Chapter 01: Introduction

....................Md. Jobayair Ibna Rafiq....................

Would the U.S. Government Be an Effective Board Director?

In response to the global economic crisis that began with the recession of 2007, many governments

became major stakeholders in companies that had been publicly traded. For example, the U.S. government

invested billions in Fannie Mae and Freddie Mac, taking them into conservatorship and having a direct say

in their leadership and operations, including the dismissal of former Fannie Mae CEO Daniel Mudd in

2008.

The U.S. government also made multibillion-dollar investments in banks (among them, Citigroup, Bank of

America, JPMorgan Chase, and Wells Fargo), insurance companies, AIG (spectacularly), and auto

companies (GM and Chrysler). Much of this was in the form of preferred stock, which did not give the

government any direct voting or decision-making authority. However, the government has certainly applied

moral suasion, as evidenced by the removal of GM’s former CEO Rick Wagoner. The government also

imposed limits on executive compensation at firms receiving additional government funds.

For the most part, however, the government did not have voting rights with bailout recipients, nor did it

have representation on their boards of directors. It will be interesting to see whether this changes and

whether the government takes a more direct role in corporate governance.

Many large banks, including Citigroup, Goldman Sachs, and JPMorgan Chase, have repaid the government’s

investments. In fact, as of early 2017, when dividends and other payments are included, the TARP funds

have returned a small profit to the Treasury, and virtually all of the TARP loans have been repaid. The

other bailouts have also earned a profit, although not all have been completely repaid.

Sources: See www.treasury.gov/initiatives/financial-stability /reports/Pages/daily-tarp-reports.aspx for updates on

TARP recipients. See http://projects.propublica.org/bailout/list for a more comprehensive list that includes the

bailouts funded through other programs, such as the bailout of Fannie Mae

Chapte

1
r
Introduction
LEARNING OBJECTIVES
Chapter Outline
1.1. Finance and Business
1.2. An Overview of Corporate Finance
1.3. The Goals of Financial Management
1.4. The Agency Problem and Control of the Corporation

1.1. Finance and Business

The field of finance is broad and dynamic. Finance influences everything that firms do, from
hiring personnel to building factories to launching new advertising campaigns. Because there are
important financial dimensions to almost any aspect of business, there are many financially
oriented career opportunities for those who understand the principles of finance. Even if you do
not see yourself pursuing a career in finance, you’ll find that an understanding of a few key
ideas in finance will help make you a smarter consumer and a wiser investor with your own money.

1.1.1. What is Finance?

Finance can be defined as the science and art of managing money. At the personal level, finance
is concerned with individuals’ decisions about how much of their earnings they spend, how much
they save, and how they invest their savings. In a business context, finance involves the same
types of decisions: how firms raise money from investors, how firms invest money in an attempt
to earn a profit, and how they decide whether to reinvest profits in the business or distribute
them back to investors.

Review Questions
1. Explain Finance.

1.1.2. Career Opportunities In Finance

Careers in finance typically fall into one of two broad categories: (1) financial services and (2)
managerial finance. Workers in both areas rely on a common analytical “tool kit,” but the types
of problems to which that tool kit is applied vary a great deal from one career path to the
other.

Financial Services. Financial services is the area of finance concerned with the design and
delivery of advice and financial products to individuals, businesses, and governments. It involves
a variety of interesting career opportunities within the areas of banking, personal financial
planning, investments, real estate, and insurance.

Managerial Finance. Managerial finance is concerned with the duties of the financial manager
working in a business. Financial managers administer the financial affairs of all types of
businesses: private and public, large and small, profit seeking and not for profit. They perform
such varied tasks as developing a financial plan or budget, extending credit to customers,
evaluating proposed large expenditures, and raising money to fund the firm’s operations.

Challenges of Financial Manager. In recent years, a number of factors have increased the
importance and complexity of the financial manager’s duties. These factors include the recent
global financial crisis and subsequent responses by regulators, increased competition, and
technological change. Globalization has led corporations to increase their transactions in other
countries, and foreign corporations have done likewise in the world. These changes increase
demand for financial experts who can manage cash flows in different currencies and protect
against the risks that arise from international transactions. These changes increase the finance
function’s complexity, but they also create opportunities for a more rewarding career. The
increasing complexity of the financial manager’s duties has increased the popularity of a variety
of professional certification programs: Certified Financial Analyst (CFA), Certified Treasury
Professional (CTP), Certified Financial Planner (CFP), American Academy Of Financial
Management (AAFM), Professional Certifications In Accounting. Financial managers today
actively develop and implement corporate strategies aimed at helping the firm grow and improve
its competitive position. As a result, many corporate presidents and chief executive officers
(CEOs) rose to the top of their organizations by first demonstrating excellence in the finance
function.

Review Questions
1. What are the career opportunities in finance? What are challenges of financial managers?

1.1.3. Legal Form in Business

One of the most important decisions all businesses confront is how to choose a legal form of
organization. This decision has very important financial implications because how a business is
organized legally influences the risks that the firm’s owners must bear, how the firm can raise
money, and how the firm’s profits will be taxed. The three most common legal forms of business
organization are the sole proprietorship, the partnership, and the corporation. More businesses
are organized as sole proprietorships than any other legal form, but the largest businesses are
almost always organized as corporations. Even so, each type of organization has its advantages
and disadvantages.

1.1.3.1. Sole Proprietorships

A sole proprietorship is a business owned by one person who operates it for his or her own
profit. The typical sole proprietorship is small, such as a bike shop, personal trainer, or plumber.
The majority of sole proprietorships operate in the wholesale, retail, service, and construction
industries. Typically, the owner (proprietor), along with a few employees, operates the
proprietorship. The proprietor raises capital from personal resources or by borrowing, and he or
she is responsible for all business decisions. As a result, this form of organization appeals to
entrepreneurs who enjoy working independently. A major drawback to the sole proprietorship is
unlimited liability, which means that liabilities of the business are the entrepreneur’s
responsibility and that creditors can make claims against the entrepreneur’s personal assets if
the business fails to pay its debts. The key strengths and weaknesses of sole proprietor ships
are:

Strengths Weaknesses
 Owner receives all profits (and sustains  Owner has unlimited liability in that total
all losses) wealth can be taken to satisfy debts
 Low organizational costs  Limited fund-raising power tends to inhibit
 Income included and taxed on growth
proprietor’s personal tax return  Proprietor must be jack-of-all trades
 Independence  Difficult to give employees long run career
 Secrecy opportunities
 Ease of dissolution  Lacks continuity when proprietor dies

Review Questions
 1. Explain sole proprietorship with strengths and weaknesses.

1.1.3.2. Partnerships

A partnership consists of two or more owners doing business together for profit. Partnerships
are typically larger than sole proprietorships. Partnerships are common in the finance, insurance,
and real estate industries. Public accounting and law partnerships often have large numbers of
partners. Most partnerships are established by a written contract known as articles of
partnership.

In a general (or regular) partnership, all partners have unlimited liability, and each partner is
legally liable for all of the debts of the partnership. Table summarizes the strengths and
weaknesses of partnerships.

