Session 2: The Objective in Corporate Finance

in this the second session of a 36 session corporate finance class I hope to talk about the objective in corporate finance every discipline needs an endgame and in corporate finance that endgame is what gives it focus in this session I hope to look at what makes the objective in corporate finance so special and what makes it corporate finance's biggest weakness in this session we're going to talk about the objective in corporate finance essentially let me show you the big picture of corporate finance because in a sense it'll show you where we're going with the session

every discipline needs a focus and the focus in corporate finance comes from the fact that the objective when you make decisions is singular it is to maximize the value of the business so what I'd like to do in this session is look at why Corporate Finance chooses that objective how it gets narrowed in practice to a much narrower objective of maximizing stock prices lay out the utopian conditions that you need for maximizing stock prices to be the only objective you need in a business then rip those utopian conditions apart by talking about what can go

wrong and then we'll end the session by leading into what we're going to do next so let's get the process on the road to understand the objective in corporate finance it's best to go back to the financial balance sheet that we introduced in the very first session and if you remember the financial balance sheet there are two items on each side there are assets in place and growth assets on the asset side and debt and equity on the other side so when you talk about maximizing the value of the business you're talking about maximizing the

value of the assets Assets in place and growth assets so put simply if you're the top manager in a Growth Company what I want you to do is not just maximize the value of the Investments you've already made but maximize the sum of the values of the Investments you've made in your growth assets you are the steward of those growth assets so in perfect Corporate Finance that's what we'd like companies to do is to go out and maximize the values of their businesses but there are some pragmatic considerations if you're the manager in a publicly

traded company you're hired and fired by stock holders you answer to them you want to keep them happy and because you want to keep them happy your focus instead of maximizing the value of the business becomes maximizing stockholder wealth and here you face a pragmatic issue if you accept that your job is to maximize stockholder wealth and you want to show your stockold ERS you are in fact increasing their wealth you want an objective measure I mean of course you could hire a consulting firm to come in and value your business every year but that's

a subjective judgment and people are likely to disagree so what you'd like is an objective third-party estimate of stockhold or wealth which even if wrong is still objective that's where stock prices come in if you're a publicly traded company you could essentially argue to your stockholders that if your stock price went up stockholder wealth has gone up and implicitly you can also argue that stockhold stockholder wealth went up the value of the business also went up now that takes a whole set of assumptions along the way but in practice that is effectively what happens in

most companies when people talk about maximizing something it's stock prices so let's take that and run with it let's see what we need to assume about the world for maximizing stock prices to be the only objective you need as a company I'm going to call this a utopian World from which Corporate Finance is born and the Very fact that I call it utopian should tell you something about the assumptions that are coming Utopia never existed and these assumptions are blatantly unrealistic but I'm going to State them anyway so here are the assumptions you need for

maximizing stock prices to be the only objective you need as a company I'm going to State these assumptions in terms of four linkages the first is the linkage between managers and stockholders the second is the linkage between the firm and lenders SL Bond holders the third is the linkage between firms and financial markets and the fourth is the linkage between firms and Society here's what I'm going to assume about each one I'm going to assume that stockholders have total power over managers they can hire them they can fire them and because they have total power

I'm going to assume that managers will go out and do stockholders bidding in other words they will want to keep stockholders happy at any cost I'm going to assume that lenders if they lend money to a company even if they don't protect themselves will not get ripped off off so what I'm effectively assuming is even if there are loopholes the size of a Mac Truck borrowers will not take advantage of lenders why you could tell a reputation story that because you have to go back to those lenders you're not going to rip them off but

it is an assumption the third linkage firms and financial markets here's what I'm going to assume I'm going to assume that companies reveal news about themselves good and bad on in a timely way and honestly I told you that these were utopian assumptions and I'm also going to assume that markets are rational and cool the trading room in this particular utopian world would be filled with intellectual people who are involved in Long discussions about value nothing like a typical trading room but in the utopian world that's what I'm going to assume and finally I'm going

to assume there are no social costs what are social costs these are costs that companies create for society that cannot be traced back and charged to the company now why am I making these assumptions I want to make the world safe for maximizing stock prices in other words I'm going to take away all the bad ways in which you can increase your stock price let's face it you could increase the stock prices of your stockholders by going out going out and ripping off your bond holders you can increase your stock price by lying to financial

markets you can increase stock prices by creating huge social costs you can't do any of those things in the utopian world that I've just described so that's the world from which traditional corporate finan is born now let's think about what can go wrong in fact the title for this slide should really be what cannot go wrong because in a sense everything that can go wrong will go wrong let's take each of the linkages first remember what I assumed about stockholders and managers I assume that stockholders have complete power over managers the two mechanisms that stockholders

have to exercise power are the annual meeting and the board of directors and neither unfortunately is very effective at keeping managers in line first let's take the annual meeting most stockholders don't shop at annual meetings and it's not in their economic best interest to do so because if you own a thousand shares showing up an annual meeting will wipe out a big chunk of your profits so most of us get proxies which we can vote even though we're not at the meeting it allows us to vote an Absentia unfortunately though most stockholders don't return their

