Copyright 2010 Pearson Prentice Hall. All rights reserved.Chapter 2Financial Goals and Corporate GovernanceCopyright 2010 Pearson Prentice Hall. All rights reserved.2-2Who Owns the Business? Most companies are created by entrepreneurs who are either individuals or a small set of partners. In either case they may be the members of a family. Over time, however, some firms may choose to go public via an initial public offering or IPO.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-3Exhibit 2.1Who Owns the Business?[Insert Exhibit 2.1]Copyright 2010 Pearson Prentice Hall. All rights reserved.2-4Separation o Ownership ro! "ana#e!ent The change in ownership from 1! privately held toward an increased share of publicly traded shares brings along with it the probability that a firm may be managed by hired professionals and not the owners. This raises the possibility that ownership and management may not be perfectly aligned in their business and financial ob"ectives, the so called agency problem. Copyright 2010 Pearson Prentice Hall. All rights reserved.2-5$he Goal o "ana#e!ent Ma#imi$ation of shareholders% wealth is the dominant goal of management in the &nglo'&merican world. In the rest of the world, this perspective still holds true (although to a lesser e#tent in some countries). In &nglo'&merican mar*ets, this goal is realistic+ in many other countries it is not. Copyright 2010 Pearson Prentice Hall. All rights reserved.2-6$he Goal o "ana#e!ent There are basic differences in corporate and investor philosophies globally. In this conte#t, the universal truths of finance become culturally determined norms.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-7Shareholder Wealth "axi!i%ation In a ,hareholder -ealth Ma#imi$ation model (,-M), a firm should strive to ma#imi$e the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of ris*. &lternatively, the firm should minimi$e the level of ris* to shareholders for a given rate of return.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-8Shareholder Wealth "axi!i%ation The ,-M model assumes as a universal truth that the stoc* mar*et is efficient. &n e.uity share price is always correct because it captures all the e#pectations of return and ris* as perceived by investors, .uic*ly incorporating new information into the share price. ,hare prices are, in turn, the best allocators of capital in the macro economy.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-9Shareholder Wealth "axi!i%ation The ,-M model also treats its definition of ris* as a universal truth. /is* is defined as the added ris* that a firm%s shares bring to a diversified portfolio. Therefore the unsystematic, or operational ris*, should not be of concern to investors (unless ban*ruptcy becomes a concern) because it can be diversified. ,ystematic, or mar*et, ris* cannot however be eliminated.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-10Shareholder Wealth "axi!i%ation Agency theory is the study of how shareholders can motivate management to accept the prescriptions of the ,-M model. 0iberal use of stoc* options should encourage management to thin* more li*e shareholders. If management deviates too e#tensively from ,-M ob"ectives, the board of directors should replace them. If the board of directors is too wea* (or not at 1arms'length2) the discipline of the capital mar*ets could effect the same outcome through a ta*eover. This outcome is made more possible in &nglo'&merican mar*ets due to the one'share one'vote rule.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-11Shareholder Wealth "axi!i%ation 0ong'term value ma#imi$ation can conflict with short'term value ma#imi$ation as a result of compensation systems focused on .uarterly or near'term results. ,hort'term actions ta*en 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 hori$on (how long it ta*es for a firm%s actions, investments and operations to result in earnings).Copyright 2010 Pearson Prentice Hall. All rights reserved.2-12Shareholder Wealth "axi!i%ation In contrast to impatient capitalism is patient capitalism. This focuses on long'term ,-M. Many investors, such as -arren 3uffet, have focused on mainstream firms that grow slowly and steadily, rather than latching on to high'growth but ris*y sectors.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-13Sta&eholder Capitalis! "odel In the non'&nglo'&merican mar*ets, controlling shareholders also strive to ma#imi$e long'term returns to e.uity. 4owever, they are more constrained by other powerful sta*eholders. In particular, labor unions are more powerful than in the &nglo'&merican mar*ets. In addition, 5overnments interfere more in the mar*etplace to protect important sta*eholder groups, such as local communities, the environment and employment.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-14Sta&eholder Capitalis! "odel The ,6M model does not assume that e.uity mar*ets are either efficient or inefficient. The inefficiency does not really matter, because the firm%s financial goals are not e#clusively shareholder'oriented, because they are constrained by the other sta*e'holders. The ,6M model assumes that long'term 1loyal2 shareholders 7 those typically with controlling interests 7 should influence corporate strategy, rather than the transient portfolio investor.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-15Sta&eholder Capitalis! "odel The ,6M model assumes that total risk 7 i.e. operating and financial ris* 7 does count. It is a specific corporate ob"ective to generate growing earnings and dividends over the long run with as much certainty as possible. In this case, ris* is measured more by product mar*et variability than by short'term variation in earnings and share price.