3. AGENDA
• Fill LAC card
• Warm-Up: Pictionary
• Define Terminology
• Group Discussion
• End of Day Quiz
• Get To Know You Survey
4. LEARNING ASSISTANCE CENTER CARD
• Semester: Spring 2016
• Name: Put your name
• Student ID#: You know it
• Target Course: Fin 300
• SI Section#: 60
• Leader’s Name: Henry Tep
5. PICTIONARY
• Get into groups of 3-4
• Everyone will be at the whiteboards, there should be a marker
• 1 student will get the word from me to draw out
• Student cannot use letters, but symbols and numbers are o.k.
• Once you have the answer, let me know!
9. S-CORPORATION, LIMITED LIABILITY
COMPANY, LIMITED LIABILITY PARTNERSHIP
• How do they differ from the three main form of
businesses?
• Why would anyone want to have one of these forms?
• What type of business should use any of these forms?
11. INTRINSIC VALUE
• Is there a true value for the intrinsic value of a stock?
• Why is the intrinsic value of a stock important?
• If a stock is more expensive than the intrinsic value,
should you buy that stock?
• If a stock is less expensive than the intrinsic value,
should you buy that stock?
12. STOCKHOLDER WEALTH MAXIMIZATION
• What is it?
• What role does the manager have in wealth
maximization?
• Should financial manager’s maximize shareholder’s
wealth at all cost?
• If not, then what are some of the things that financial
managers should be aware of?
13. ETHICS
• Why are ethics important to society and to
businesses?
• Do all financial managers require ethics?
15. 1ST SCENARIO
Suppose you were a member of Company X’s
board of directors and chairperson of the
company’s compensation committee. What factors
should your committee consider when setting the
CEO’s compensation? Should the compensation
consist of a dollar salary, stock options that
depend on the firm’s performance, or a mix of the
two? If “Performance” is to be considered, how
should it be measured? Think of both theoretical
and practical (that is, measurement)
considerations. If you were also a vice president of
Company X, might your actions be different than if
you were the CEO of some other company?
16. 2ND SCENARIO
You are a financial manager of Tunnel
Vision Corporation, who has to make a
decision on which project to pursue next.
There are two choices that will create
positive net income. The first project is an
oil drilling project that will add $3.00 to
the price of the company’s stock in the
next 6 months, than another $3.00 dollars
in the following 5 years for a max increase
of $6.00 dollars. On the other hand, the
second project is a research and
development project for solar panels. The
project will not increase the value of the
company in the first 4 years, but is
expected to increase the company’s value
by $8.00 dollars in the 5th year. Which
action would be better? Why would it be
better? Finally, is it better to think short-
term or long-term when investing?
17. 3RD SCENARIO
• Note that the two projects have the same
expected payoff, but Project H has higher risk.
The debtholders always get paid first and the
stockholders receive any money that is available
after the debtholders have been paid. Assume
that if the company doesn’t have enough funds
to pay off its debtholders on year from now,
then Bedrock will declare bankruptcy. If
bankruptcy is declared, the debtholders will
receive all available funds and the stockholders
will receive nothing.
• A. Assume that the company selects Investment
L. What is the expected payoff to the firm’s
debtholders? What is the expected payoff to the
firm’s stockholders?
• B. Assume that the company selects Investment
H. What is the expected payoff to the firm’s
debtholders? What is the expected payoff to the
firm’s stockholders?
• C. Would the debtholders prefer that the
company’s managers select Project L or Project
H? Briefly explain your reason.
• D. Explain why the company’s managers acting
on behalf of the stockholders might select
Project H even though it has greater risk.
• E. What actions can debtholders take to protect
their interest.
Bedrock Company has $70 million in debt and $30
million in equity. The debt matures in one year and
has a 10% interest rate, so the company is
promising to pay back $77 million to its
debtholders one year from now. The company is
considering two possible investments, each of
which will require an upfront cost of $100 million.
Each investment will last for one year and the
payoff from each investment depends on the
strength of the economy. There is a 50% chance
that the economy will be weak and a 50% chance it
will be strong. Here are the expected payoffs
(dollars are in millions) from the two investments.
