1-1
FINANCIAL ISSUES & INCENTIVES
IN MODERN ORGANIZATIONS
Asso.Prof.Dr. NGUYEN THU THUY
Faculty of Business Administration...
1-2
Finance?
A foremost concept in finance concerns how individuals
interact in order to allocate resources (capital) and...
1-3
Two examples of common corporate
financial decisions
A firm must spend $100 million for the required assets if
a prop...
1-4
Example of common investments type
financial decisions
A mutual fund manager that manages a
fund with $10 billion por...
1-5
Corporate finance vs.
Investments
Board of Directors
CEO
Assets
Equity
Debt Issue Fixed Income Products (Bonds)
Issue ...
1-6
I: Corporate Finance
 Imagine you are the CFO of a company with $2
billion in excess cash.
What can the firm do with ...
1-7
II: Investments
Investment theory tries to answer questions
like:
in which combination of securities should
investor...
1-8
Corporate finance decisions - summary
 Capital budgeting decision
 investment projects  physical plants,
equipment
...
1-9
Two Main Functions of Corporate Finance
Current Assets
Cash
Marketable Securities
Account Receivables
Inventory
Fixed ...
1-10
Check:
Capital budgeting or Financing decisions?
Intel decides to spend $500 mil to develop a new
microprocessor
Vo...
1-11
Managerial Issues
How to measure the project’s worth for the
company?
Are companies' market prices justified?
Exam...
1-12
Managerial Issues (cont.)
Does it matter how to finance the project: by
debt or by equity?
Would you like the compa...
1-13
Managerial Issues (cont.)
Should we give managers higher salaries or
higher bonuses?
How should the company communi...
1-14
Forms of Business Organization 
impact on financial decisions
Sole proprietorship
Partnership
Corporation
Evaluat...
1-15
Sole Proprietorship
Advantages
Ease of organization
Subject to fewer government regulations
Disadvantages
Unlimi...
1-16
Partnership
Advantages
Ease of organization
Able to raise more money than the sole
proprietor
Disadvantages
Unli...
1-17
Corporation
Advantages
Limited liability
Easy transfer of ownership
Unlimited life
Ability to raise large amount...
1-18
Characteristics of business organizations
Sole Proprietorship Partnership Corporation
Who owns the
business? The mana...
1-19
Check:
Which form of business organization
might best suit the following? Why?
A consulting firm with several senior...
1-20
About corporations:
Book versus Market values
The book value of an asset is determined based
on accounting rules.
T...
1-21
Book versus market values
Market value of a firm
Mkt. value of equity
Mkt. value of debtMarket value of the
asset’s ...
1-22
Book versus market values
The Book value of a firm often contrasts
sharply with the Market value.
Book equity
Book d...
1-23
Book versus market values: a
hypothetical example
A firm begins with $2000 of debt and $4000 of
equity in order to p...
1-24
Book versus market values for the
hypothetical example
Book values of firm:
Market values of firm: $4,000 Book equi...
1-25
A question:
What can you tell from a market-to-book
ratio?
 large/small ratios
 > 1
 < 1
What shall you do if yo...
1-26
Intrinsic (fundamental) values
Market values are what investors are willing to
either buy or sell an asset for, base...
1-27
Intrinsic (fundamental) values
Assume that a New York Stock Exchange listed
firm has an equity market value of $10 b...
1-28
Financial goals of the corporation
The primary financial goal is shareholder
wealth maximization — a function of
fut...
1-29
Stock price maximization is NOT profit or
earnings maximization?
Market (and intrinsic) values are driven by risk
an...
1-30
Wealth maximization and societal welfare
Is the general welfare of society advanced when
individual agents pursue we...
1-31
Wealth maximization and societal welfare
(Adam Smith, 1776)
“As every individual, endeavours as much as he can
both t...
1-32
What is the Objective of the Firm?
Van Horne: "In this book, we assume that the
objective of the firm is to maximize...
1-33
Why Focus on Maximizing Stockholder Wealth?
Shareholders are the legal owners of the business,
management has a resp...
1-34
Why Focus on Maximizing Stock Price?
Stock price is easily observable and constantly
updated
If investors are ratio...