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-16Operational Goals or "'Es The M89 must determine for itself proper balance between three common operational financial ob"ectives:7 ma#imi$ation of consolidated after'ta# income+7 minimi$ation of the firm%s effective global ta# burden+7 correct positioning of the firm%s income, cash flows, and available funds as to country and currency. These goals are fre.uently incompatible, in that the pursuit of one may result in a less'desirable outcome in regard to another.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-17Corporate Governance &lthough the governance structure of any company 7 domestic, international, or multinational 7 is fundamental to its very e#istence, this sub"ect has become a lightning rod for political and business debate in the past few years. ,pectacular failures in corporate governance have raised issues about the very ethics and culture of the conduct of business.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-18Corporate Governance The single overriding ob"ective of corporate governance is the optimi$ation over time of the returns to shareholders. In order to achieve this goal, good governance practices should focus the attention of the board of directors of the corporation by developing and implementing a strategy that ensures corporate growth and improvement in the value of the corporation%s e.uity.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-19Corporate Governance The most widely accepted statement of good corporate governance practices are established by the O96;:7 The corporate governance framewor* should protect shareholders ri#hts.7 The corporate governance framewor* should ensure the e(uitable treat!ent o all shareholders.7 ,ta*eholders should be involved in corporate governance.7 )isclosure and transparenc* is critical.7 The board of directors should be !onitored and held accountable for what guidance it gives.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-20Structure o Corporate Governance The modern corporation%s actions and behaviors are directed and controlled by both internal forces and external forces. The internal forces, the officers of the corporation and the board of directors are those directly responsible for determining both the strategic direction and the e#ecution of the company%s future. The e#ternal forces include e.uity mar*ets in which the shares are traded, the analysts who criti.ue the company%s investment prospects and e#ternal regulators, among others.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-21Exhibit 2.2$he Structure o Corporate GovernanceCopyright 2010 Pearson Prentice Hall. All rights reserved.2-22Structure o Corporate Governance 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.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-23Structure o Corporate Governance 9.uity mar*ets should reflect the mar*et%s constant evaluation of the promise and performance of the company. ;ebt mar*ets should reflect the company%s ability to repay its debt in a timely and efficient manner. &uditors and legal advisors are responsible for providing an e#ternal professional opinion as to the fairness, legality and accuracy of corporate financial statements. /egulators wor* 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 accuracyCopyright 2010 Pearson Prentice Hall. All rights reserved.2-24Exhibit 2.+Co!parative Corporate Governance ,e#i!esCopyright 2010 Pearson Prentice Hall. All rights reserved.2-25Failures in Corporate Governance > and has three ma"or re.uirements:7 69Os of publicly traded companies must vouch for the veracity of published financial statements+7 corporate boards must have audit committees drawn from independent directors+7 companies can no longer ma*e loans to corporate directors, and7 6ompanies must test their internal financial controls against fraud Penalties have been spelled out for various levels of failure. Most of its terms are appropriate for the =, situation, but some terms do conflict with practices in other countries.Copyright 2010 Pearson Prentice Hall. All rights reserved.2-28.dditional Corporate Governance /ssues 3oard structure and compensation issues Transparency, accounting and auditing Minority shareholder rightsCopyright 2010 Pearson Prentice Hall. All rights reserved.2-29"ini-Case 0uestions1 Governance Failure at Enron -hich parts of the corporate governance system, internal and e#ternal, do you believe failed 9nron the most? 4ow do you thin* each of the individual sta*eholders and components of the corporate governance system should have either prevented the problems at 9nron or acted to resolve the problems before they reached crisis proportions? If all publicly traded firms in the =nited ,tates are operating within the same basic corporate governance system as 9nron, why would some people believe this was an isolated incident, and not an e#ample of many failures to come?Copyright 2010 Pearson Prentice Hall. All rights reserved.Chapter 2.dditional Chapter ExhibitsCopyright 2010 Pearson Prentice Hall. All rights reserved.2-31Exhibit 2.2Countr* Governance ,an&in#s 2334Copyright 2010 Pearson Prentice Hall. All rights reserved.2-32Exhibit 2.5$he 6re!iu! 6aid or 7otin# Shares1 .ccountin# StandardsCopyright 2010 Pearson Prentice Hall. All rights reserved.2-33Exhibit 2.8$he 6re!iu! 6aid or 7otin# Shares1 9aw Enorce!entCopyright 2010 Pearson Prentice Hall. All rights reserved.2-34Exhibit 2.:;.S. )irector /ndependence 2334Copyright 2010 Pearson Prentice Hall. All rights reserved.2-35Exhibit 2.46otential ,esponses to Shareholder )issatisactionCopyright 2010 Pearson Prentice Hall. All rights reserved.2-36Exhibit 1Enron