Principles of Corporate Finance Chapter 1 PDF

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Page 1 Part 1 Value CHAPTER 1 Introduction to Corporate Finance his book is about how corporations make financial decisions. We start by explaining what these decisions T are and what they are intended to accomplish. Corporations invest in real assets, which generate income. Some of these assets, such as plant and machinery, are tangible; others, such as brand names and patents, are intangible. Corporations finance their investments through the money they earn from selling goods and services, and by raising additional cash through borrowing from banks or issuing shares to investors. Thus, the financial manager faces two broad financial questions: First, what investments should the company make? Second, how should it pay for those investments? The investment decision involves spending money; the financing decision involves raising it. A large corporation may have hundreds of thousands of shareholders. These shareholders differ in many ways, including their wealth, risk tolerance, and investment horizon. Yet we shall see that they usually share the same financial objective. They want the financial manager to increase the value of the corporation; in an efficient market, this will in turn increase its current stock price. Thus, the secret of success in financial management is to increase value. That is easy to say but not very helpful. Instructing the financial manager to increase shareholder value is like advising an investor in the stock market to find stocks that will go up in the future. The problem is how to do it. That’s the purpose of this book. Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. It covers the concepts that govern good financial decisions, and it shows you how to use the tools of the trade of modern finance. This chapter begins with specific examples of recent investment and financing decisions made by well- known corporations. The middle of the chapter covers what a corporation is and what its financial managers do. We conclude by explaining why increasing the market value of the corporation is a sensible financial goal. Financial managers increase value whenever the corporation earns a higher return than shareholders can earn for themselves. The shareholders’ investment opportunities outside the corporation set the standard for investments inside the corporation. Financial managers, therefore, refer to the opportunity cost of the capital contributed by shareholders. Managers are, of course, human beings with their own interests and circumstances; they are not always the perfect servants of shareholders. Therefore, corporations must combine governance rules and procedures with appropriate incentives to make sure that all managers and employees pull together to increase value. This chapter introduces five themes that occur again and again throughout the book: Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  1. Corporate finance is all about maximizing shareholder value. 2. Maximizing shareholder value involves considering the long-term consequences of all decisions, including their effects on stakeholders such as customers, employees, and the environment. 3. The opportunity cost of capital sets the standard for investment decisions. 4. A safe dollar is worth more than a risky dollar. 5. Good governance matters. Page 2 The second point is important, but frequently misunderstood. We will stress that maximizing the current stock price does not involve focusing on short-term profits, and increasing shareholder value does not involve price-gouging customers, overworking employees, or polluting the environment. In a forward-looking market, even the short-term share price takes these long-term effects into account. However, we will also highlight the arguments for managers having objectives other than shareholder value. 1-1 Corporate Investment and Financing Decisions To do business, a corporation needs an almost endless variety of real assets. These may be tangible assets, such as oil fields, factories, and machines, or intangible assets, such as patents, brands, and corporate culture. Real assets don’t drop free from a blue sky. Corporations pay for their real assets by selling claims on them and the cash flows they will generate. These claims are called financial assets. One example of a financial asset is a bank loan. The bank provides the corporation with cash in exchange for a financial asset, which is the corporation’s promise to Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. repay the loan with interest. A second example is a corporate bond. The corporation sells the bond to investors in exchange for the promise to pay interest on the bond and to pay off the bond at its maturity. The main difference between a bond and a bank loan is that bonds can be sold second-hand to other investors in financial markets. Tradeable financial assets are known as securities. Shares of stock are also securities, as are a dizzying variety of specialized instruments such as options. We describe bonds in Chapter 3, stocks in Chapter 4, and other securities in later chapters. The above discussion suggests the following definitions: Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  But these equations are too simple. The investment decision also involves managing assets already in place and deciding when to shut down and dispose of assets that are no longer profitable. The corporation also has to manage and control the risks of its investments. The financing decision includes not just raising cash today but also meeting its obligations to banks, bondholders, and shareholders that have contributed financing in the past. For example, the corporation has to repay its debts when they become due. If it cannot do so, it ends up insolvent and bankrupt. Sooner or later the corporation will also want to pay out cash to its shareholders.1 1.1 