1-35
The Classical Objective Function
1-36
What Can Go Wrong?
1-37
Solutions
Choose a different mechanism for corporate
governance
Choose a different objective
Maximizing earnings /...
1-38
Counter Reaction
1-39
The Modified Objective Function
For publicly traded firms in reasonably efficient markets,
where bondholders (lender...
1-40
Agency relationships — the separation of
ownership and control
An agency relationship exists whenever a
principal (o...
1-41
Shareholders versus Managers
Managers are naturally inclined to act in
their own best interests.
But the following ...
1-42
Shareholders versus Creditors
Shareholders (through managers) could
take actions to maximize stock price that
are de...
1-43
Case study
Michael Eisner – CEO of The Walt Disney
Company (Sep 1984 – Sep 2005)
Discuss the paper by Stephen F. O’...
1-44
Another example:
The compensation for Mr. Palmisano, Chairman and CEO
of IBM Corp., during 2003-2005 (Source: IBM Not...
1-45
To mitigate the agency problems in
practice (1)
 Compensation schemes (to tie the
fortune of the manager to that of ...
1-46
To mitigate the agency problems in
practice (2)
Monitoring by lenders, stock market
analysts, and investors
Indepen...
1-47
Summary –
Keep in mind the differences between:
 Real vs. financial assets
 Capital budgeting and financing decisio...
1-48
Đọc case study và trả lời các câu hỏi
sau đây:
1. Đại ý của bài là gì? Tác giả muốn ca ngợi
cái gì?...
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Phase 3 financial issues & incentives in organizations

  1. 1. 1-1 FINANCIAL ISSUES & INCENTIVES IN MODERN ORGANIZATIONS Asso.Prof.Dr. NGUYEN THU THUY Faculty of Business Administration FOREIGN TRADE UNIVERSITY Email: thuynguyen0202@gmail.com
  2. 2. 1-2 Finance? A foremost concept in finance concerns how individuals interact in order to allocate resources (capital) and/or shift consumption across time by borrowing or investing. If you receive $1 million today then what decision would you make regarding consumption and investment?  Suppose you spend (consume) $100,000 now.  This leaves you with $900,000. You can postpone consumption to future time periods by investing the $900,000 today. On the other hand, what if you have $20,000 but need to consume $30,000. You can borrow the $10,000 and pay it back in a future period along with the interest.
  3. 3. 1-3 Two examples of common corporate financial decisions A firm must spend $100 million for the required assets if a proposed project is approved. Important issues are:  Should the project be accepted or rejected? What do investors demand as a (minimum acceptable) project rate of return?  What are the project’s forecasted future cash flows? How risky are these forecasted cash flows?  Where will the $100 million come from, i.e., what mix of equity and debt financing should be used? If a firm has $200 million of cash flow, but needs reinvest $120 million, what should be done with the remaining $80 million of cash.  Pay it out as a dividend or repurchase some stock?
  4. 4. 1-4 Example of common investments type financial decisions A mutual fund manager that manages a fund with $10 billion portfolio receives an additional $100 million in cash from new investors. Which stocks or bonds to purchase? How will any proposed new investments affect the expected return and risk of the overall portfolio?
  5. 5. 1-5 Corporate finance vs. Investments Board of Directors CEO Assets Equity Debt Issue Fixed Income Products (Bonds) Issue Shares Stock Holders Debt Holders Investors CFO
  6. 6. 1-6 I: Corporate Finance  Imagine you are the CFO of a company with $2 billion in excess cash. What can the firm do with the cash? 1. Invest in a new project 2. Find an acquisition candidate 3. Invest in financial assets 4. Repay debt 5. Repurchase shares of a stock 6. Pay a dividend
  7. 7. 1-7 II: Investments Investment theory tries to answer questions like: in which combination of securities should investors put their money? what is the relation between risk & return? what return can you expect on a portfolio? is it possible to outperform the market?
