithnoeffectonownership.Visitusatwww.mhhe.com/bmabbre30735_ch01_001-019.indd16re30735_ch01_001-019.indd16112/1/093:25:44PM2/1/093:25:44PM confirmingpagesChapter1GoalsandGovernanceoftheFirm175.Whichofthefollowingstatementsmoreaccuratelydescribethetreasurerthanthecontroller?a.Responsibleforinvestingthefirm’ssparecash.b.Responsibleforarranginganyissueofcommonstock.c.Responsibleforthecompany’staxaffairs.INTERMEDIATE6.Inmostlargecorporations,ownershipandmanagementareseparated.Whatarethemainimplicationsofthisseparation?7.F&HCorp.continuestoinvestheavilyinadecliningindustry.HereisanexcerptfromarecentspeechbyF&H’sCFO:WeatF&Hhaveofcoursenotedthecomplaintsofafewspinelessinvestorsanduninformedsecurityanalystsabouttheslowgrowthofprofitsanddividends.Unlikethoseconfirmeddoubters,wehaveconfidenceinthelong-rundemandformechanicalencabulators,despitecompetingdigitalproducts.Wearethereforedeterminedtoinvesttomaintainourshareoftheoverallencabulatormarket.F&HhasarigorousCAPEXapprovalprocess,andweareconfidentofreturnsaround8%oninvestment.That’safarbetterreturnthanF&Hearnsonitscashholdings.TheCFOwentontoexplainthatF&Hinvestedexcesscashinshort-termU.S.governmentsecurities,whicharealmostentirelyrisk-freebutofferedonlya4%rateofreturn.a.Isaforecasted8%returnintheencabulatorbusinessnecessarilybetterthana4%safereturnonshort-termU.S.governmentsecurities?Whyorwhynot?b.IsF&H’sopportunitycostofcapital4%?HowinprincipleshouldtheCFOdeterminethecostofcapital?8.Wecanimaginethefinancialmanagerdoingseveralthingsonbehalfofthefirm’sstockholders.Forexample,themanagermight:a.Makeshareholdersaswealthyaspossiblebyinvestinginrealassets.b.Modifythefirm’sinvestmentplantohelpshareholdersachieveaparticulartimepatternofconsumption.c.Choosehigh-orlow-riskassetstomatchshareholders’riskpreferences.d.Helpbalanceshareholders’checkbooks.Butinwell-functioningcapitalmarkets,shareholderswillvoteforonlyoneofthesegoals.Whichone?Why?9.Ms.Espinozaisretiredanddependsonherinvestmentsforherincome.Mr.Liuisayoungexecutivewhowantstosaveforthefuture.BotharestockholdersinScaledComposites,LLC,whichisbuildingSpaceShipOnetotakecommercialpassengersintospace.Thisinvestment’spayoffismanyyearsaway.AssumeithasapositiveNPVforMr.Liu.ExplainwhythisinvestmentalsomakessenseforMs.Espinoza.10.Ifafinancialinstitutioniscaughtupinafinancialscandal,wouldyouexpectitsvaluetofallbymoreorlessthantheamountofanyfinesandsettlementpayments?Explain.11.Whymightoneexpectmanagerstoactinshareholders’interests?Givesomereasons.12.Manyfirmshavedeviseddefensesthatmakeitmoredifficultorcostlyforotherfirmstotakethemover.Howmightsuchdefensesaffectthefirm’sagencyproblems?Aremanagersoffirmswithformidabletakeoverdefensesmoreorlesslikelytoactintheshareholders’interestsratherthantheirown?Whatwouldyouexpecttohappentothesharepricewhenmanagementproposestoinstitutesuchdefenses?Visitusatwww.mhhe.com/bmabbre30735_ch01_001-019.indd17re30735_ch01_001-019.indd17112/1/093:25:44PM2/1/093:25:44PM confirmingpages18PartOneValueAPPENDIX!!!!!FoundationsoftheNetPresentValueRuleWehavesuggestedthatwell-functioningfinancialmarketsallowdifferentinvestorstoagreeontheobjectiveofmaximizingvalue.Thisideaissufficientlyimportantthatweneedtopauseandexamineitmorecarefully.HowFinancialMarketsReconcilePreferencesforCurrentvs.FutureConsumptionSupposethattherearetwopossibleinvestorswithentirelydifferentpreferences.ThinkofAasanant,whowishestosaveforthefuture,andofGasagrasshopper,whowouldprefertospendallhiswealthonsomeephemeralfrolic,takingnoheedoftomorrow.Supposethateachhasanesteggofexactly$100,000incash.Gchoosestospendallofittoday,whileApreferstoinvestitinthefinancialmarket.Iftheinterestrateis10%,Awouldthenhave1.10#$100,000!$110,000tospendayearfromnow.Ofcourse,therearemanypossibleintermediatestrategies.Forexample,AorGcouldchoosetosplitthedifference,spending$50,000nowandputtingtheremaining$50,000toworkat10%toprovide1.10#$50,000!