Chapter 2 Notes

Chapter 2 Notes - Chapter 2 Financial Goals and Corporate...

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Unformatted text preview: Chapter 2 Financial Goals and Corporate Governance Questions 2-1. Ownership of the Business. How does ownership alter the goals and governance of a business? The return to a shareholder in a publicly traded firm combines current income in the form of dividends and capital gains from the appreciation of share price: 2 1 1 1 Price Price Dividend Shareholder return Price Price- = + where the initial price, P 1 , is equivalent to the initial investment by the shareholder, and P 2 is the price of the share at the end of period. The shareholder theoretically receives income from both components. For example, over the past 50 or 60 years in the U.S. marketplace, a diversified investor may have received a total average annual return of 14%, split roughly between dividends, 2%, and capital gains, 12%. Management generally believes it has the most direct influence over the first componentthe dividend yield . Management makes strategic and operational decisions that grow sales, generate profits, and then distributes those profits to ownership in the form of dividends. Capital gains the change in the share price as traded in the equity marketsis much more complex, and reflects many forces that are not in the direct control of management. Despite growing market share, profits, or any other traditional measure of business success, the market may not reward these actions directly with share price appreciation. A privately held firm has a much simpler shareholder return objective function: maximize current and sustainable income. The privately held firm does not have a share price (it does have a value, but this is not a definitive market-determined value in the way in which we believe markets work). It therefore simply focuses on generating current income, dividend income, to generate the returns to its ownership. If the privately held ownership is a family, the family may also place a great emphasis on the ability to sustain those earnings over time while maintaining a slower rate of growth which can be managed by the family itself. 2-2. Separation of Ownership and Management. Why is this separation so critical to the understanding of how businesses are structured and led? The field of agency theory is the study of how shareholders can motivate management to accept the prescriptions of the Shareholder Wealth Maximization (SWM) model. For example, liberal use of stock options should encourage management to think like shareholders. Whether these inducements succeed is open to debate. However, if management deviates too much from SWM objectives of working to maximize the returns to the shareholdersthe board of directors should replace them. In cases where the board is too weak or ingrown to take this action, the discipline of 6 Eiteman/Stonehill/Moffett Multinational Business Finance, Twelfth Edition the equity markets could do it through a takeover. This discipline is made possible by the one- share-one-vote rule that exists in most Anglo-American markets.share-one-vote rule that exists in most Anglo-American markets....
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This note was uploaded on 12/06/2011 for the course FIN 536 taught by Professor Staff during the Fall '11 term at S.F. State.

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Chapter 2 Notes - Chapter 2 Financial Goals and Corporate...

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