Self-Test Are the following assets tangible, intangible, or financial? a. Unsold goods on your store shelves. b. Your company’s reputation for customer service. c. The negotiation skills of your company’s sales force. d. A 5% stake in your main supplier. Page 3 Let’s go to more specific examples. Table 1.1 lists 10 well-known corporations from all over the world. Company Recent Investment Decisions Recent Financing Decisions Intel (U.S.) Invests $7 billion in expanding Borrows $600 million from Chandler semiconductor plant in Chandler, Industrial Development Authority. Arizona. Amazon (U.S.) Acquires self-driving start-up, Reinvests $33 billion that it generates Zoox, for over $1.2 billion from operations Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. Tesla (U.S.) Announces construction of new Announces plans to sell $2 billion of plant to build the electric shares Cybertruck Shell Starts production at a deep-water Cuts dividend to preserve cash (U.K./Holland) development in the Gulf of Mexico GlaxoSmithKline Spends $6 billion on research and Raises $1 billion by an issue 8-year (U.K.) development for new drugs. bonds Ørsted Completes a 230-MW wind farm in Arranges a borrowing facility with 14 (Denmark) Nebraska international banks Unilever Spends $8 billion on advertising Pays a dividend and completes $200 (U.K./Holland) and marketing million program to buy back shares Carnival Launches four new cruise ships Raises $770 million by sale of bonds; Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  Corporation each bond can be converted into about (U.S./U.K.) 19 shares ⟩ TABLE 1.1 Examples of recent investment and financing decisions by major public corporations. Investment Decisions The second column of Table 1.1 shows an important recent investment decision for each corporation. Some of the investments in Table 1.1, such as Shell’s new oil field or Intel’s factory, involve buying or building tangible assets. Such investment decisions are often referred to as capital expenditure (CAPEX) or capital budgeting decisions. However, corporations also need to invest in intangible assets, through undertaking research and development (R&D), advertising, and developing computer software. For example, GlaxoSmithKline and other major pharmaceutical companies invest billions every year on R&D for new drugs. Similarly, consumer goods companies, such as Unilever or Procter & Gamble, invest huge sums in advertising and marketing their products. These outlays are investments because they build know-how, brand recognition, and reputation for the long run. Today’s investments generate future cash returns. Sometimes the cash inflows last for decades. For example, many U.S. nuclear power plants, which were initially licensed by the Nuclear Regulatory Commission to operate for 40 years, are now being re-licensed for 20 more years and may be able to operate efficiently for 80 years overall. Investing to develop self-driving cars or reduce greenhouse gas emissions also has long-term payoffs. Of course, not all investments have such distant payoffs. For example, Walmart spends about $50 billion each year to stock up its stores and warehouses before the holiday season. The company’s return on this investment comes within months as the inventory is drawn down and the goods are sold. In addition, financial managers know (or quickly learn) that cash returns are not guaranteed. An investment could be a smashing success or a dismal failure. For example, Disneyland Paris opened in 1992 and became Europe’s largest tourist attraction by visitor Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. numbers. After Europe’s debt crisis in the early 2010s and subsequent terror Page 4 attacks in Paris, attendance fell, and its huge debts led Disney to bail it out in 2014 and 2017. Financing Decisions The third column of Table 1.1 lists a recent financing decision by each corporation. A corporation can raise money from lenders or from shareholders. If it borrows, the lenders contribute the cash, and the corporation promises to pay back the debt plus a fixed rate of interest. If the shareholders put up the cash, they do not get a fixed return, but instead a fraction of any future dividends the company chooses to pay out. The shareholders are equity Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  investors, who contribute equity financing. The choice between debt and equity financing is called the capital structure decision. Capital refers to the firm’s sources of long-term financing. The financing choices available to large corporations seem almost endless. Suppose the firm decides to borrow. Should it borrow from a bank or issue tradeable bonds? Should it borrow for 1 year or 20 years? If it borrows for 20 years, should it reserve the right to pay off the debt early? Should it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars in New York? Corporations raise equity financing in two ways. First, they can issue new shares of stock. The investors who buy the new shares put up cash in exchange for a fraction of the corporation’s future cash flow and profits. Second, the corporation can take the cash flow generated by its existing assets and reinvest that cash in new assets. In this case the corporation is reinvesting on behalf of existing shareholders. No new shares are issued. That last observation is important. Often, a manager may think that a corporation’s money is hers, free to invest as she pleases. But whenever a manager reinvests cash, she’s choosing not to pay out that cash to shareholders—she’s effectively raising money from shareholders. For example, let’s say you own a house and hire a property management company to rent it out for you. You receive the monthly rental payments, less the company’s management fee and expenses. So if the management company uses some of the rent to pay for repairs, it’s you who’s financing the repairs because they come out of