Strengths Weaknesses
 Can raise more funds than sole  Owners have unlimited liability and may
proprietorships have to cover debts of other partners
 Borrowing power enhanced by more owners  Partnership is dissolved when a partner
 More available brain power and managerial dies
skill  Difficult to liquidate or transfer
 Income included and taxed on partner’s partnership
personal tax return

Review Questions
1. Explain Partnership with strengths and weaknesses.

1.1.3.3. Corporations

A corporation is an entity created by law. A corporation has the legal powers of an individual in
that it can sue and be sued, make and be party to contracts, and acquire property in its own
name. The largest businesses nearly always are; corporations account for roughly 80 percent of
total business revenues. Although corporations engage in all types of businesses, manufacturing
firms account for the largest portion of corporate business receipts and net profits.

The owners of a corporation are its stockholders, whose ownership, or equity, takes the form of
common stock or, less frequently, preferred stock. Unlike the owners of sole proprietorships or
partnerships, stockholders of a corporation enjoy limited liability, meaning that they are not
personally liable for the firm’s debts. Their losses are limited to the amount they invested in
the firm when they purchased shares of stock. Common stock is the purest and most basic form
of corporate ownership. Stockholders expect to earn a return by receiving dividends—periodic
distributions of cash—or by realizing gains through increases in share price. Because the money
to pay dividends generally comes from the profits that a firm earns, stockholders are
sometimes referred to as residual claimants, meaning that stockholders are paid last, after
employees, suppliers, tax authorities, and lenders receive what they are owed. If the firm does
not generate enough cash to pay everyone else, there is nothing available for stockholders.
The stockholders (owners) vote periodically to elect members of the board of directors and to
decide other issues such as amending the corporate charter. The board of directors is typically
responsible for approving strategic goals and plans, setting general policy, guiding corporate
affairs, and ap proving major expenditures. Most importantly, the board decides when to hire or
fire top managers and establishes compensation packages for the most senior executives. The
board consists of “inside” directors, such as key corporate executives, and “outside” or
“independent” directors, such as executives from other companies, major shareholders, and
national or community leaders. Outside directors for major corporations receive compensation in
the form of cash, stock, and stock options.

The president or chief executive officer (CEO) is responsible for managing day-to-day
operations and carrying out the policies established by the board of directors. The CEO reports
periodically to the firm’s directors. Table lists the key strengths and weaknesses of
corporations.

Strengths Weaknesses
 Owners have limited liability, which  Taxes are generally higher because corporate
guarantees that they cannot lose more income is taxed, and dividends paid to owners
than they invested are also taxed.
 Can achieve large size via sale of  More expensive to organize than other
ownership (stock) business forms
 Ownership (stock) is readily  Subject to greater government regulation
transferable  Lacks secrecy because regulations require
 Long life of firm firms to disclose financial results
 Can hire professional managers
 Has better access to financing

Review Questions
1. Explain corporation with strengths and weaknesses.

1.1.3.4. Other Limited Liability Organizations

A number of other organizational forms provide owners with limited liability. The most popular
are limited partnership (LP), S corporation (S corp), limited liability company (LLC), and limited
liability partnership (LLP). Each represents a specialized form or blending of the
characteristics of the organizational forms described previously. What they have in common is
that their owners enjoy limited liability, and they typically have fewer than 100 owners.

S corporation (S corp) A tax-reporting entity that allows certain corporations with 100 or
fewer stockholders to choose to be taxed as partnerships. Its stockholders receive the
organizational benefits of a corporation and the tax advantages of a partnership

Limited liability company (LLC) Permitted in most states, the LLC gives its owners limited
liability and taxation as a partnership. But unlike an S corp, the LLC can own more than 80% of
another corporation, and corporations, partnership, or non-U.S. Residents can own LLC shares.
Limited liability partnership (LLP) Permitted in most states, LLP partners are liable for their
own acts of malpractice, but not for those of other partners. The LLP is taxed as a partnership
and is frequently used by legal and accounting professionals.

Review Questions
1. Explain S Corp, LLC and LLP.
2. Explain the three legal forms of business with strengths and weaknesses.
Concept Questions
3. What is finance? Explain how this field affects all the activities in which businesses
engage.
4. What is the financial services area of finance? Describe the field of managerial finance.
5. Which legal form of business organization is most common? Which form is dominant in
terms of business revenues?
6. Describe the roles and the relationships among the major parties in a corporation:
stockholders, board of directors, and managers. How are corporate owners rewarded for
the risks they take?
7. Briefly name and describe some organizational forms other than corporations that provide
owners with limited liability.
8. Why is the study of managerial finance important to your professional life regardless of
the specific area of responsibility you may have within the business firm? Why is it
important to your personal life?

1.2. An Overview of Corporate Finance

1.2.1. Balance Sheet Model of Firm

Suppose we take a financial snapshot
of the firm and its activities at a
single point in time. shows a graphic
conceptualization of the balance
sheet, and it will help introduce you to
corporate finance. In a balance sheet,
there are two sides:

Assets: The assets of the firm are

on the left side of the balance sheet.
These assets can be thought of as
current and fixed.
Fixed assets are those that will last a
long time, such as buildings. Some
fixed assets are tangible, such as
machinery and equipment. Other
fixed assets are intangible, such as Figure 1: The Balance Sheet Model of the Firm
patents and trademarks.
Current assetscomprises those that have short lives, such as inventory.
Financing: Before a company can invest in an asset, it must obtain financing, which means that it
must raise the money to pay for the investment. The forms of financing are represented on the
right side of the balance sheet. A firm will issue (sell) pieces of paper called debt (loan
agreements) or equity shares (stock certificates). Just as assets are classified as long-lived or
short-lived, so too are liabilities.
A short term debt is called a current liability. Short-term debt represents loans and other
obligations that must be repaid within one year. Long-term debt is debt that does not have to be
repaid within one year.
Shareholders’ equity represents the difference between the value of the assets and the debt
of the firm. In this sense, it is a residual claim on the firm’s assets.
Review Questions
1. What is the balance sheet model of firm? How is it related with corporate finance?

1.2.2. What is Corporate Finance?

Corporate finance, broadly speaking, is the study of ways to answer these three questions. From
the balance sheet model of the firm, it is easy to see why finance can be thought of as the
study of the following three questions:
1. In what long-lived assets should the firm invest? That is, what lines of business will you be in
and what sorts of buildings, machinery, and equipment will you need?
Capital Budgeting: This question concerns the left side of the balance sheet. Of course the
types and proportions of assets the firm needs tend to be set by the nature of the business.
We use the term capital budgeting to describe the process of making and managing
expenditures on long-lived assets.
2. How can the firm raise cash for required capital expenditures? or Where will you get the
long-term financing to pay for your investment? Will you bring in other owners or will you
borrow the money?
Capital Structure: This question concerns the right side of the balance sheet. The answer to
this question involves the firm’s capital structure, which represents the proportions of the
firm’s financing from current and long-term debt and equity.
3. How should short-term operating cash flows be managed? or How will you manage your
everyday financial activities such as collecting from customers and paying suppliers?
Working Capital Management: This question concerns the upper portion of the balance sheet.
There is often a mismatch between the timing of cash inflows and cash outflows during
operating activities. Furthermore, the amount and timing of operating cash flows are not known
with certainty. Financial managers must attempt to manage the gaps in cash flow. From a balance
sheet perspective, short-term management of cash flow is associated with a firm’s net working
capital. Net working capital is defined as current assets minus current liabilities. From a
financial perspective, short-term cash flow problems come from the mismatching of cash
inflows and outflows. This is the subject of short-term finance.
Concept Questions:
2. What is corporate finance? what are the three things that corporate finance is concerned
about?
1.2.3. Why Study Corporate Finance?