proxies and here's what happens in companies where proxies don't get returned in most companies managers get to vote those proxies effectively that means at an annual meeting if you're the if you're the Inc commit manager you might start off with 45 50 or 55% of votes already in your favor it is very difficult to get a vote against Inc commit managers at an annual meeting you saying what about the board of directors well think about it who comes up with the names of the people who served in the board of directors of a publicly traded

company it's not some independent group of people who really don't care about what the top management think in most cases it's either CEO or a committee that thinks about what the CEO would like to see there in in most companies the people who serve in the board of directors are people that the CEO wants in the board in fact let me show you an example of a really bad board here in my view is one of the worst corporate boards created and it's Disney's board in 1997 let me explain why I think this is such

a bad board first there are 17 members in the board that's way too many for a board in fact studies show that once you get past about nine or 10 members it becomes counterproductive that's just too many people to make a decision second of the 17 members on this board are insiders they either work for Disney or used to work for Disney in other words they work for the company that they oversee this is the board after all that is supposed to keep an eye on top management the third issue with the board is the

chairman of the board Michael Eisner happens to be the CEO of Disney now remember what this board is supposed to do it's supposed to keep an eye on the top management and the person heading the board is the top manager himself well good luck with that the fourth and final factor is even if you look at the N9 Outsiders of the board they're really not Outsiders they all have connections to Michael Eisen in one way or the other in fact as you go down the list you will see Michael eisner's personal attorney on the board

you'll see the head head Mistress of the of the elementary school that his kids went to you'll see somebody from Georgetown University that his son attended in other words the the tangle of conflicts of interest here is pretty deep and this is the board that's supposed to keep an eye on Michael Eisner during the 1990s Disney did some very strange things from a stock orderer perspective and often you'd see people asking why would the board let Michael Eisner do that the answer lies in this particular board this is the board that is supposed to keep

an eye on Michael Eisner there is little chance that it will accomplish that objective this is a rubber stamp board and unfortunately in most companies the board of directors access a rubber stamp for top management so let me go back to the previous page and and return to my story stockholders have little power now over managers because the annual meeting is not very effective and the board of directors Works more for the managers than it does for the stockholders so he's saying so what well managers given a choice will then put their interest over stockholder

interest again I'm going to move forward a couple of slides to illustrate some examples of managerial interest overwhelming stockholder interest here are five examples of managers putting their interest of stocker old renters the first is what's called Green mail what's green mail it's just like blackmail but it's a lot more money and it's legal it's often in response to hostile acquisition where the managers do not want the company to be acquired here's what they do they go to the acquire and offer him 00 $150 million more to just go away often they use stockholder wealth

to fight off the Hostile acquisition the only Interest being served in green mail are the interests of the managers not the stockholders second is golden parachutes golden parachutes are special deals put into compensation contracts by managers after they've been targeted in a hostile acquisition the only purpose again of golden parachutes is to protect the managers in case the company gets taken over again stockholder interest are way down the line the third example is poison pills a poison pill is something you introduced into your company to make it unpalatable to choirs basically is it makes hostile

Acquisitions much more difficult and in the process makes it less likely that your stockholders will get a premium on their stock price the fourth are shock repellents these are special anti-takeover amendments put into a company at least on these the stockholders get to vote but as we said earlier because most stockholders do not show up at annual meetings many of these anti-takeover amendments find their way into the corporate charter here's a simple one instead of having to acquire 51% to buy a company there are some some companies where that threshold can be raised to 60

70 or even 80% and finally and here's where you see Inc commit managers and stockold renters really Clash if you're the acquiring company in an acquisition and you're using stockholder money to do the Acquisitions the case of many CEOs their ego and self-interest will drive them to do Acquisitions which really make no sense from a stockholder perspective but all of this again relates back to a fundamental problem which is that stockholders of little power over manages so again going back two pages what can go wrong if stockholders have little power over managers managers are going

to do things that are not in stockholders interest and you can't blame them self-interest is the dominant Paradigm when it comes to human behavior let's take the second linkage I assume that lenders lend money to a company and they don't protect themselves what can go wrong Lots as we see in stories that happen all around us when Banks and bond hold ERS lend money to firms they don't protect themselves they are often exploited let me give you an example RJR Nabisco company that had been around a long time in the early 1980s a lot of

people who bought RJ abisco Bond saying hey it's a wellestablished company it's got a great reputation what can go wrong four years later arj abisco was targeted in a leverage buyout you saying what's that well KKR a private Equity Firm in New York targeted RJ Nabisco and they quadrupled nbis goes debt in the process they impoverished existing bond holders and lenders in fact on the day of the lbo Nabisco bond prices Dro by 20% in fact I've introduced a word into the finance lexicon that I call Nabisco if you B if you lend money to

a company and you don't protect yourself you are begging to be Nabisco let's take the linkage between firms and financial markets I assume that firms reveal information to financial markets honestly and on time in what Universe the universe that I live in companies constantly delay bad news they might not lie but there are errors of emission rather than errors of commission once in a while you do get companies that cross the line and commit outright fraud in other words information does not get to financial markets freely and on time and in response markets are not