your monthly income. What happens when a corporation does not reinvest all of the cash flow generated by its existing assets? It may hold the cash in reserve for future investment, or it may pay the cash back to its shareholders. Table 1.1 shows that Unilever paid back $200 million to its shareholders by repurchasing shares, in addition to paying a cash dividend. The decision to pay dividends or repurchase shares is called the payout decision. We cover payout decisions in Chapter 15. Both investment and financing decisions are important, so we will consider both carefully in this book. But the real value of a company stems from its investment decisions—what makes a company great is what it does (its investment decisions) rather than how it pays for it (its financing decisions). That’s why financial managers say that “value comes mainly from Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. the asset side of the balance sheet.” Take Apple as an example. Its market capitalization or market cap is about $2 trillion. Where did this market value come from? It came from Apple’s best-selling products, from its brand name and worldwide customer base, from its research and development, and from its ability to make profitable future investments. The value did not come from sophisticated financing. Apple’s financing strategy is very simple: It carries no debt to speak of and finances almost all investment by retaining and reinvesting cash flow. Indeed, the most successful corporations sometimes have the simplest financing strategies. Page 5 Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  While investment decisions matter more on the upside, financial decisions are particularly important on the downside. Financing decisions alone can’t turn a company into a success, but they can cause it to fail. For example, after a consortium of investment companies bought the energy giant TXU in 2007, the company took on an additional $50 billion of debt. This decision proved fatal. The consortium did not foresee the expansion of shale gas production and the resulting sharp fall in natural gas and electricity prices. In 2014, the company (renamed Energy Future Holdings) was no longer able to service its debts and filed for bankruptcy. Business is inherently risky. The financial manager needs to identify the risks and make sure they are managed properly. For example, debt has its advantages, but too much debt can land the company in bankruptcy, as the buyers of TXU discovered. Companies can also be knocked off course by recessions, by changes in commodity prices, interest rates and exchange rates, or by adverse political developments. Some of these risks can be hedged or insured, however, as we explain in Chapters 27 and 28. 1.2 Self-Test Are the following decisions investment or financing decisions? a. Redesigning your products’ packaging to use less plastic. b. Launching a program to improve employee mental health. c. Lending to your supplier to enable them to develop a new technology. d. Accepting a capital injection from a venture capital firm. e. Selling an airplane and leasing it back. What Is a Corporation? We have been referring to “corporations.” Before going too far or too fast, we need to offer some basic definitions. Details follow in later chapters. A corporation is a legal entity. In the view of the law, it is a legal person that is owned Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. by its shareholders. As a legal person, the corporation can make contracts, carry on a business, borrow or lend money, and sue or be sued. It must also pay taxes. Unlike an actual person, a corporation cannot vote, but it can buy another corporation. In the United States, corporations are formed under state law, based on articles of incorporation that set out the purpose of the business and how it is to be governed and operated.2 For example, the articles of incorporation specify the composition and role of the board of directors.3 A corporation’s directors are elected by the shareholders. They choose and advise top management and must sign off on important corporate actions, such as mergers and the payment of dividends to shareholders. We’ll consider how a corporation is governed in more detail in Chapter 19, and the purpose of the corporation in Chapter 20. Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  BEYOND THE PAGE Zipcar’s articles mhhe.com/brealey14e A corporation is owned by its shareholders but is legally distinct from them. Therefore the shareholders have limited liability, which means that they cannot be held personally responsible for the corporation’s debts. When the U.S. financial corporation Lehman Brothers failed in 2008, its shareholders did not have to put up more money to cover Lehman’s massive debts. Shareholders can lose their entire investment in a corporation, but no more. Page 6 When a corporation is first established, its shares may be privately held by a small group of investors, such as the company’s managers and a few backers. In this case, the shares are not publicly traded and the company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, its shares are traded in public markets such as the New York Stock Exchange or Hong Kong Stock Exchange. These corporations are known as public companies. Most well-known corporations in the United States are public companies with widely dispersed shareholdings. In other countries, it is more common for large corporations to remain in private hands, and many public companies may be controlled by just a handful of investors. The latter category includes such well-known names as Volkswagen (Germany), Alibaba (China), Softbank (Japan), and the Swatch Group (Switzerland). BEYOND THE PAGE Zipcar’s bylaws Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. mhhe.com/brealey14e A large public corporation may have millions of shareholders, who own the business but cannot possibly manage or control it directly. This separation of ownership and control gives corporations permanence. Even if managers quit or are dismissed and replaced, the corporation survives. Today’s shareholders can sell all their shares to new investors without disrupting the operations of the business. Corporations can, in principle, live forever, and in practice, they may survive many human lifetimes. One of the oldest corporations is the Hudson’s Bay Company, which was formed in 1670 to profit from the fur trade between northern Canada and England. Although the company still operates as one of Canada’s leading retail chains, its shareholders voted in 2020 to turn it into a private company, and it was delisted from the Toronto Stock Exchange. Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  The separation of ownership and control can also have a downside because it can open the door for managers and directors to act in their own interests rather than in the shareholders’ interest. We return to this problem later in this chapter and again in Chapter 19. BEYOND THE PAGE An Early Corporation mhhe.com/brealey14e Almost all large and medium-sized businesses are corporations, but the nearby Finance in Practice box describes how smaller businesses may be organized. 1.3 Self-Test A company is bankrupt and has outstanding debt of $100 million. Its assets can be liquidated for $80 million. a. How much will creditors receive? b. How much will shareholders receive? c. How much extra are shareholders obliged to pay into the company to stop it from going bankrupt? The Role of the Financial Manager What is the essential role of the financial manager? Figure 1.1 gives one answer. The figure traces how money flows from investors to the corporation and back to investors again. The flow starts when cash is raised from investors (arrow 1 in the figure). The cash could come from banks or from securities sold to investors in financial markets. The cash is then used to pay for the real assets needed for the corporation’s business (arrow 2). Later, as the business operates, the assets produce cash inflows (arrow 3). That cash is either reinvested (arrow 4a) Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. or returned to the investors who furnished the money in the first place (arrow 4b). Of course, the choice between arrows 4a and 4b is constrained by the promises made when cash was raised at arrow 1. For example, if the firm borrows money from a bank at arrow 1, it must repay this money plus interest at arrow 4b. Page 7 Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  ◗ FIGURE 1.1 Flow of cash between financial markets and the firm’s operations. Key: (1) Cash raised by selling financial assets to investors; (2) cash invested in the firm’s operations and used to purchase real assets; (3) cash generated by the firm’s operations; (4a) cash reinvested; (4b) cash returned to investors. FINANCE IN PRACTICE Other Forms of Business Organization ⟩ Corporations do not have to be prominent, multinational businesses such as those listed in Table 1.1. You can organize a local plumbing contractor or barber shop as a corporation if you want to take the trouble. But most corporations are larger businesses or businesses that aspire to grow. Small “mom-and-pop” businesses are usually organized as sole proprietorships. What about the middle ground? What about businesses that grow too large for sole Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. proprietorships but don’t want to reorganize as corporations? For example, suppose you wish to pool money and expertise with some friends or business associates. The solution is to form a partnership and enter into a partnership agreement that sets out how decisions are to be made and how profits are to be split up. Partners, like sole proprietors, face unlimited liability. If the business runs into difficulties, each partner can be held responsible for all the business’s debts. Partnerships have a tax advantage. Partnerships, unlike corporations, do not have to pay income taxes. The partners simply pay personal income taxes on their shares of the profits. Some businesses are hybrids that combine the tax advantage of a partnership with the limited liability advantage of a corporation. In a limited partnership, partners are classified as general or limited. General partners manage the business and have unlimited personal Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  liability for its debts. Limited partners are liable only for the money they invest and do not participate in management. Many states allow limited liability partnerships (LLPs) or, equivalently, limited liability companies (LLCs). These are partnerships in which all partners have limited liability. Another variation on the theme is the professional corporation (PC) or professional limited liability company (PLCC), which is commonly used by doctors, lawyers, and accountants. In this case, the business has limited liability, but the professionals can still be sued personally—for example, for malpractice. Most large investment banks such as Morgan Stanley and Goldman Sachs started as partnerships. But eventually these companies and their financing requirements grew too large for them to continue as partnerships, and they reorganized as corporations. The partnership form of organization does not work well when ownership is widespread and separation of ownership and management is essential. You can see examples of arrows 4a and 4b in Table 1.1. Amazon financed its new projects by reinvesting earnings (arrow 4a). Unilever decided to return cash to shareholders by paying cash dividends and by buying back its stock (arrow 4b). BEYOND THE PAGE S-corporations mhhe.com/brealey14e Notice how the financial manager stands between the firm and outside investors. On the one hand, the financial manager helps manage the firm’s operations, particularly by helping to make good investment decisions. On the other hand, the financial manager deals with investors—not just with shareholders but also with financial institutions such as banks and with financial markets such as the New York Stock Exchange. Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. Page 8 BEYOND THE PAGE The financial managers mhhe.com/brealey14e Notice also that the structure of Figure 1.1 mirrors the structure of a company’s balance sheet. A company’s investments are on the left-hand side of the balance sheet, and the financial assets that it has issued—its liabilities— are on the right-hand side.4 Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  1-2 The Financial Goal of the Corporation Shareholders Want Managers to Maximize Market Value Major corporations may have millions of shareholders. There is no way that all of these shareholders can be actively involved in management; it would be like trying to run a city solely through local meetings where residents vote on every tax and expenditure decision. Authority has to be delegated to professional managers, just as residents delegate the running of a city to the mayor. A mayor’s job is complex. She is supposed to act in residents’ interests. But residents have different views on how high taxes should be and what projects money should be spent on—and these views may change over time. It would be impractical to run every decision past the residents. Then, how does the mayor know what to do to serve their interests? It might seem that a company manager’s job is equally complex. Shareholders have different interests. Some may plan to cash in their investments next year; others may be investing for a distant old age. Some may be wary of taking much risk; others may be more venturesome. How does the manager know what to do to serve their interests? Fortunately, for managers, there is a natural financial objective on which most shareholders can agree despite their differences: Maximize the current market value of shareholders’ investment in the firm. A smart and effective manager makes decisions that increase the current market value of the company’s shares. This increased market value can then be put to whatever purposes the shareholders want. They can sell their shares and give the proceeds to charity or spend them on exotic holidays; they can alternatively retain their entire investment in the firm. Whatever their personal tastes or objectives, they can all do more when their shares are worth more. Thus, every investor wants the financial manager to increase shareholder wealth. Maximizing market value is a sensible goal when the shareholders have access to well- functioning financial markets.5 Financial markets allow them to transport savings across Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. time, by borrowing money or selling shares (if they wish to consume today) or lending money or buying more shares (if they prefer to consume in the future). For example, the corporation’s roster usually includes investors with both long horizons (such as a child’s trust fund) and short horizons (such as retirees). You might expect short-horizon investors to say, “Sure, maximize value, but don’t invest in too many long-term projects.” But they won’t, because if the long-term project increases shareholder wealth and thus market value, short- horizon investors can sell their shares for a higher price and thus consume more today. The same is true for risk. Financial markets allow shareholders to adjust the risk they bear. A corporation’s roster of shareholders usually includes both risk-averse and risk-tolerant investors. You might expect the risk-averse to say, “Sure, maximize value, but don’t touch too many high-risk projects.” Instead, they say, “Risky projects are OK, provided that Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  expected returns are more than enough to offset the risks. If this firm ends up too Page 9 risky for my taste, I’ll adjust my investment portfolio to make it safer.” They could sell their shares in the risky firm and buy safer ones or government bonds. If the risky investments increase market value, the departing shareholders can sell at a higher price, and thus are better off, than if the risky investments were turned down. Financial markets give them the flexibility to manage their own savings and investment plans, leaving the corporation’s financial managers with only one task: to increase market value and hence shareholder wealth. Sometimes, managers say that, rather than maximizing wealth, their job is to “maximize profits.” That sounds reasonable. After all, don’t shareholders want their company to be profitable? But taken literally, profit maximization is not a well-defined financial objective for at least two reasons: 1. Which year’s profits? A corporation may be able to increase current profits by cutting R&D, but that may result in lower profits in the future. How do we know whether “profits” are maximized if some years’ profits rise and others fall? 2. What about risk? If a project will increase the company’s profits but also make it riskier, it is not clear that the manager should take it. As we’ll soon explain, risk is a crucial factor that affects shareholder wealth. While profits are not defined, shareholder wealth is. As Chapter 2 will show, it considers all future profits from a company and converts them into the common currency of current shareholder wealth that takes into account whether they are short-term or long-term, risky or safe. A Fundamental Result: Why Maximizing Shareholder Wealth Makes Sense The goal of maximizing shareholder value is widely accepted in both theory and practice. It’s important to understand why. Let’s walk through the argument step by step, assuming that the financial manager should act in the interests of the firm’s owners, its shareholders. Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. 