An understanding of the concepts, techniques, and practices of corporate finance will fully
acquaint you with the financial manager’s activities and decisions. Because the consequences of
most business decisions are measured in financial terms, the financial manager plays a key
operational role. To improve your chance of success in your chosen business career, you still will
need to understand how financial managers think. Whether you are hiring new workers,
negotiating an advertising budget, or upgrading the technology used in a manufacturing process,
understanding the financial aspects of your actions will help you gain the resources you need to
be successful.
Although we focus on publicly held profit-seeking firms, the principles presented are equally
applicable to private and not-for-profit organizations. The decision-making principles developed
can also be applied to personal financial decisions. First exposure to the exciting field of finance
will provide the foundation and initiative for further study and possibly even a future career.As
you study, you will learn about the career opportunities in corporate finance, which are briefly
below:

Financial Analyst.Financial analyst prepares the firm’s financial plans and budgets. Other duties
include financial forecasting, performing financial comparisons, and working closely with
accounting.
Capital Expenditures Manager.Capital expenditures manager evaluates and recommends
proposed long-term investments. May be involved in the financial aspects of implementing
approved investments.
Project Finance Manager.Project finance manager arranges financing for approved long-term
investments. Coordinates consultants, investment bankers, and legal counsel.
Cash Manager.Cash manager maintains and controls the firm’s daily cash balances. Frequently
manages the firm’s cash collection and disbursement activities and short-term investments and
coordinates short-term borrowing and banking relationships.
Credit Analyst/Manager.Credit analyst/manager administers the firm’s credit policy by
evaluating credit applications, extending credit, and monitoring and collecting accounts
receivable.
Pension Fund Manager.Pension fund manageroversees or manages the assets and liabilities of
the employees’ pension fund.
Foreign Exchange Manager.Foreign exchange manager manages specific foreign operations and
the firm’s exposure to fluctuations in exchange rates.
Review Questions
1. What are the career opportunities in corporate finance?
1.2.4. The Financial Manager
A striking feature of large
corporations is that the owners
(the stockholders) are usually
not directly involved in making
business decisions, particularly
on a day-to-day basis. Instead,
the corporation employs
managers to represent the
owners’ interests and make
decisions on their behalf. In a
large corporation, the financial
manager would be in charge of
answering the three questions
we raised in the preceding
section.
In figure -02, The financial
management function is usually
associated with a top officer of
the firm, such as a vice
Figure 2: A Sample Simplified Organizational Chart
president of finance or some
other chief financial officer (CFO).The chart is a simplified organizational chart that highlights
the finance activity in a large firm. As shown, the vice president of finance coordinates the
activities of the treasurer and the controller.
The controller’s office handles cost and financial accounting, tax payments, and management
information systems. The treasurer’s office is responsible for managing the firm’s cash and
credit, its financial planning, and its capital expenditures.
The treasury activities are all related to the three general questions raised earlier, and the
chapters ahead deal primarily with these issues. Our corporate finance study thus bears mostly
on activities usually associated with the treasurer’s office.

Primary Activities of The Financial Manager

In addition to ongoing involvement in financial analysis and planning, the financial manager’s
primary activities are making investment and
financing decisions. Investment decisions
determine what types of assets the firm
holds. Financing decisions determine how the
firm raises money to pay for the assets in
which it invests. One way to visualize the
difference between a firm’s investment and
financing decisions is to refer to the
Figure 3: Financial Activities: Primary activities of the financial
balance sheet shown in Figure-3. Investment
manager
decisions generally refer to the items that
appear on the left-hand side of the balance sheet, and financing decisions relate to the items on
the right-hand side. Keep in mind, though, that financial managers make these decisions based
on their effect on the value of the firm, not on the accounting principles used to construct a
balance sheet.

Review Questions
1. What are the primary activities of financial manager?
2. Explain the role of a financial manager for a firm
Concept Questions
3. Between controller and treasurer functions, what functions does corporate finance deal
with?

1.2.5. Corporate Finance (Financial Management) Decisions

As the preceding discussion suggests, the financial manager must be concerned with three basic
types of questions. We consider these in greater detail next.

Capital Budgeting:
Capital budgeting concerns the firm’s long-term investments. The process of planning and
managing a firm’s long-term investments is called capital budgeting. In capital budgeting, the
financial manager tries to identify investment opportunities that are worth more to the firm
than they cost to acquire. Loosely speaking, this means that the value of the cash flow
generated by an asset exceeds the cost of that asset. The types of investment opportunities
that would typically be considered depend in part on the nature of the firm’s business. For
example, for a large retailer such as Wal-Mart, deciding whether to open another store would
be an important capital budgeting decision.

Capital Budgeting Decision: Regardless of the specific nature of an opportunity under

consideration, financial managers must be concerned not only with how much cash they expect
to receive, but also with when they expect to receive it and how likely they are to receive it.
Evaluating the size, timing, and riskof future cash flows is the essence of capital budgeting.

Capital Structure:
Capital Structurefor the financial manager concerns ways in which the firm obtains and manages
the long-term financing it needs to support its long term investments. A firm’s capital
structure(or financial structure) is the specific mixture of long-term debt and equity the firm
uses to finance its operations. The financial manager has two concerns in this area.

Capital Structure Decision: First decision is that the firm has to take how much the firm
should borrow and the best mixture of debt and equity. The mixture chosen will affect both the
risk and the value of the firm. If we picture the firm as a pie, then the firm’s capital structure
determines how that pie is sliced—in other words, what percentage of the firm’s cash flow goes
to creditors and what percentage goes to shareholders. Firms have a great deal of flexibility in
choosing a financial structure. The question of whether one structure is better than any other
for a particular firm is the heart of the capital structure issue.
Second one is what the least expensive sources of funds for the firm are. In addition to
deciding on the financing mix, the financial manager has to decide exactly how and where to
raise the money. The expenses associated with raising long-term financing can be considerable,
so different possibilities must be carefully evaluated. Also, corporations borrow money from a
variety of lenders in a number of different, and sometimes exotic, ways. Choosing among lenders
and among loan types is another job handled by the financial manager.

Working Capital Management:

The term working capitalrefers to a firm’s short-term assets, such as inventory, and its short-
term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-
day activity that ensures that the firm has sufficient resources to continue its operations and
avoid costly interruptions. This involves a number of activities related to the firm’s receipt and
disbursement of cash.
Working Capital Decision: Some questions about working capital that must be answered are the
following:
(1) How much cash and inventory should we keep on hand?
(2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them?
(3) How will we obtain any needed short-term financing? Will we purchase on credit or will we
borrow in the short term and pay cash? If we borrow in the short term, how and where should
we do it? These are just a small sample of the issues that arise in managing a firm’s working
capital.
Conclusion:The three areas of corporate financial management we have described— capital
budgeting, capital structure, and working capital management—are very broad categories. Each
includes a rich variety of topics, and we have indicated only a few questions that arise in the
different areas. The chapters ahead contain greater detail.