$55,000nextyear.TheentirerangeofpossibilitiesisshownbythegreenlineinFigure1A.1.Inourexample,Ausedthefinancialmarkettopostponeconsumption.Butthemarketcanalsobeusedtobringconsumptionforwardintime.Let’sillustratebyassumingthatinsteadofhavingcashonhandof$100,000,ourtwofriendsareduetoreceive$110,000eachattheendoftheyear.InthiscaseAwillbehappytowaitandspendtheincomewhenitarrives.Gwillprefertoborrowagainsthisfutureincomeandpartyitawaytoday.Withaninterestrateof10%,Gcanborrowandspend$110,000/1.10!$100,000.Thusthefinancialmarketprovidesakindoftimemachinethatallowspeopletoseparatethetimingoftheirincomefromthatoftheirspending.Noticethatwithaninterestrateof10%,AandGareequallyhappywithcashonhandof$100,000oranincomeof$110,000attheendoftheyear.Theydonotcareaboutthetimingofthecashflow;theyjustpreferthecashflowthathasthehighestvaluetoday($100,000inourexample).InvestinginRealAssetsInpracticeindividualsarenotlimitedtoinvestinginfinancialmar-kets;theymayalsoacquireplant,machinery,andotherrealassets.Forexample,supposethatAandGareofferedtheopportunitytoinvesttheir$100,000inanewbusinessthatafriendisfounding.Thiswillproduceaone-offsurefirepaymentof$121,000nextyear.Awouldclearlybehappytoinvestinthebusiness.Itwillprovideherwith$121,000tospendattheendoftheyear,ratherthanthe$110,000thatshegetsbyinvestingher$100,000inthefinancialmarket.ButwhataboutG,whowantsmoneynow,notinoneyear’stime?Hetooishappytoinvest,aslongashecanborrowagainstthefuturepayoffoftheinvestmentproject.Ataninterestrateof"FIGURE1A.1DollarsnextyearThegreenlineshowsthepossiblespendingpatternsforTheantconsumeshere$121,000theantandgrasshopperiftheyinvest$100,000inthecapital$110,000market.Themaroonlineshowsthepossiblespendingpatternsiftheyinvestintheirfriend’sbusiness.BotharebetteroffbyinvestingintheThegrasshopperbusinessaslongasthegrass-consumesherehoppercanborrowagainstthe$100,000$110,000DollarsnowVisitusatwww.mhhe.com/bmafutureincome.bbre30735_ch01_001-019.indd18re30735_ch01_001-019.indd18112/1/093:25:44PM2/1/093:25:44PM Rev.confirmingPagesChapter1GoalsandGovernanceoftheFirm1910%,Gcanborrow$110,000andsowillhaveanextra$10,000tospendtoday.BothAandGarebetteroffinvestingintheirfriend’sventure.Theinvestmentincreasestheirwealth.ItmovesthemupfromthegreentothemaroonlineinFigure1A.1.ACrucialAssumptionThekeyconditionthatallowsAandGtoagreetoinvestinthenewven-tureisthatbothhaveaccesstoawell-functioning,competitivecapitalmarket,inwhichtheycanborrowandlendatthesamerate.Wheneverthecorporation’sshareholdershaveequalaccesstocompetitivecapitalmarkets,thegoalofmaximizingmarketvaluemakessense.Itiseasytoseehowthisrulewouldbedamagedifwedidnothavesuchawell-functioningcapitalmarket.Forexample,supposethatGcouldnoteasilyborrowagainstfutureincome.Inthatcasehemightwellprefertospendhiscashtodayratherthaninvestitinthenewventure.IfAandGwereshareholdersinthesameenterprise,Awouldbehappyforthefirmtoinvest,whileGwouldbeclamoringforhighercurrentdividends.Noonebelievesunreservedlythatcapitalmarketsfunctionperfectly.Laterinthisbookwediscussseveralcasesinwhichdifferencesintaxation,transactioncosts,andotherimperfectionsmustbetakenintoaccountinfinancialdecisionmaking.However,wealsodiscussresearchindicatingthat,ingeneral,capitalmarketsfunctionfairlywell.Inthiscasemaximizingshare-holdervalueisasensiblecorporateobjective.Butfornow,havingglimpsedtheproblemsofimperfectmarkets,weshall,likeaneconomistinashipwreck,simplyassumeourlifejacketandswimsafelytoshore.QUESTIONS1.LookbacktothenumericalexamplegraphedinFigure1A.1.Supposetheinterestrateis20%.Whatwouldtheant(A)andgrasshopper(G)doiftheybothstartwith$100,000?Wouldtheyinvestintheirfriend’sbusiness?Wouldtheyborroworlend?Howmuchandwhenwouldeachconsume?2.AnswerthisquestionbydrawinggraphslikeFigure1A.1.CasperMilktoasthas$200,000availabletosupportconsumptioninperiods0(now)and1(nextyear).Hewantstocon-sumeexactlythesameamountineachperiod.Theinterestrateis8%.Thereisnorisk.a.Howmuchshouldheinvest,andhowmuchcanheconsumeineachperiod?b.SupposeCasperisgivenanopportunitytoinvestupto$200,000at10%risk-free.Theinterestratestaysat8%.Whatshouldhedo,andhowmuchcanheconsumeineachperiod?Visitusatwww.mhhe.com/bmabre30735_ch01_001-019.indd1912/10/095:12:20PM