1. Each shareholder wants three things: a. To be as rich as possible–that is, to maximize his current wealth. b. To manage the timing of his consumption plan by deciding whether to consume his wealth now or invest it to spend later. c. To manage the risk characteristics of that consumption plan. 2. But shareholders don’t need the financial manager’s help to achieve the best time pattern of consumption. They can do that on their own, provided they have free access to competitive financial markets, by deciding when to sell their shares. They can also choose the risk characteristics of their consumption plan by investing in more- or less-risky securities. Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  3. How then can the financial manager help the firm’s shareholders? There is only one way: by increasing their wealth. That means increasing the market value of the firm and the current price of its shares. Economists have proved this value-maximization principle with great rigor and generality. It is known as the Fisher separation theorem, because it shows that a financial manager’s investment decisions can be separated from shareholder preferences. After you have absorbed this chapter, take a look at the Appendix, which contains a simple example that illustrates how the principle of value maximization follows from formal economic reasoning. It’s important to highlight the role of well-functioning financial markets in this result. We often think that the main role of financial markets is to allow companies to raise funds for investment. Primary financial markets are where companies obtain new money—through selling shares, issuing bonds, or taking out a bank loan. But most activity takes place in secondary financial markets. On a typical day in the New York Stock Exchange, Page 10 investors trade over 1 trillion shares with each other. These shares are “second hand”—they’d been issued previously. No new money flows to companies, yet secondary financial markets have an important social function. By giving shareholders freedom to do what they want with their wealth, they not only improve shareholders’ welfare but also make the manager’s task simple—to maximize shareholder wealth. Should Managers Maximize Shareholder Wealth? We earlier wrote that managers have a single objective: to “maximize the current market value of shareholders’ investment in the firm.” We’ve explained how this idea has several advantages—it gives a clear decision rule for managers and benefits almost all shareholders regardless of their preferences. But this idea has also been heavily criticized. One challenge is that maximizing the “current” market value leads managers to be short-termist—that is, focus on short-term profits by reducing investment or cutting wages. A second criticism is that it’s narrowly focused on shareholders at the expense of stakeholders—other parties affected by the company, such as customers, employees, suppliers, the environment, communities, and Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. taxpayers. A single-minded focus on shareholders might cause managers to price-gouge customers, overwork employees, or pollute the environment in pursuit of shareholder wealth. These two criticisms must be taken seriously. Indeed, they have led to capitalism becoming unpopular with many citizens and politicians. Perhaps in response, in August 2019, 181 CEOs of the largest U.S. companies signed a statement claiming their objective was no longer solely “generating long-term value for shareholders” but also “delivering value to our customers … investing in our employees … dealing fairly and ethically with our suppliers … supporting the communities in which we work.”* However, these criticisms are not fully warranted. Starting with the former, as we’ll explain in Chapter 2, current shareholder wealth depends on all future cash flows generated Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  by a company, not just current cash flows. A company developing renewable energy may be improving current shareholder wealth, even if the project is not profitable for 20 years. A company failing to train its workforce may be destroying shareholder value, even though the cost savings will boost short-term profits. Moving to the latter, it is not true that a focus on enriching the shareholders means that managers must act as greedy mercenaries riding roughshod over the weak and helpless. In most instances, little conflict arises between doing well (increasing shareholder value) and doing good (increasing stakeholder value). Investing in stakeholders often benefits shareholders, and any financial manager who fails to take these effects into account is failing at her job. Profitable firms are those with satisfied customers and loyal employees; firms with dissatisfied customers and a disgruntled workforce will probably end up with declining profits and a low stock price. Indeed, as we explain in Chapter 20, evidence shows that companies that treat customers, employees, and the environment well also generate higher longer-term returns to their shareholders. So, when we say that the objective of the firm is to maximize shareholder wealth, we don’t mean that managers should ignore everything else. The law deters managers from making blatantly exploitative decisions. But managers shouldn’t be simply concerned with observing the letter of the law or with keeping to written contracts—they should go above and beyond. This is not just for “ethical” reasons; it’s good business sense. In business and finance, as in other day-to-day affairs, there are unwritten rules of behavior that Page 11 can’t be specified in a contract. These rules make routine transactions feasible because each party trusts the other to keep their side of the bargain. Corporations create shareholder value by building long-term relationships with their customers and establishing a reputation for fair dealing and financial integrity. When something happens