Review Question
1. What are the important decisions to be taken by a financial manager? Explain
2. What is the capital budgeting decision?
Concept Questions
3. What do you call the specific mixture of long-term debt and equity that a firm chooses to
use? or Describe capital structure. What are the two capital structure decisions?
4. Into what category of financial management does cash management fall?

1.3. The Goals of Financial Management

What goal should managers pursue? There is no shortage of possible answers to this question.
Some might argue that managers should focus entirely on satisfying customers. Progress toward
this goal could be measured by the market share attained by each of the firm’s products.
Others suggest that managers must first inspire and motivate employees; in that case, employee
turnover might be the key success metric to watch. Clearly, the goal managers select will affect
many of the decisions they make, so choosing an objective is a critical determinant of how
businesses operate.
Assuming that we restrict ourselves to for-profit businesses, the goal of financial management
is to make money or add value for the owners. This goal is a little vague, of course, so we
examine some different ways of formulating it to come up with a more precise definition. Such a
definition is important because it leads to an objective basis for making and evaluating financial
decisions.

1.3.1. Possible Goals of Financial Management

The goals listed below are all different, but they tend to fall into two classes. The first of
these relates to profitability. The goals involving sales, market share, and cost control all
relate, at least potentially, to different ways of earning or increasing profits.
The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in
some way to controlling risk. Unfortunately, these two types of goals are somewhat
contradictory. The pursuit of profit normally involves some element of risk, so it isn’t really
possible to maximize both safety and profit. What we need, therefore, is a goal that
encompasses both factors.If we were to consider possible financial goals, we might come up with
some ideas like the following:
Maximize Profits.Profit maximization would probably be the most commonly cited goal, but even
this is not a precise objective. The goal of maximizing profits may refer to some sort of “long-
run” or “average” profits, but it’s still unclear exactly what this means. These accounting
numbers may have little to do with what is good or bad for the firm. As a famous economist once
remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us what the
appropriate tradeoff is between current and future profits.
Maximize sales or market share.It’s easy to increase market share or unit sales: All we have
to do is lower our prices or relax our credit terms.
Minimize costs.Similarly, we can always cut costs simply by doing away with things such as
research and development.
Avoid financial distress and bankruptcy. We can avoid bankruptcy by never borrowing any
money or never taking any risks, and so on. It’s not clear that any of these actions are in the
stockholders’ best interests.
Beat the competition. Firm wants to beat the competitors by providing superior customer value
and make profitable relationship with customers
Maintain steady earnings growth. Firm
Survive.
Review Questions
1. What are the two groups of goals? Explain the possible goals of corporate finance.

1.3.2. Profit Maximization and Its Problems

It might seem intuitive that maximizing a firm’s share price is equivalent to maximizing its
profits. That thought is not always correct, however. Corporations commonly measure profits in
terms of earnings per share (EPS),which represent the amount earned during the period on
behalf of each outstanding share of common stock. EPS are calculated by dividing the period’s
total earnings available for the firm’s common stockholders by the number of shares of common
stock outstanding.
Problem-1: Profit maximization does not considertimingof profit

First, timing is important. An investment that provides a lower profit overall may be preferable
to one that earns a lower profit in the short run. Because the firm can earn a return on funds it
receives, the receipt of funds sooner rather than later is preferred.

Example: Saad Rahman, the financial manager of Jabir Manufacturing, a producer of marine
engine components, is choosing between two investments, Rotor and Valve. The following table
shows the EPS that each investment is expected to have over its 3-year life.

Earnings Per Share (EPS)

Investment Year 1 Year 2 Year 3 Total for year 1, 2, and 3
Rotor $ 1.40 $ 1.00 $ 0.40 $ 2.80
Valve $ 0.60 $ 1.00 $ 1.40 $ 3.00

In terms of the profit maximization goal, Valve would be preferred over Rotor because it
results in higher total earnings per share over the 3-year period ($3.00 EPS compared with
$2.80 EPS).Does profit maximization lead to the highest possible share price? For at
least three reasons, the answer is often no.

In our example, even though the total earnings from Rotor are smaller than those from Valve,
Rotor provides much greater earnings per share in the first year. It’s possible that by investing
in Rotor, Neptune Manufacturing can reinvest the earnings that it receives in year 1 to generate
higher profits overall than if it had invested in project Valve. If the rate of return that
Neptune can earn on reinvested earnings is high enough, project Rotor may be preferred even
though it does not alone maximize total profits.

Problem-02: Profit maximization does not consider Cash Flows

Second, profits and cash flows are not identical. The profit that a firm reports is simply an
estimate of how it is doing, an estimate that is influenced by many different accounting choices
firms make when assembling their financial reports. Cash flow is a more straightforward
measure of the money flowing into and out of the company than profit is. Companies have to pay
their bills with cash, not earnings, so cash flow is what matters most to financial
managers.Profits do not necessarily result in cash flows available to the stockholders. There is
no guarantee that the board of directors will increase dividends when profits increase. In
addition, the accounting assumptions and techniques that a firm adopts can sometimes allow a
firm to show a positive profit even when its cash outflows exceed its cash inflows. Furthermore,
higher earnings do not necessarily translate into a higher stock price. Only when earnings
increases are accompanied by increased future cash flows is a higher stock price expected.

For example, a firm with a high-quality product sold in a very competitive market could increase
its earnings by significantly reducing its equipment maintenance expenditures. The firm’s
expenses would be reduced, thereby increasing its profits. If the reduced maintenance results
in lower product quality, however, the firm may impair its competitive position, and its stock
price could drop as many well-informed investors sell the stock in anticipation of lower future
cash flows. In this case, the earnings increase was accompanied by lower future cash flows and
therefore a lower stock price.

Problem-03: Profit maximization does not count Risk

Third, risk matters a great deal. A firm that earns a low but reliable profit might be more
valuable than another firm with profits that fluctuate a great deal and therefore can be very
high or very low at different times.Profit maximization also fails to account for risk, the chance
that actual outcomes may differ from those expected. A basic premise in managerial finance is
that a trade-off exists between return (cash flow) and risk. Return and risk arethe key
determinants of share price, which represents the wealth of the owners in the firm. Cash flow
and risk affect share price differently: Holding risk fixed, higher cash flow is generally
associated with a higher share price. In contrast, holding cash flow fixed, higher risk tends to
result in a lower share price because the stockholders do not like risk. In general, stockholders
are risk averse, which means that they are only willing to bear risk if they expect compensation
for doing so. In other words, investors expect to earn higher returns on riskier investments, and
they will accept lower returns on relatively safe investments. The key point is that differences
in risk can significantly affect the value of different investments.

Review Questions
1. Explain profit maximization and its problems.
2. Why isn't profit maximization the ultimate goal of the firm?

