Chapter 4 Notes

1.Who Owns the Business?

• In global business today the ownership and control of organizations varies dramatically across
countries and cultures.

•To understand how and why those businesses operate, one must first understand the many different
ownership structures.

•A public enterprise is a business owned by a government

•A private enterprise is owned by a private company or individual

•A business owned by a private party is privately held. Becomes a publicly traded company if the owners
sell a portion of their ownership in the business in the capital markets

•Any business can “go public” by listing a portion of its ownership in the public marketplace via an initial
public offering.

•Conversely, some publicly traded firms go private when a single investor or group buys outstanding
shares and ceases to trade.

•SOEs and widely held publicly traded companies typically separate management and ownership.

•This raises the possibility that ownership and management may not be perfectly aligned in their
business and financial objectives, the so-called agency problem.

2.The Goal of Management: Shareholder Wealth Maximization

•Maximization of shareholders’ wealth is the dominant goal of management in the Anglo-American

world.

•In the rest of the world, this perspective still holds true (although to a lesser extent in some
countries).

•In Anglo-American markets, this goal is realistic; in many other countries it is not.

•There are basic differences in corporate and investor philosophies globally.

•In this context, the universal truths of finance become culturally determined norms.

• In a Shareholder Wealth Maximization (SWM) model, a company should strive to maximize

shareholder return, measured by the sum of capital gains and dividends, for a given level of risk.

• Alternatively, the company should minimize the level of risk to shareholders for a given rate of return.
For a company the return could be computed using the following formula:

•Where D2 is dividend paid at time 2, P2 and P1 are the prices at time 2 and 1.
•The SWM model assumes as a universal truth that the stock market is efficient.

•An equity share price is always correct because it captures all the expectations of return and
risk as perceived by investors, quickly incorporating new information into the share price.

•Share prices are, in turn, the best allocators of capital in the macro economy.

•The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk
that a firm’s shares bring to a diversified portfolio.

•Therefore the unsystematic, or operational risk, should not be of concern to investors (unless
bankruptcy becomes a concern) because it can be diversified.

•Systematic, or market, risk cannot however be eliminated.

•Long-term value maximization can conflict with short-term value maximization as a result of
compensation systems focused on quarterly or near-term results.

•Short-term actions taken by management that are destructive over the long-term have been
labeled impatient capitalism.

•This point of debate is often referred to a firm’s investment horizon (how long it takes for a
firm’s actions, investments and operations to result in earnings).

•In contrast to impatient capitalism is patient capitalism. This focuses on long-term SWM.

•Many investors, such as Warren Buffet, have focused on mainstream firms that grow slowly
and steadily, rather than latching on to high-growth but risky sectors.

•In the non-Anglo-American markets, controlling shareholders also strive to maximize long-term returns
to equity.
 •However, they are more constrained by other powerful stakeholders.

•In particular, labor unions are more powerful than in the Anglo-American markets.

•In addition, Governments interfere more in the marketplace to protect important stakeholder groups,
such as local communities, the environment and employment.

•The SCM model does not assume that equity markets are either efficient or inefficient.

•The inefficiency does not really matter, because the firm’s financial goals are not exclusively
shareholder-oriented, because they are constrained by the other stakeholders.

•The SCM model assumes that long-term “loyal” shareholders – those typically with controlling interests
– should influence corporate strategy, rather than the transient portfolio investor.

•The objective of the privately held firm is to maximize current and sustainable income.

•The SCM model assumes that total risk—i.e., operating and financial risk—does count.

•It is a specific corporate objective to generate growing earnings and dividends over the long
run with as much certainty as possible.

•In this case, risk is measured more by product market variability than by short-term variation in
earnings and share price.

•The MNE must determine for itself proper balance between three common operational financial
objectives:

•maximization of consolidated after-tax income;

•minimization of the firm’s effective global tax burden;

•correct positioning of the firm’s income, cash flows, and available funds as to country and
currency.

•These goals are frequently incompatible, in that the pursuit of one may result in a less-desirable
outcome in regard to another.
•Many firms are publicly traded but are still heavily influenced or even controlled by families.
•Exhibit 4.3 illustrates how family businesses on average out-perform indexes of public companies in the
United States France, Germany, and Western Europe.

3.Publicly Traded Versus Privately Held: The Global Shift

•Exhibit 4.4 illustrates how the number of U.S. publicly listed firms peaked in 1996 at 8,783. Today
around 5,000 listings.

•The number of publicly listed firms worldwide peaked in 2008.