to damage that trust, the costs can be enormous. Volkswagen (VW) is a case in point. VW had installed secret software that cut emissions by up to forty times when it detected a test was being conducted. Discovery of the software in 2015 caused a tidal wave of criticism. VW’s stock price dropped by 35%. Its CEO was fired. VW diesel vehicles piled up unsold in car dealers’ lots. In the United States alone, the scandal may ultimately cost the company more than $35 billion in fines and compensation payments. While we have explained how shareholder and stakeholder value are much more aligned than commonly believed, it is important to acknowledge that the two preceding criticisms Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. may sometimes be valid. This is why we earlier said that they are “not fully warranted” rather than “unwarranted.” Starting with the short-termism critique, we’ve implicitly assumed that the stock market is efficient—an assumption we will later devote an entire chapter to scrutinizing (Chapter 12). In an efficient stock market, the share price indeed takes into account all future cash flows from a company. But what if the stock market is myopic and ignores cash flows far into the future? Then, market value no longer equals shareholder value. A company that undertakes a far-sighted investment might be unfairly punished with a low stock price. Knowing that, the manager may turn down the investment even if it creates shareholder value. As we’ll explain in Chapter 19, a solution is to pay the manager in long-term shares, so that she is less concerned with the short-term stock price. Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  Let’s move to the second criticism, that maximizing shareholder value means exploiting stakeholders. We’ve argued that, in many cases, maximizing shareholder value involves taking seriously a company’s responsibility to stakeholders. But some investments in stakeholders won’t fully feed back into shareholder value, even in the long term. If a company invests billions in reducing its greenhouse gas emissions, the benefits are enjoyed by many, but the company’s own share of the gains may be small. The consequences that companies exert on society, but don’t feed back into their profits, are known as externalities. A company that’s focused on shareholder wealth will ignore externalities and thus may turn down certain investments in stakeholders. As a result, managers’ objectives may need to be broadened for them to fully take stakeholder interests into account. We’ll revisit this issue in Chapter 20 and consider how a financial manager makes decisions under multiple objectives. This is not to sweep it under the carpet; in contrast, the idea that the purpose of the corporation may be wider than shareholder wealth should be taken sufficiently seriously that it merits its own chapter. For now, we will take the manager’s objective as maximizing shareholder wealth for two main reasons. First, it does take into account most effects on stakeholders, even those that arise in the very long-term. Second, it leads to a clear framework for making decisions. Under multiple objectives, it is unclear (for example) how much to pay workers. Increasing wages will benefit employees but may hurt shareholders, and there’s no clear way of evaluating this trade-off. Under shareholder wealth maximization, there is a clear rule—balance the financial costs of higher pay with the financial benefits stemming from superior worker recruitment, retention, and motivation. 1.4 Self-Test a. Does maximizing current shareholder value lead managers to be short-termist? b. Does maximizing current shareholder value lead to managers completely ignoring stakeholders? Page 12 Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. The Investment Trade-Off Taking the manager’s objective as being market value, we now must ask: Why do some investments increase market value while others reduce it? The answer is given by Figure 1.2, which sets out the fundamental trade-off for corporate investment decisions. Suppose the corporation has a proposed investment in a real asset and enough cash on hand to finance it. If the corporation doesn’t invest, it can instead pay out the cash to shareholders—say, as an extra dividend. How does the financial manager decide whether to go ahead with the project or to pay out the cash? (The investment and dividend arrows in Figure 1.2 are arrows 2 and 4b in Figure 1.1.) Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  ◗ FIGURE 1.2 The firm can either keep and reinvest cash or return it to investors. (Arrows represent possible cash flows or transfers.) If cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets. Assume that the financial manager is acting in the interests of the corporation’s owners, its shareholders. What do these shareholders want the financial manager to do? The answer depends on the project’s rate of return versus the rate of return that the shareholders can earn by investing in financial markets. To see this, let’s say the investment project in Figure 1.2 is a proposal for Tesla to launch a new electric car. Suppose Tesla has set aside cash to launch the new model in 2025. It could go ahead with the launch, or it could cancel the investment and instead pay the cash out to its shareholders. If it pays out the cash, the shareholders can then invest for themselves. Suppose that Tesla’s new project is just about as risky as the U.S. stock market and that investment in the stock market offers a 10% expected rate of return. If the project offers a superior rate of return—say, 20%—then Tesla’s shareholders would be happy for the company to keep the cash and invest it in the new model. If the project offers only a 5% return, then the shareholders are better off with the cash and without the new model; in that Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. case, the financial manager should