  8. 8. 1-8 Corporate finance decisions - summary  Capital budgeting decision  investment projects  physical plants, equipment  brand building (intangible assets)  R&D  Financing decision:  Funding sources  Long-term financing mix  capital structure decision
  9. 9. 1-9 Two Main Functions of Corporate Finance Current Assets Cash Marketable Securities Account Receivables Inventory Fixed Assets Buildings Equipment Land Intangible Assets Brand Names Trademarks and Patents Distribution Networks Customer Loyalty Loyal and Skilled Work Force Current Liabilities Accounts Payable Short-Term Debt Product Warranties Long-Term Liabilities Long-Term Debt Pension Obligations Deferred Taxes Leases Equity Proceeds from Stock Sales Retained Earnings Value Created by Investments Intangible Liabilities No-Layoff Policy Commitment to Quality Products and Services Need to Advertise and Promote The Investment/Capital budgeting Decision: Assets The Financing Decision: Liabilities and Equity
  10. 10. 1-10 Check: Capital budgeting or Financing decisions? Intel decides to spend $500 mil to develop a new microprocessor Volkswagen decides to raise 350 mil euros through a bank loan Exxon constructs a pipeline to bring natural gas on shore from the Gulf of Mexico Pierre Lapin sells shares to finance expansion of his newly formed securities trading firm. Norvatis buys a license to produce and sell a new drug developed by a biotech company Maersk issues new shares to help pay for the purchase of two new vessels.
  11. 11. 1-11 Managerial Issues How to measure the project’s worth for the company? Are companies' market prices justified? Example: dot-coms How to choose among the projects given the budget constraint and externalities? How to account for risks associated with the project? Are risks always bad? Is it good to have volatile oil prices? Should we invest now in an unprofitable project? Should we invest now in a profitable project?
  12. 12. 1-12 Managerial Issues (cont.) Does it matter how to finance the project: by debt or by equity? Would you like the company to have much debt? Should the company borrow more money from banks or issue bonds? Would you like the company to pay high dividends? Example: Microsoft How will the market react to the share buyback? How will the market react to the new equity issue?
  13. 13. 1-13 Managerial Issues (cont.) Should we give managers higher salaries or higher bonuses? How should the company communicate with the market? What drives the company’s decision to go public? Would you like the company to grow via acquisitions?
  14. 14. 1-14 Forms of Business Organization  impact on financial decisions Sole proprietorship Partnership Corporation Evaluate by The owners' liability The life of the entity The ability to raise capital
  15. 15. 1-15 Sole Proprietorship Advantages Ease of organization Subject to fewer government regulations Disadvantages Unlimited personal liability Inability to raise large amounts of money Life of the business is limited to the life of the proprietor
  16. 16. 1-16 Partnership Advantages Ease of organization Able to raise more money than the sole proprietor Disadvantages Unlimited personal liability Difficult to transfer ownership Ability to raise capital is limited by the partner’s personal wealth
  17. 17. 1-17 Corporation Advantages Limited liability Easy transfer of ownership Unlimited life Ability to raise large amounts of money Disadvantages Start-up can be costly Earnings subject to double taxation Separation of control and ownership
  18. 18. 1-18 Characteristics of business organizations Sole Proprietorship Partnership Corporation Who owns the business? The manager Partners Shareholders Are managers and owner(s) separate? No No Usually What is the owner's liability? Unlimited Unlimited Limited Are the owner and business taxed separately? No No Yes
  19. 19. 1-19 Check: Which form of business organization might best suit the following? Why? A consulting firm with several senior consultants and support staff. A pharmaceutical company with sales of $ 300 mil and 1,500 employees. An advertisement design firm owned and operated by a (industrial design) college student who occasionally hires friends for manual help.
  20. 20. 1-20 About corporations: Book versus Market values The book value of an asset is determined based on accounting rules. The book value is at best a rough approximation of the asset’s replacement cost. The market value of an asset is that investors are willing to pay today for stocks and bonds in order to receive a risky stream of future expected cash flows. Market values are forward looking. Stocks and bonds represent claims on the future cash flows that a firm’s assets generate.