Payoff in one
Year if
is weak
Payoff in one year
if economy is
strong
Expected payoff
Investment L $90 $130 $110
Investment H $50 $170 $110
18. 3RD SCENARIO
• Note that the two projects have the same expected payoff, but Project H
has higher risk. The debtholders always get paid first and the
stockholders receive any money that is available after the debtholders
have been paid. Assume that if the company doesn’t have enough
funds to pay off its debtholders on year from now, then Bedrock will
declare bankruptcy. If bankruptcy is declared, the debtholders will
receive all available funds and the stockholders will receive nothing.
19. GET TO KNOW YOU SURVEY
• Survey to get to know you better
• You do not have to answer any questions you feel uncomfortable
answering
• This is not graded!
21. QUESTION 1
• What is a firm’s intrinsic value? Its current stock price? Is the stock’s
“true” long-run value more closely related to its intrinsic value or to its
current price?
22. QUESTION 2
• When is a stock said to be in equilibrium? Why might a stock at any
point in time not be in equilibrium?
23. QUESTION 5
• If a company’s board of directors wants management to maximize
shareholder wealth, should the CEO’s compensation be set as a fixed
dollar amount, or should the compensation depend on how well the firm
performs? If it is to be based on performance, how should performance
be measured? Would it be easier to measure performance by the
growth rate in reported profits or the growth rate in the stock’s intrinsic
value? Which would be the better performance measure? Why?
24. QUESTION 6
• What are the various forms of business organization? What are the
advantages and disadvantages of each?
25. QUESTION 7
• Should stockholder wealth maximization be thought of as a long-term
or a short-term goal? For example, if one action increases a firm’s stock
price from a current level of $20 to $25 in 6 months and then to $30 in 5
years but another action keeps the stock at $20 for several years but
then increases it to $40 in 5 years, which action would be better? Think
of some specific corporate actions that have these general tendencies.
26. QUESTION 9
• The president of Southern Semiconductor corporation (SSC) made this statement in
the company’s annual report: “SSC’s primary goal is to increase the value of our
common stockholder’s equity.” Later in the report, the following announcements were
made:
• A. The company contributed $1.5 million to the symphony orchestra in Birmingham,
Alabama, its headquarters city.
• B. The company is spending $500 million to open a new plant and expand operations
in China. No profits will be produced by the Chinese operartions for 4 years, so
earnings will be depressed during this period versus what the would have been had
the decision been made not to expand in China.
• C. The company holds about half of its assets n the form of U.S. Treasury bonds, and it
keeps these funds available for use in emergencies. In the future, though, SSC plans to
shift its emergency funds from Treasury bonds to common stocks.
Editor's Notes
The Sarbanes-Oxley Act was passed by Congress in the wake of a series of corporate scandals involving now-defunct companies such as Enron and WorldCom, where investors, workers, and suppliers lost billions of dollars due to false information released by those companies. Arthur Anderson was the accounting firm that also suffered from the Enron scandal. It used to be one of the largest accounting firm in the world.
Why does it exist in the first place? It exist to keep businesses from having fraudulent accounting practices.
Does it help or harm businesses? In the short-run it may hurt businesses because of the extra regulation added, but in the long-run it helps businesses because it makes businesses more transparent.
Proprietorship: Unincorporated business owned by one individual. Advantages(3): They are easy and inexpensive to form. They are subject to few government regulations. They are subject to lower income taxes than are corporations. Disadvantages (3): Unlimited liability, therefore they can lose more than what the business is worth. Ex. Getting sued for $1 million due to negligence. The life of the business is limited to the life of the individual who created it, and to bring in new equity, investors require a change in the structure of the business. Because of the first two disadvantages, proprietorship have difficulty obtaining large sums of capital, hence they are mainly used for small businesses.
Partnership: Legal arrangement between two or more people who decide to do business together. Advantages(3): Same advantages as proprietorship. Firm avoid corporate income taxes. Disadvantages: Members of the partnership bear each other liability. Hard to raise large amounts of capital.
Two types of partnership, limited partnership and general partnership.
Corporation: Legal entity created by a state, and it is separate and distinct from its owners and managers. Separation limits stockholder’s losses. Unlimited lives, easier to transfer shares of stock in a corporation than one’s interest in an unincorporated business. Easier to raise capital.
S-corporation: Small corporations with no more than 100 shareholders. Get taxed like proprietorship or partnerships. Exempt from income tax.