turn down the project. As long as a corporation’s proposed investments offer higher rates of return than its shareholders can earn for themselves in financial markets, its shareholders will welcome the investments, and its stock price will increase. But if the company earns an inferior return, shareholders are unhappy, the stock price falls, and shareholders demand their money back so that they can invest on their own. In our example, the minimum acceptable rate of return on Tesla’s new car is 10%. This minimum rate of return is called the opportunity cost of capital (or cost of capital for short) because it depends on the investment opportunities available to investors in financial markets. Whenever a corporation invests cash in a new project, its shareholders lose the opportunity to invest the cash on their own. Corporations increase value by accepting all Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  investment projects that earn more than the opportunity cost of capital. For this reason, the cost of capital is also known as the hurdle rate, because a project’s return must Page 13 be higher than this hurdle for it to create value for shareholders. Notice that the opportunity cost of capital depends on the risk of the proposed investment project. The “apples-to-apples” alternative of investing in a project is to pay out the cash to shareholders and allow them to invest in financial markets at the same level of risk. In turn, the return that shareholders get when they invest on their own depends on the risk they take. The safest investments, such as U.S. government debt, offer low rates of return. Investments with higher expected rates of return—the stock market, for example—are riskier and sometimes deliver painful losses. (The U.S. stock market was down 38% in 2008 and fell more than 20% in March 2020, for example.) Other investments, such as high-tech growth stocks, are riskier still and thus investors demand higher returns. That the hurdle rate is an opportunity cost of investing elsewhere should make it clear that the minimum required return for a project depends entirely on external factors—the rates of return that shareholders could obtain elsewhere. It does not depend on internal factors, such as the interest rate the company pays on a bank loan, or the return on a company’s existing investments. Managers look to the financial markets to measure the opportunity cost of capital for the firm’s investment projects. They can observe the opportunity cost of capital for safe investments by looking up current interest rates on safe debt securities. For risky investments, the opportunity cost of capital has to be estimated. We start to tackle this task in Chapter 7. 1.5 Self-Test a. Epsilon is taking out a low-interest-rate bank loan to finance construction of a number of stores in South Carolina. Upsilon is making a similar-risk investment in North Carolina, which it is financing with an issue of shares. Should Upsilon require a higher return than Epsilon on its investment? b. Two pharmaceuticals companies are developing a cure for cancer. Company A has been successful in drug development in the past and earned a 25% rate of return on its past Copyright © 2022. McGraw-Hill US Higher Ed ISE. All rights reserved. investments. Company B has been less successful and only yielded 15%. Should Company A require a higher, lower, or the same return on the cancer cure than Company B? Agency Problems and Corporate Governance We have emphasized the separation of ownership and control in public corporations. The owners (shareholders) cannot control what the managers do, except indirectly through the board of directors. This separation is necessary but also dangerous. You can see the risks. Managers may be tempted to buy flashy corporate jets or to schedule business meetings at Brealey, Richard, et al. Principles of Corporate Finance, McGraw-Hill US Higher Ed ISE, 2022. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/corvinus/detail.action?docID=6953660. Created from corvinus on 2023-09-11 10:17:42.  luxury resorts. They may shy away from attractive but risky projects because they are worried more about the safety of their jobs than about maximizing shareholder value. They may work just to maximize their own bonuses, and therefore slash investment in employees or reducing their company’s carbon footprint. Conflicts between shareholders’ and managers’ objectives create agency problems. Agency problems arise when agents work for principals. The shareholders are the principals; the managers are their agents. Agency costs are incurred when (1) managers do not attempt to maximize firm value and (2) shareholders incur costs to monitor the managers and constrain their actions. Agency problems can sometimes lead to outrageous behavior. For example, when Dennis Kozlowski, the CEO of Tyco, threw a $2 million 40th birthday bash for his wife, he charged half of the cost to the company. This, of course, was an extreme conflict of interest, as well as illegal. But more subtle and moderate agency problems arise whenever managers Page 14 don’t own the entirety of their firm. As we’ll revisit in Chapter 20, errors of omission (failing to take good actions, such as launching a new product or closing down an unprofitable division) are often even more serious than errors of commission (undertaking bad actions). Later in the book, and in particular in Chapter 19, we will look at how good systems of governance ensure that managers’ hearts are close to shareholders’ pockets. This means well- designed incentives for managers, standards for accounting and disclosure to investors, requirements for boards of directors, and legal sanctions for self-dealing by management. When scandals happen, we say that corporate governance has broken down. When corporations compete effectively and ethically to deliver value to shareholders, we conclude that governance is working properly.