Angelic either the trading room that I describe full of polite intellectuals well that's not exactly the trading room you see in the real world Traders tend to be short-term they tend to be reactive and often they make decisions on bad information so markets are not that cool and not that rational and finally we know that companies create social costs not just bad companies but all businesses create social costs it's unavoidable so the assumption that there are no social costs is laughable this is the world we live in if you go out and ask CEOs to

maximize stock prices in this particular world you can see that terrible things can happen to companies and terrible things can happen to people around companies you can maximize stock prices by doing all the wrong things that is of course a problem because traditional Corporate Finance puts so much weight on market prices so here's what I'd like to do I'd like to at least set the process going by thinking about any company and I'm going to take my companies through this process and I'd encourage you to pick a company on your own and take it through

this process what I'm going to try to do is look at where the the power in my company lies or put differently if I as a stockholder in this company whatever that company might be will have any say in how the companies run power oror of vacuum and in in any publicly traded company it's going to go somewhere and here are your choices it can dress with the managers it can dress with stockholders but it might dress with inside stockholders who are inside stock holders well in many big companies these might be the people who

own large Stakes of stock and have a say the management of the company it might sometimes be with outside stockholders in know in some odd cases it might rest with the government it might lie with lenders and even employees might have a say in how a compan is run one of the first things you do before you look at the numbers in a company is look to see where the power in a company lies so with my companies let me try here's what I'm going to do I'm going to take each of my companies and

look at who owns shares in the companies and then ask a question as a stock C in that company can I look at this list and expect any of the people on this list to watch out for my interest so let me start with Disney in 2003 I was a stockholder in 2003 and as I looked at this list that year my stomach dropped CU out of this the out of the 17 top stockholders in Disney and these were the 17 top stockholders in Disney in 2003 16 were institutional investors mutual funds and Pension funds

you're saying so what well we know how institutional invest investors react to disappointment if they don't like the way a companies run rather than stand and fight or get the company to change the way it's run they walk away they sell and move on so that's what I'd expect these 16 institutional investors to do they're not going to be looking out for my interest the only individual on that list is Roy Disney and at least in 2003 he was still part of Disney's top management so I don't have much hope resting on him either the

case of Disney I'm afraid as an individual stockholder I don't see much hope in 2003 the second company I'm going to look at is Val Val is two classes of shares and that already makes me a little unhappy as a stockholder in valet I own the shares with a few voting rights the the higher voting right Shares are basically held by seven entities which control Val one of them is an entity called vespar which appoints most of the directors for Val they effectively run the company so as a C in valy what do I expect

to do not much I have very little power in the company because those seven big investors in in in the voting shares will run the company one added one added feature in val that might make it an issue in corporate governance they have a golden share what's a golden share a golden share is a share with veto power and the Brazilian government owns it what it effectively gives the Brazilian government the power to do is make a judgment on big decisions and say say no again as a stockholder in Vol I have to I have

to walk in with open eyes and recognize that sometimes there will be things that I want Vol to do that they will not be able to do because of that golden share third case I looked at TARTA Motors and I looked at the top stock HS and I noticed quite a few Tata companies on that list remember I said Tata Motors was part of a family group called The Tata group the way these companies preserve control for the family is by holding shares in each other it becomes almost impossible for Outsiders to change the way

these companies are run so the case of TARTA Motors here's what I expect to see as we go through this process I expect to see a lot of decisions made by the company that are in the best interest of the group but may not be in my best interest as a t Motors stockholder the fourth company that I looked at was Buu and Buu is a very unique holding structure when you buy shares in Buu you're not buying shares in Buu the Chinese search engine you're buying shares in bu do the Cayman Islands shell company

that company has a legal arrangement with the operating company in China allowing it to run the company and collect the profits but that legal Arrangement might be subject to oversight by the Chinese government the Chinese government might decide tomorrow or the day after that that legal Arrangement does not hold up I'm in a very weak position when it comes to BU because I don't control the real company and I definitely don't control the management of the company but that again is something you have to factor in when you look at corporate finance decisions and here's

the final slide I want to show you I showed you what Disney looked like in 2003 fast forward 6 years here's what Disney's top 17 stockholders look like in 2009 notice a very big difference who's on top of the list Steve Jobs right how did Steve Jobs become the largest stockholder in Disney well he owned 60% of Pixar and when Disney bought Pixar he became the largest stockholder in Disney as a stockold in Disney doesn't matter to me I think so I feel a little more comfortable with these stockholders in 2009 than I did in

2003 not because Steve Jobs is watching out for me but because I have a feeling that he will push the company to change if it needs change in other words we want somebody rocking the boat as stockholders because existing management is stuck with inertia and as far as I'm concerned Steve Jobs is going to be my agent for change in 2009 so what you're looking at in a company is basically things that might change the way the companies run and whether any of the managers in this company can be forced to do things differently not

because you own a thousand shares but because there's somebody on this list who's activist enough powerful enough to make changes so it might be a call I can it might be a bill acman it might be a book Shire hatway but you want somebody pushing for your interest because you really don't have the power to make the change yourself so as we go through this process remember the objective and corporate finance might be maximizing stock prices but there are multiple interests at play in a modern Corporation thank you