  21. 21. 1-21 Book versus market values Market value of a firm Mkt. value of equity Mkt. value of debtMarket value of the asset’s earning power (as a going concern) Liabilities + EquityAssets
  22. 22. 1-22 Book versus market values The Book value of a firm often contrasts sharply with the Market value. Book equity Book debtPhysical assets at historical book value Liabilities + EquityAssets
  23. 23. 1-23 Book versus market values: a hypothetical example A firm begins with $2000 of debt and $4000 of equity in order to purchase $6000 of assets. These become the original accounting book values. In contrast, Market values are based on today’s expectations of future performance, i.e., what cash amounts are expected to be paid out and the perception of risk. Assume the following: Investors are willing to pay $2000 for the bonds. Investors are willing to pay $10,000 for the equity.
  24. 24. 1-24 Book versus market values for the hypothetical example Book values of firm: Market values of firm: $4,000 Book equity $2,000 Book debt$6,000 physical assets Liabilities + EquityAssets $10,000 M.V. equity $2,000 M.V. debt$12,000 M.V. as a going concern Liabilities + EquityAssets
  25. 25. 1-25 A question: What can you tell from a market-to-book ratio?  large/small ratios  > 1  < 1 What shall you do if you observe/think that your shares are undervalued?
  26. 26. 1-26 Intrinsic (fundamental) values Market values are what investors are willing to either buy or sell an asset for, based on investors’ expectations of future performance. Market values are very often publicly observed, e.g., the transactions in the stock markets. In contrast, intrinsic values are usually considered as private estimates of what something, e.g., a common stock, is actually worth. Intrinsic value is not something that you can prove. If ten analysts are asked to value IBM stock, then there will likely be ten different intrinsic value estimates!
  27. 27. 1-27 Intrinsic (fundamental) values Assume that a New York Stock Exchange listed firm has an equity market value of $10 billion. However, those that manage the firm (insiders) believe the firm is actually worth $12 billion (intrinsic value), based on their private or inside forecasts of future cash flow performance. For the most part, market prices are driven by public expectations and consensus, while intrinsic values represent private forecasts.
  28. 28. 1-28 Financial goals of the corporation The primary financial goal is shareholder wealth maximization — a function of future cash flow and risk. In reality, this is maximizing intrinsic value  For now we will assume that this is synonymous with maximizing the market value, i.e., stock price maximization. Warren Buffett states that his goal is to maximize Berkshire Hathaway’s intrinsic value, and hopefully, the stock’s market value will be close to the intrinsic value.
  29. 29. 1-29 Stock price maximization is NOT profit or earnings maximization? Market (and intrinsic) values are driven by risk and expectations (forecasts) of future cash flows. Earnings and other accounting profitability measures are not cash flows and have limited use in estimating financial values. Some actions may cause an increase in reported earnings, yet cause the stock price to decrease (and vice versa).
  30. 30. 1-30 Wealth maximization and societal welfare Is the general welfare of society advanced when individual agents pursue wealth maximization? Is intrinsic or market value maximization good or bad for society. Should firms behave ethically? The following slide contains a quote is from Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations, 1776. Adam Smith believed that an economic system in which individual agents strive to increase their market value results in the most efficient level of general welfare, as it facilitates the allocation of resources to their most productive use.
  31. 31. 1-31 Wealth maximization and societal welfare (Adam Smith, 1776) “As every individual, endeavours as much as he can both to employ his capital in the industry, and to direct that industry that its produce may be of the greatest value, every individual necessarily labours to render the annual revenue of the society as great as he can. In doing so he generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Thus, by pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who pretended to trade for the public good.”
  32. 32. 1-32 What is the Objective of the Firm? Van Horne: "In this book, we assume that the objective of the firm is to maximize its value to its stockholders" Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value." Copeland & Weston: The objective of the firm is to maximize the wealth of its stockholders." Brigham and Gapenski: we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.
  33. 33. 1-33 Why Focus on Maximizing Stockholder Wealth? Shareholders are the legal owners of the business, management has a responsibility to act in their best interest Stockholders provide the risk capital that serves as a “shock absorber” to the claims of other stakeholders Focusing on shareholder value avoids value gaps Undervalued firms are prime targets for a takeover Profit or earnings per share maximization is inferior: Shareholders don’t really get profits; the only direct returns are dividends and stock price appreciation Accounting measures ignore shareholder opportunity costs Focusing on expected profits ignores risks
  34. 34. 1-34 Why Focus on Maximizing Stock Price? Stock price is easily observable and constantly updated If investors are rational, stock prices reflect the risks, short term and long term Maximizing stock price is not incompatible with meeting other stakeholders' needs/objectives The objective of stock price performance provides some elegant theory on: how to pick projects how to finance them how much to pay in dividends
  35. 35. 1-35 The Classical Objective Function
  36. 36. 1-36 What Can Go Wrong?