1.3.3. The Goal Of Financial Management-The Ultimate Goal of Firm

Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s
owners, the stockholders. The
simplest and best measure of
stockholder wealth is the firm’s share
price. Managers should take actions
that increase the firm’s share price.
Therefore, we argue that the goal of
the firm, and also of managers, should
be to maximize the wealth of the
owners for whom it is being operated,
which in most instances is equivalent Figure 4: Share Price Maximization Financial decisions and share price
to maximize the stock price. This goal
translates into a straightforward decision rule for managers: Only take actions that are
expected to increase the wealth of shareholders. Although that goal sounds simple,
implementing it is not always easy. To determine whether a particular course of action will
increase or decrease shareholders’ wealth, managers have to assess what return (that is, cash
inflows net of cash outflows) the action will bring and how risky that return might be. Figure-4
depicts this process. In fact, we can say that the key variables that managers must consider
when making business decisions are return (cash flows) and risk.
The financial manager in a corporation makes decisions for the stockholders of the firm. If we
assume that stockholders buy stock because they seek to gain financially, then the answer is
obvious: Good decisions increase the value of the stock, and poor decisions decrease the value
of the stock. The financial manager acts in the shareholders’ best interests by making decisions
that increase the value of the stock. The appropriate goal for the financial manager can thus be
stated quite easily:

The goal of firm, manager and financial management is to maximize the current value per
share of the existing stock.

The goal of maximizing the value of the stock avoids the problems associated with the different
goals. There is no ambiguity in the criterion, and there is no short run versus long-run issue. We
explicitly mean that our goal is to maximize the current stock value.

Can wealth maximization goal reduce the problems of profit maximization goal?
Wealth maximization reduces the problems of profit maximization goal. Wealth maximization is
to maximize the current value per share of the existing stock. To increase current value per
share considers cash flows- not profit, timing of the cash flow, risk of the cash flow.

What is the common misconception about shareholder maximization goal?

A common misconception is that when firms strive to make their shareholders happy, they do so
at the expense of other constituencies such as customers, employees, or suppliers. This line of
thinking ignores that to enrich shareholders, managers must first satisfy the demands of these
other interest groups. Dividends that stockholders receive ultimately come from the firm’s
profits. It is unlikely that a firm whose customers are unhappy with its products, whose
employees are looking for jobs at other firms, or whose suppliers are reluctant to ship raw
materials will make shareholders rich because such a firm will likely be less profitable in the
long run than one that better manages its relations with these stakeholder groups.

Does one-dimensional-goal (Wealth Maximization) denies other stakeholders interest?

Although maximization of shareholder wealth is the primary goal, many firms broaden their
focus to include the interests of stakeholders as well as shareholders. Stakeholders are groups
such as employees, customers, suppliers, creditors, owners, and others who have a direct
economic link to the firm. A firm with a stakeholder focus consciously avoids actions that would
prove detrimental to stakeholders. The goal is not to maximize stakeholder well-being but to
preserve it. The stakeholder view does not alter the goal of maximizing shareholder wealth.
Such a view is often considered part of the firm’s “social responsibility.” It is expected to
provide long-run benefit to shareholders by maintaining positive relationships with stakeholders.
Such relationships should minimize stakeholder turnover, conflicts, and litigation. Clearly, the
firm can better achieve its goal of shareholder wealth maximization by fostering cooperation
with its other stake holders rather than conflict with them.

If this goal seems a little strong or one-dimensional to you, keep in mind that the stockholders
in a firm are residual owners. By this we mean that they are entitled to only what is left after
employees, suppliers, and creditors (and anyone else with a legitimate claim) are paid their due.
If any of these groups go unpaid, the stockholders get nothing. So, if the stockholders are
winning in the sense that the leftover, residual portion is growing, it must be true that everyone
else is winning also.

What is the appropriate goal when the firm has no traded stock?
Corporations are certainly not the only type of business; and the stock in many corporations
rarely changes hands, so it’s difficult to say what the value per share is at any given time. As
long as we are dealing with for-profit businesses, only a slight modification is needed. The total
value of the stock in a corporation is simply equal to the value of the owners’ equity. Therefore,
a more general way of stating our goal is as follows:

Maximize the market value of the existing owners’ equity

It doesn’t matter whether the business is a proprietorship, a partnership, or a corporation. For

each of these, good financial decisions increase the market value of the owners’ equity and poor
financial decisions decrease it.

Does the financial manager should take illegal or unethical actions to increase shareholders
wealth?
Finally, our goal does not imply that the financial manager should take illegal or unethical actions
in the hope of increasing the value of the equity in the firm. What we mean is that the financial
manager best serves the owners of the business by identifying goods and services that add
value to the firm by taking legal and ethical actions because they are desired and valued in the
free marketplace.

Does profit maximization help to achieve wealth maximization?

Profit maximization means increasing net income or EPS. Net income is used to pay dividends or
to keep it as retained earnings. If the firm has higher net income, it pays higher dividends or
higher retained earnings. If actual dividend is higher than expected dividend, stock price goes
up.If the firm has higher retained earnings, it seeks profitable investment with positive NPV
and stock price will increase by positive NPV per share.
Review Questions
1. What is the goal of the firm and, therefore, of all managers and employees? Discuss how
one measures achievement of this goal.
2. For what three main reasons is profit maximization inconsistent with wealth maximization?
3. What is risk? Why must risk as well as return be considered by the financial manager who
is evaluating a decision alternative or action?

1.4. The Agency Problem and Control of the Corporation

The majority of owners of a corporation are normally distinct from its managers. Managers are
nevertheless entrusted to only take actions or make decisions that are in the best interests of
the firm’s ownersby taking actions that increase the value of the stock, its shareholders. In
most cases, if managers fail to act on the behalf of the shareholders, they will also fail to
achieve the goal of maximizing shareholder wealth. To help ensure that managers act in ways
that are consistent with the interests of shareholders and mindful of obligations to other
stakeholders, firms aim to establish sound corporate governance practices.However, we’ve also
seen that in large corporations ownership can be spread over a huge number of stockholders.
This dispersion of ownership arguably means that management effectively controls the firm. In
this case, management may not necessarily act in the best interests of the stockholders.

1.4.1. Individual versus Institutional Investors

To better understand the role that shareholders play in shaping a firm’s corporate governance,
it is helpful to differentiate between the two broad classes of owners: individuals and
institutions.

Generally, individual investors own relatively few shares and as a result do not typically have
sufficient means to influence a firm’s corporate governance. To influence the firm, individual
investors often find it necessary to act as a group by voting collectively on corporate matters.
The most important corporate matter individual investors vote on is the election of the firm’s
board of directors. The corporate board’s first responsibility is to the shareholders. The board
not only sets policies that specify ethical practices and provide for the protection of
stakeholder interests, but it also monitors managerial decision making on behalf of investors.
Although they also benefit from the presence of the board of directors, institutional investors
have advantages over individual investors when it comes to influencing the corporate governance
of a firm.

Institutional investors are investment professionals that are paid to manage and hold large
quantities of securities on behalf of individuals, businesses, and governments. Institutional
investors include banks, insurance companies, mutual funds, and pension funds. Unlike individual
investors, institutional investors often monitor and directly influence firm’s corporate
governance by exerting pressure on management to perform or communicating their concerns to
the firm’s board. These large investors can also threaten to exercise their voting rights or
liquidate their holdings if the board does not respond positively to their concerns. Because
individual and institutional investors share the same goal, individual investors benefit from the
shareholder activism of institutional investors.