•U.S. listings as a % of worldwide listings of publicly traded firms dropped from 33.3% in 1996 to
11% at year-end 2010.

•Possible Causes in the Decline of Publicly Traded Shares

•Sarbanes-Oxley has added reporting requirements

•The growth of private equity markets

•The growth of Electronic Communication Networks (ECNs) helped reduce transaction costs, but
also made it less profitable for brokerage houses to research smaller firms. Thus trading volume
on smaller firms fell off and some ceased trading at all.

4.Corporate Governance: The Goals of Corporate Governance

•Although the governance structure of any company – domestic, international, or multinational – is

fundamental to its very existence, this subject has become a lightning rod for political and business
debate in the past few years.

•Spectacular failures in corporate governance have raised issues about the very ethics and
culture of the conduct of business.

•The single overriding objective of corporate governance is the optimization over time of the returns to
shareholders.

•In order to achieve this goal, good governance practices should focus the attention of the board of
directors of the corporation by developing and implementing a strategy that ensures corporate growth
and improvement in the value of the corporation’s equity.

The most widely accepted statement of good corporate governance practices has been established by

the OECD:

• Shareholder rights. Shareholders are the owners of the firm, and their interests should take
precedence over other stakeholders.

• Board responsibilities. The board of the company is recognized as the individual entity with final full
legal responsibility for the firm, including proper oversight of management.

• Equitable treatment of shareholders. Equitable treatment is specifically targeted toward domestic

versus foreign residents as shareholders, as well as majority and minority interests.
• Stakeholder rights. Governance practices should formally acknowledge the interests of other
stakeholders—employees, creditors, community, and government.

• Transparency and disclosure. Public and equitable reporting of firm operating and financial results and
parameters should be done in a timely manner, and available to all interests equitably

•The modern corporation’s actions and behaviors are directed and controlled by both internal forces
and external forces (Exhibit 4.5).

•The internal forces, the officers of the corporation and the board of directors, are those directly
responsible for determining both the strategic direction and the execution of the company’s future.

•The external forces include equity markets in which the shares are traded, the analysts who critique
the company’s investment prospects and external regulators, among others.

•The board of directors is the legal body that is accountable for the governance of the corporation.

•The senior officers of the corporation are the creators and directors of the corporation’s strategic and
operational direction.

•Equity markets should reflect the market’s constant evaluation of the promise and performance of the
company.

•Debt markets should reflect the company’s ability to repay its debt in a timely and efficient manner.

•Auditors and legal advisors are responsible for providing an external professional opinion as to the
fairness, legality and accuracy of corporate financial statements.

•Regulators work to ensure, among other things, that a regular and orderly disclosure process of
corporate performance is conducted so that investors may evaluate a company’s investment value with
accuracy.
•The need for a corporate governance process arise from the separation of ownership from
management and from varying stakeholder views.

•Corporate governance regimes may be classified by the evolution of business ownership over time (see
Exhibit 4.6).

•Exchange rate regimes are a function of:

 •the financial market development;

•the degree of separation between management and ownership;

•the concept of disclosure and transparency; and

•the historical development of the legal system.

•Failures in corporate governance have become increasingly visible in recent years.

•In each case, prestigious auditing firms missed the violations or minimized them, presumably because
of lucrative consulting relationships or other conflicts of interest.

•In addition, security analysts urged investors to buy the shares of firms they knew to be highly risky (or
even close to bankruptcy).

•Top executives themselves were responsible for mismanagement and still received overly generous
compensation while destroying their firms.

•Within the U.S. and U.K., the main corporate governance problem is the one treated by agency theory:
with widespread share ownership, how can a firm align management’s interest with that of the
shareholders?

•Because individual shareholders do not have the resources or the power to monitor management, the
U.S. and U.K. markets rely on regulators to assist in the agency theory monitoring task.

•Outside the U.S. and U.K., large, controlling shareholders are in the majority—these entities are able to
monitor management in some ways better than the regulators can.
•Poor performance of management usually requires changes in management, ownership, or both.

•Exhibit 4.8 illustrates some of the alternative paths available to shareholders when they are dissatisfied
with firm performance.

•The purpose of the corporation is to certainly create profits and value for its stakeholders, but the
responsibility of the corporation is to do so in a way that inflicts no costs on the environment and
society

•Sustainability is often described as a goal, while responsibility is an obligation of the corporation.

•The obligation is to pursue profit, social development, and the environment—but to do so

along sustainable principles.

To do exercises!

•Questions 1-8

•Problems: 1-5; 11-12