  37. 37. 1-37 Solutions Choose a different mechanism for corporate governance Choose a different objective Maximizing earnings / revenues / firm size / market share The key thing to remember is that these are intermediate objective functions Maximize stock price, but reduce the potential for conflict and breakdown: Making managers and employees into stockholders Providing information honestly and promptly to financial markets
  38. 38. 1-38 Counter Reaction
  39. 39. 1-39 The Modified Objective Function For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected:  Maximize stock price: this will also maximize firm value For publicly traded firms in inefficient markets, where bondholders are protected:  Maximize stockholder wealth: this will also maximize firm value, but might not maximize the stock price For publicly traded firms in inefficient markets, where bondholders are not fully protected  Maximize firm value, though stockholder wealth and stock prices may not be maximized at the same point. For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not)
  40. 40. 1-40 Agency relationships — the separation of ownership and control An agency relationship exists whenever a principal (owner of a resource) hires an agent to act on their behalf. Examples are: Citizen (principal) and elected official (agent) Stockholder (principal) and corporate manager (agent) Within a corporation, agency relationships exist between: Shareholders and managers Shareholders and creditors
  41. 41. 1-41 Shareholders versus Managers Managers are naturally inclined to act in their own best interests. But the following factors affect managerial behavior: Managerial compensation plans Direct intervention by shareholders The threat of firing The threat of corporate takeover
  42. 42. 1-42 Shareholders versus Creditors Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors, i.e., actions that result in a wealth transfer from creditors to stockholders. In the long run, such actions will raise the cost of debt and ultimately lower the stock price.
  43. 43. 1-43 Case study Michael Eisner – CEO of The Walt Disney Company (Sep 1984 – Sep 2005) Discuss the paper by Stephen F. O’Byrne “What pay for performance looks like: the case of Michael Eisner", Journal of Applied Corporate Finance 5 (summer 1992), pp. 135-136
  44. 44. 1-44 Another example: The compensation for Mr. Palmisano, Chairman and CEO of IBM Corp., during 2003-2005 (Source: IBM Notice of 2006 Annual Meeting and Proxy Statement) Year Annual compensation (US$) Long-term compensation (US$) Salary Bonus Others Restricted stock award Stock option Others 2005 1,680,000 5,175,000 103,302 990,674 230,325 4,241,981 2004 1,660,000 5,175,000 104,406 250,000 1,676,480 2003 1,550,000 5,400,000 11,037 250,000 769,095
  45. 45. 1-45 To mitigate the agency problems in practice (1)  Compensation schemes (to tie the fortune of the manager to that of the firm)  Example: Walt Disney offers its CEO with a package that includes A base annual salary An annual bonus (2% of Disney’s net income above a threshold of “normal” profitability) A (10-year) option that allows the CEO to purchase stocks (e.g., 2 mils shares for $14 per share)
  46. 46. 1-46 To mitigate the agency problems in practice (2) Monitoring by lenders, stock market analysts, and investors Independent board members Takeover threats  Labor market forces:  Threat that poor performance will result in the removal of the manager  Bad reputation/remuneration for managers if badly performing
  47. 47. 1-47 Summary – Keep in mind the differences between:  Real vs. financial assets  Capital budgeting and financing decision  Closely held vs. public corporations  Limited and unlimited liability
  48. 48. 1-48 Đọc case study và trả lời các câu hỏi sau đây: 1. Đại ý của bài là gì? Tác giả muốn ca ngợi cái gì? 2. Phân tích tình hình Walt Disney Co. trước khi M.Eisner trở thành CEO. 3. Các đặc điểm nào trong hợp đồng 6 năm của M.Eisner có tính chất khuyến khích người lao động làm việc hiệu quả nhất? 4. So sánh các điểm khác biệt của HĐ 10 năm với HĐ 6 năm.

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