Review Questions
1. Differentiate between individual and institutional investors.

1.4.2. Agency Issue and Relationships

The relationship between stockholders and management is called an agency relationship. Such a
relationship exists whenever someone (the principal) hires another (the agent) to represent his
or her interests. We know that the duty of the financial manager is to maximize the wealth of
the firm’s owners. Shareholders give managers decision-making authority over the firm; thus,
managers can be viewed as the agents of the firm’s shareholders. Technically, any manager who
owns less than 100 percent of the firm is an agent acting on behalf of other owners. It is
representative of the classic principal–agent relationship where the shareholders are the
principals. In general, a contract is used to specify the terms of a principal–agent relationship.
This arrangement works well when the agent makes decisions that are in the principal’s best
interest but doesn’t work well when the interests of the principal and agent differ. For example,
you might hire someone (an agent) to sell a car you own while you are away at school. In
companies, the primary agency relationships are between:

(1) Stockholders and creditors,

(2) inside owner/managers managers who own a controlling interest in the company) and
outside owners (who have no control), and
(3) Outside stockholders and hired managers.

In theory, most financial managers would agree with the goal of shareholder wealth
maximization. In reality, however, managers are also concerned with their personal wealth, job
security, and fringe benefits. Such concerns may cause managers to make decisions that are not
consistent with shareholder wealth maximization. For example, financial managers may be
reluctant or unwilling to take more than moderate risk if they perceive that taking too much
risk might jeopardize their job or reduce their personal wealth.

Review Questions
1. Explain agency relation. What are the three primary agency relationships?

1.4.3. Agency Problems or Conflicts

There is no conflict at a one-person company—the owner makes all the decisions, does all the
work, reaps all the rewards, and suffers all the losses. This situation changes as the owner
begins hiring employees because the employees don’t fully share in the owner’s rewards and
losses. The situation becomes more complicated if the owner sells some shares of the company
to an outsider, and even more complicated if the owner hires someone else to run the company.

An important theme of corporate governance is to ensure the accountability of managers in an

organization through mechanisms that try to reduce or eliminate the principal–agent problem;
when these mechanisms fail, however, agency problems arise. In all such relationships, there is a
possibility of conflict of interest between the principal and the agent. Such a conflict is called
an agency problem.Agency problems arise when managers deviate from the goal of maximization
of shareholder wealth by placing their personal goals ahead of the goals of shareholders.

Review Questions
1. What is agency problem or conflict?

1.4.4. Types of Agency Conflicts

An agency relationship arises whenever someone, called a principal, hires someone else, called an
agent, to perform some service, and the principal delegates decision-making authority to the
agent. In companies, the primary agency relationships are betweenstockholders and creditors,
inside owner/managers managers who own a controlling interest in the company) and outside
owners (who have no control), and outside stockholders and hired managers. These conflicts lead
to agency costs, which are the reductions in a company’s value due to agency conflicts. The
following sections describe the agency conflicts, the costs, and methods to minimize the costs.

1.4.4.1. Conflicts between Stockholders and Creditors

Conflict-1: Decision Making Authority. Creditors have a claim on the firm’s earnings stream,
and they have a claim on its assets in the event of bankruptcy. However, stockholders have
control (through the managers) of decisions that affect the firm’s riskiness. Therefore,
creditors allocate decision-making authority to someone else, creating a potential agency
conflict.
Conflict-2: Lending Rate Fixation. Creditors lend funds at rates based on the firm’s perceived
risk at the time the credit is extended, which in turn is based on (1) the risk of the firm’s
existing assets, (2) expectations concerning the risk of future asset additions, (3) the existing
capital structure, and (4) expectations concerning future capital structure changes. These are
the primary determinants of the risk of the firm’s cash flows and hence the safety of its debt.
Conflict-3: Asset Switching or Bait-and-Switch.Suppose the firm borrows money, then sells
its relatively safe assets and invests the proceeds in assets for a large new project that is far
riskier. The new project might be extremely profitable, but it also might lead to bankruptcy. If
the risky project is successful, most of the benefits go to the stockholders, because creditors’
returns are fixed at the original low-risk rate. However, if the project is unsuccessful, the
bondholders take a loss. From the stockholders’ point of view, this amounts to a game of “heads,
I win; tails, you lose,” which obviously is not good for the creditors. Thus, the increased risk due
to the asset change will cause the required rate of return on the debt to increase, which in turn
will cause the value of the outstanding debt to fall. This is called asset switching or bait-and-
switch.
Conflict-4: Additional Debt. A similar situation can occur if a company borrows and then issues
additional debt, using the proceeds to repurchase some of its outstanding stock, thus increasing
its financial leverage. If things go well, the stockholders will gain from the increased leverage.
However, the value of the debt will probably decrease because now there will be a larger amount
of debt backed by the same amount of assets. In both the asset switch and the increased
leverage situations, stockholders have the potential for gaining, but such gains are made at the
expense of creditors.
Conflict-5: Charging Higher Rate. Creditors may charge a higher rate to protect themselves in
case the company engages in activities that increase risk. However, if the company doesn’t
increase risk, then its weighted average cost of capital (WACC) will be higher than is justified
by the company’s risk. This higher WACC will reduce the company’s intrinsic value (recall that
intrinsic value is the present value of free cash flows discounted at the WACC). In addition, the
company will reject projects that it otherwise would have accepted at the lower cost of capital.
Therefore, this potential agency conflict has a cost, an agency cost.
Conflict- 6: Debt Covenants. Lenders address the potential agency problems is by writing
detailed debt covenants specifying what actions the borrower can and cannot take. Most debt
covenants prohibit the borrower from (1) increasing debt ratios above specified levels, (2)
repurchasing stock or paying dividends unless profits and retained earnings are above specified
amounts, and (3) reducing liquidity ratios below specified levels. These covenants can cause
agency costs if they restrict a company from value adding activities. For example, a company
may not be able to accept an unexpected but particularly good investment opportunity if it
requires temporarily adding debt above the level specified in the bond covenant. In addition, the
costs incurred to write the covenant and monitor the company to verify compliance also are
agency costs.

1.4.4.2. Conflicts between Inside Owner (Managers) and Outside Owners

Conflict-1: Perquisite. If a company’s owner also runs the company, the owner/manager will
presumably operate it so as to maximize his or her own welfare. This welfare obviously includes
the increased wealth due to increasing the value of the company, but it also includes perquisites
(or “perks”) such as more leisure time, luxurious offices, executive assistants, expense accounts,
limousines, corporate jets, and generous retirement plans. However, if the owner/manager
incorporates the business and then sells some of the stock to outsiders, a potential conflict of
interest immediately arises. Notice that the value of the perquisites still accrues to the
owner/manager, but the cost of the perquisites is now partially born by the outsiders. This
might even induce the owner/ manager to increase consumption of the perquisites because they
are relatively less expensive now that the outsider is sharing their costs.
This agency problem causes outsiders to pay less for a share of the company and require a
higher rate of return. This is exactly why dual class stock that doesn’t have voting rights has a
lower price per share than voting stock.