The manager role is to maximize stockholder wealth. Wealth is a long-term idea, so maximizing the wealth in the long-run is what their suppose to do. Management’s goal should be focused on maximizing the firm’s intrinsic value, and not its current market price.
Financial managers must behave ethically.
Dodd-Frank act
Sarbanes-Oxley act
Ethics are important to businesses because it reflects on positively if a company has good ethics, and poorly if a company has bad ethics. This is their reputation. They get penalized for bad business ethics.
The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date. The board should probably set the CEO’s compensation as a mix between a fixed salary and stock options. The actions of the vice president of Company X would be different than if he were CEO of some other company.
a. The expected payoff to debtholders is $77 million. The expected payoff to stockholders is (0.5 × $13 million + 0.5 × $53 million) = $33 million. If management selects Project L, then the firm will have enough cash flow to fully pay debtholders the promised $77 million, regardless of the state of the economy. The stockholders receive the cash flows that are available after the debtholders have been paid.
b. The expected payoff to debtholders is (0.5 × $50 million + 0.5 × $77 million) = $63.5 million. The expected payoff to stockholders is (0.5 × 0 + 0.5 × $93) = $46.5 million. If management selects Project H and the economy is weak, then the company will not have enough cash to fully pay off its debts. In this case, the debtholders would receive all of the available cash ($50 million) and there will be nothing left over for the stockholders. If the economy is strong, there will be enough cash to fully pay off the debtholders and the stockholders will receive all the remaining cash ($170 million – $77 million = $93 million).
c. The bondholders would clearly prefer that the company select Project L, since it would give them a higher cash flow and less risk.
d. Even though Project L and Project H have the same overall expected payoff, Project H shifts the distribution of the firm’s cash flow payoffs from debtholders to stockholders. So, in many instances, despite the higher risk, stockholders may prefer Project H because it provides them with a significantly higher expected payoff.
e. Bondholders attempt to protect themselves by including covenants in the bond agreements that limit firms’ use of additional debt and constraining managers’ actions (such as taking on risky projects to the detriment of bondholders) in other ways.
A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. It can be estimated but not measured precisely. A stock’s current price is its market price—the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock’s “true” long-run value is more closely related to its intrinsic value rather than its current price.
Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying and selling a stock. If a stock is in equilibrium then there is no fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued. Investor optimism and pessimism, along with imperfect knowledge about the true intrinsic value, leads to deviations between the actual prices and intrinsic values.
The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date.
The different forms of business organization are proprietorships, partnerships, corporations, and limited liability corporations and partnerships. The advantages of the first two include the ease and low cost of formation. The advantages of corporations include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. Limited liability companies and partnerships have limited liability like corporations.
The disadvantages of a proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) setting up a corporation and filing required state and federal reports, which are complex and time-consuming. Among the disadvantages of limited liability corporations and partnerships are difficulty in raising capital and the complexity of setting them up.
Stockholder wealth maximization is a long-run goal. Companies, and consequently the stockholders, prosper by management making decisions that will produce long-term earnings increases. Actions that are continually shortsighted often “catch up” with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the U.S. auto industry, which has been accused of continuing to build large “gas guzzler” automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.
Discuss how SSC’s stockholders might view each of these actions and how the actions might affect the stock price.
a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a more attractive community that will make it easier to hire a productive work force. This corporate philanthropy could be received by stockholders negatively, especially those stockholders not living in its headquarters city. Stockholders are interested in actions that maximize share price, and if competing firms are not making similar contributions, the “cost” of this philanthropy has to be borne by someone—the stockholders. Thus, stock price could decrease.
b. Companies must make investments in the current period in order to generate future cash flows. Stockholders should be aware of this, and assuming a correct analysis has been performed, they should react positively to the decision. The Chinese plant is in this category. Capital budgeting is covered in depth in Part 4 of the text. Assuming that the correct capital budgeting analysis has been made, the stock price should increase in the future.
c. U.S. Treasury bonds are considered safe investments, while common stocks are far more risky. If the company were to switch the emergency funds from Treasury bonds to stocks, stockholders should see this as increasing the firm’s risk because stock returns are not guaranteed—sometimes they increase and sometimes they decline. The firm might need the funds when the prices of their investments were low and not have the needed emergency funds. Consequently, the firm’s stock price would probably fall.