1.4.4.3. Conflicts between Managers and Shareholders

Shareholders want companies to hire managers who are able and willing to take legal and ethical
actions to maximize intrinsic stock prices.2 This obviously requires managers with technical
competence, but it also requires managers who are willing to put forth the extra effort
necessary to identify and implement value-adding activities. However, managers are people, and
people have both personal and corporate goals. Logically, therefore, managers can be expected
to act in their own self-interests, and if their self-interests are not aligned with those of
stockholders, then corporate value will not be maximized.
There are six ways in which a manager’s behavior might harm a firm’s intrinsic value.

(1) Conflict-1: Shirking Responsibility. Managers might not expend the time and effort
required to maximize firm value. Rather than focusing on corporate tasks, they might spend
too much time on external activities, such as serving on boards of other companies, or on
nonproductive activities, such as golf, gourmet meals, and travel.
(2) Conflict-2: Perquisite. Managers might use corporate resources on activities that benefit
themselves rather than shareholders. For example, they might spend company money on such
perquisites as lavish offices, memberships at country clubs, museum-quality art for
corporate apartments, large personal staffs, and corporate jets. Because these perks are
not actually cash payments to the managers, they are called non-pecuniary benefits.
(3) Conflict-3: Avoid Value Enhancing Decision: Managers might avoid making difficult but
value-enhancing decisions that harm friends in the company. For example, a manager might
not close a plant or terminate a project if the manager has personal relationships with those
who are adversely affected by such decisions, even if termination is the economically sound
action.
(4) Conflict- 4: Taking Risky Projects or Negative NPV Projects.Managers might take on too
much risk, or they might not take on enough risk. For example, a company might have the
opportunity to undertake a risky project with a positive NPV. If the project turns out badly,
then the manager’s reputation will be harmed, and the manager might even be fired. Thus, a
manager might choose to avoid risky projects even if they are desirable from a
shareholder’s point of view. On the other hand, a manager might take on projects with too
much risk. Consider a project that is not living up to expectations. A manager might be
tempted to invest even more money in the project rather than admit that the project is a
failure. Or a manager might be willing to take on a second project with a negative NPV if it
has even a slight chance of a very positive outcome because hitting a home run with this
second project might cover up the first project’s poor performance. In other words, the
manager might throw good money after bad.
(5) Conflict- 5: Acquisition of Other Company or Not Returning FCF to Investors. If a
company is generating positive free cash flow, a manager might “stockpile” it in the form of
marketable securities instead of returning FCF to investors. This potentially harms
investors because it prevents them from allocating these funds to other investments with
good expected returns. Even worse, positive FCF often tempts a manager into paying too
much for the acquisition of another company. In fact, most mergers and acquisitions end up
as break-even deals, at best, for the acquiring company because the premiums paid for the
targets are often very large.
Why would a manager be reluctant to return cash to investors?
First, extra cash on hand reduces the company’s risk, which appeals to many managers.
Second, a large distribution of cash to investors is an admission that the company doesn’t
have enough good investment opportunities. Slow growth is normal for a maturing company,
but this isn’t very exciting for a manager to admit. Third, there is a lot of glamour
associated with making a large acquisition, and this can provide a large boost to a manager’s
ego. Fourth, compensation usually is higher for executives at larger companies; cash
distributions to investors make a company smaller, not larger.
(6) Conflict-6: Not Disclosing All Information to Investors. Managers might not release all
the information that investors desire. Sometimes, they might withhold information to
prevent competitors from gaining an advantage. Other times, they might try to avoid
releasing bad news. For example, they might “massage” the data or “manage the earnings” so
that the news doesn’t look so bad. If investors are unsure about the quality of information
managers provide, they tend to discount the company’s expected free cash flows at a higher
cost of capital, which reduces the company’s intrinsic value

If senior managers believe there is little chance they will be removed, the company has a
problem with entrenchment. Such a company faces a high risk of being poorly run, because
entrenched managers are able to act in their own interests rather than in the interests of
shareholders

Review Questions

1. What are agency conflicts? What groups can have agency conflicts?
2. Explain the conflicts between Stockholders and Creditors, Inside Owner (Managers)
 and Outside Owners, and Managers and Shareholders
3. Name six types of managerial behaviors that can reduce a firm’s intrinsic value.

1.4.5. Agency Cost

The term agency costsrefers to the costs of the conflict of interest between stockholders and
management. These costs can be indirect or direct. Agency problems in turn give rise to agency
costs. Agency costs are costs borne by shareholders due to the presence or avoidance of agency
problems and in either case represent a loss of shareholder wealth. For example, shareholders
incur agency costs when managers fail to make the best investment decision or when managers
have to be monitored to ensure that the best investment decision is made because either
situation is likely to result in a lower stock price.

1. Indirect agency cost. An indirect agency cost is a lost opportunity. To see how management
and stockholder interests might differ, imagine that the firm is considering a new investment.
The new investment is expected to favorably impact the share value, but it is also a relatively
risky venture. The owners of the firm will wish to take the investment (because the stock value
will rise), but management may not because there is the possibility that things will turn out
badly and management jobs will be lost. If management does not take the investment, then the
stockholders may lose a valuable opportunity. This is one example of an agency cost.
2. Direct agency costs.Direct agency costscome in two forms. The first type is a corporate
expenditure that benefits management but costs the stockholders. Perhaps the purchase of a
luxurious and unneeded corporate jet would fall under this heading. The second type of direct
agency cost is an expense that arises from the need to monitor management actions. Paying
outside auditors to assess the accuracy of financial statement information could be one
example.
3. Cost Incurred to Protect Job Security. Managers would tend to maximize the amount of
resources over which they have control- corporate power or wealth. This goal could lead to an
overemphasis on corporate size or growth. For example, cases in which management is accused
of overpaying to buy up another company just to increase the size of the business or to
demonstrate corporate power are not uncommon. Obviously, if overpayment does take place,
such a purchase does not benefit the stockholders of the purchasing company. This discussion
indicates that management may tend to overemphasize organizational survival to protect job
security. Also, management may dislike outside interference, so independence and corporate
self-sufficiency may be important goals.
Review Questions:
1. Explain different agency costs.

1.4.6. Mechanisms to Reduce Agency Conflict

Whether managers willact in the best interests of stockholders depends on two factors.
 First thing depends on how closely management goals are aligned with stockholder goals.
This issue relatesto the way managers are compensated.
 Second thing depends onhow managers can be replaced if they do not pursue stockholder
goals. This issue relates to control of the firm.
1.4.6.1.Management Compensation Plans

In addition to the roles played by corporate boards, institutional investors, and government
regulations, corporate governance can be strengthened by ensuring that managers’ interests are
aligned with those of shareholders. A common approach is to structure management
compensation to correspond with firm performance. In addition to combating agency problems,
the resulting performance based compensation packages allow firms to compete for and hire the
best managers available. The two key types of managerial compensation plans are incentive plans
and performance plans.

Incentive plans.Incentive plans tie management compensation to share price. The incentive
relates to job prospects. Better performers within the firm will tend to get promoted. More
generally, managers who are successful in pursuing stockholder goals will be in greater demand
in the labor market and thus command higher salaries. In fact, managers who are successful in
pursuing stockholder goals can reap enormous rewards.
Employee Stock Option Plan (ESOP).One incentive plan grants stock options to management.
Managers are frequently given the option to buy stock at a bargain price. The more the stock is
worth, the more valuable is this option. In fact, options are often used to motivate employees of
all types, not just top managers. If the firm’s stock price rises over time, managers will be
rewarded by being able to purchase stock at the market price in effect at the time of the grant
and then to resell the shares at the prevailing higher market price.
Performance Plans. Many firms also offer performance plans that tie management
compensation to performance measures such as earnings per share (EPS) or growth in EPS.
Compensation under these plans is often in the form of performance shares or cash bonuses.
Performance shares are shares of stock given to management as a result of meeting the stated
performance goals, whereas cash bonuses are cash payments tied to the achievement of certain
performance goals.

The execution of many compensation plans has been closely scrutinized in light of the past
decade’s corporate scandals and financial woes. Both individual and institutional stockholders as
well as the Securities and Exchange Commission (SEC) and other government entities continue
to publicly question the appropriateness of the multimillion-dollar compensation packages that
many corporate executives receive.

1.4.6.2.Control of the Firm

Control of the firm ultimately rests with stockholders. They elect the board of directors, who
in turn hire and fire managers.
Proxy Fight. An important mechanism by which unhappy stockholders can act to replace existing
management is called a proxy fight. A proxy is the authority to vote someone else’s stock. A
proxy fight develops when a group solicits proxies in order to replace the existing board and
thereby replace existing managers.
Threat of Takeover. Another way that managers can be replaced is by takeover. Firms that are
poorly managed are more attractive as acquisitions than well-managed firms because a greater
profit potential exists. Thus, avoiding a takeover by another firm gives management another
incentive to act in the stockholders’ interests.
When a firm’s internal corporate governance structure is unable to keep agency problems in
check, it is likely that rival managers will try to gain control of the firm. Because agency
problems represent a misuse of the firm’s resources and impose agency costs on the firm’s
shareholders, the firm’s stock is generally depressed, making the firm an attractive takeover
target. The threat of takeover by another firm that believes it can enhance the troubled firm’s
value by restructuring its management, operations, and financing can provide a strong source of
external corporate governance.The constant threat of a takeover tends to motivate
management to act in the best interests of the firm’s owners.
Concept Questions
 What are mechanisms to reduce agency conflict?
 What incentives do managers in large corporations have to maximize share value?
 Explain how a firm’s corporate governance structure can help avoid agency problems.
 How can the firm structure management compensation to minimize agency problems? What
is the current view with regard to the execution of many compensation plans?
 How do market forces—both shareholder activism and the threat of takeover—act to
prevent or minimize the agency problem? What role do institutional investors play in
shareholder activism?

1.4.7. Corporate Governance

Corporate governance refers to the rules, processes, and laws by which companies are operated,
controlled, and regulated. It defines the rights and responsibilities of the corporate
participants such as the shareholders, board of directors, officers and managers, and other
stakeholders as well as the rules and procedures for making corporate decisions. A well-defined
corporate governance structure is intended to benefit all corporate stakeholders by ensuring
that the firm is run in a lawful and ethical fashion, in accordance with best practices, and
subject to all corporate regulations. A firm’s corporate governance is influenced by both
internal factors such as the shareholders, board of directors, and officers as well as external
forces such as clients, creditors, suppliers, competitors, and government regulations. In
particular, the stockholders elect a board of directors, who in turn hire officers or managers to
operate the firm in a manner consistent with the goals, plans, and policies established and
monitored by the board on behalf of the shareholders.

Review Questions

 What is corporate governance?

Suggested Questions

1. Define Finance. What are the functions of finance? (BBA Professional 2010, 2016)
2. What do you mean by business finance? (BBA Professional 2005, 2006, 2008, 2010, 2013,
2016)
3. Briefly discuss the scope of business finance. (BBA Professional 2006)
4. "Finance is the lifeblood of business organization" - Explain. (BBA Professional 2008, 2010)
5. "Finance is the process of collecting funds and then proper utilization of those funds" (BBA
Professional 2007)
6. Define financial management. (BBA Professional 2009, 2010, 2013)
7. What are the important decisions to be taken by a financial manager? Explain (BBA
professional 2007, 2010, 2013, 2016)
8. Explain the role of a financial manager for a firm. (BBA Professional 2010, 2017)
9. There are two concepts: profit maximization and wealth maximization. Which concept is the
best one from the view point of the shareholders, why?/ Why wealth maximization is
considered as a better approach than profit maximization./ What should be the ultimate
goal of the firm? (BBA Professional 003, 2005, 2008, 2009, 2010, 2013)
10. Differentiate between profit maximization and wealth maximization? (BBA Professional
2008)
11. Explain the agency relationship and agency problem.
12. What are the agency conflict and agency cost? (BBA Professional 2009, 2011, 2014)
13. What are the mechanisms/ways to reduce agency conflict? (BBA Professional 2009, 2014)

Review Questions & Concept Questions

 Explain Finance.
 What are the career opportunities in finance? What are challenges of financial managers?
 Explain sole proprietorship, partnership and corporation with strengths and weaknesses./
Explain the three legal forms of business with strengths and weaknesses.
 Explain S Corp, LLC and LLP.
 What is the balance sheet model of firm? How is it related with corporate finance?
 What are the career opportunities in corporate finance?
 What are the primary activities of financial manager?
 What is the capital budgeting decision?
 What are the two groups of goals? Explain the possible goals of corporate finance.
 Explain profit maximization and its problems.
 Why isn't profit maximization the ultimate goal of the firm?
 What is the goal of the firm and, therefore, of all managers and employees? Discuss how
one measures achievement of this goal.
 For what three main reasons is profit maximization inconsistent with wealth maximization?
 What is risk? Why must risk as well as return be considered by the financial manager who is
evaluating a decision alternative or action?
 Differentiate between individual and institutional investors.
 Explain agency relation. What are the three primary agency relationships?
 What is agency problem or conflict?
 What are agency conflicts? What groups can have agency conflicts?
 Explain different agency costs.
 Explain how this field affects all the activities in which businesses engage.
 What is the financial services area of finance? Describe the field of managerial finance.
 Which legal form of business organization is most common? Which form is dominant in
terms of business revenues?
 Describe the roles and the relationships among the major parties in a corporation:
stockholders, board of directors, and managers. How are corporate owners rewarded for
the risks they take?
 Briefly name and describe some organizational forms other than corporations that provide
owners with limited liability.
 Why is the study of managerial finance important to your professional life regardless of
the specific area of responsibility you may have within the business firm? Why is it
important to your personal life?
 What is corporate finance? what are the three things that corporate finance is concerned
about?
 Between controller and treasurer functions, what functions does corporate finance deal
with?
 What do you call the specific mixture of long-term debt and equity that a firm chooses to
use? or Describe capital structure. What are the two capital structure decisions?
 Into what category of financial management does cash management fall?
 What are mechanisms to reduce agency conflict?
 What incentives do managers in large corporations have to maximize share value?
 Explain how a firm’s corporate governance structure can help avoid agency problems.
 How can the firm structure management compensation to minimize agency problems? What
is the current view with regard to the execution of many compensation plans?
 How do market forces—both shareholder activism and the threat of takeover—act to
prevent or minimize the agency problem? What role do institutional investors play in
shareholder activism?
 What is corporate governance?