[0:06]In this, the second session of a 36 session corporate finance class, I hope to talk about the objective in corporate finance. Every discipline needs an end game and in corporate finance that end game is what gives it focus. In this session, I hope to look at what makes the objective in corporate finance so special and what makes it corporate finance's biggest weakness. In this session, we're going to talk about the objective in corporate finance. Essentially, let me show you the big picture of corporate finance because in a sense, it'll show you where we're going with the session. Every discipline needs a focus and the focus in corporate finance comes from the fact that the objective when you make decisions is singular. It is to maximize the value of the business.So what I'd like to do in the session is look at why corporate finance chooses that objective. How it gets narrowed in practice to a much narrower objective of maximizing stock prices. Lay out the utopian conditions that you need for maximizing stock prices to be the only objective you need in a business. Then rip those utopian conditions apart by talking about what can go wrong. And then we'll end the session by leading into what we're going to do next.So let's get the process on the road. To understand the objective in corporate finance, it's best to go back to the financial balance sheet that we introduced in the very first session. And if you remember the financial balance sheet, there are two items on each side. There are assets in place and growth assets on the asset side and debt and equity in the other side. So when you talk about maximizing the value of the business, you're talking about maximizing the value of the assets, assets in place and growth assets. So put simply, if you're the top manager in a growth company, what I want you to do is not just maximize the value of the investments you've already made, but maximize the sum of the values of the investments you've made in your growth assets. You are the steward of those growth assets. So in perfect corporate finance, that's what we'd like companies to do is to go out and maximize the values of their businesses. But there are some pragmatic considerations. If you're the manager of a publicly traded company, you're hired and fired by stockholders, you answer to them, you want to keep them happy. And because you want to keep them happy, your focus instead of maximizing the value of the business becomes maximizing stockholder wealth. And here you face a pragmatic issue. If you accept that your job is to maximize stockholder wealth and you want to show your stockholders, you are in fact increasing their wealth, you want an objective measure. I mean, of course, you could hire a consulting firm to come in and value your business every year, but that's a subjective judgment and people are likely to disagree. So what you'd like is an objective third party estimate of stockholder wealth, which even if wrong, is still objective. That's where stock prices come in. If you're a publicly traded company, you could essentially argue to your stockholders that if your stock price went up, stockholder wealth has gone up, and implicitly, you can also argue that stockholder stockholder wealth went up, the value of the business also went up. Now that takes a whole set of assumptions along the way, but in practice, that is effectively what happens. In most companies, when people talk about maximizing something, it's stock prices. So let's take that and run with it. Let's see what we'd need to assume about the world for maximizing stock prices to be the only objective you need as a company. I'm going to call this a utopian world from which corporate finance is born and the very fact that I call it utopian should tell you something about the assumptions that are coming. Utopia never existed and these assumptions are blatantly unrealistic, but I'm going to state them anyway. So here are the assumptions you need for maximizing stock prices to be the only objective you need as a company. I'm going to state these assumptions in terms of four linkages. The first is the linkage between managers and stockholders. The second is the linkage between the firm and lenders slash bondholders. The third is the linkage between firms and financial markets and the fourth is the linkage between firms and society. Here's what I'm going to assume about each one. I'm going to assume that stockholders have total power over managers, they can hire them and they can fire them. And because they have total power, I'm going to assume that managers will go out and do stockholders bidding. In other words, they will want to keep stockholders happy at any cost. I'm going to assume that lenders, if they lend money to a company, even if they don't protect themselves, will not get ripped off. So what I'm effectively assuming is even if there are loopholes the size of a Mack truck, borrowers will not take advantage of lenders. Why? You could tell a reputation story that because you have to go back to those lenders, you're not going to rip them off, but it is an assumption. The third linkage, firms and financial markets, here's what I'm going to assume. I'm going to assume that companies reveal news about themselves, good and bad, honestly, and on time. I told you that these were utopian assumptions. And I'm also going to assume that markets are rational and cool. The trading room in this particular utopian world would be filled with intellectual people who are involved in long discussions about value. Nothing like a typical trading room, but in utopian world, that's what I'm going to assume. And finally, I'm going to assume there are no social costs. What are social costs? These are costs that companies create for society that cannot be traced back and charged to the company. Now, why am I making these assumptions? I want to make the world safe for maximizing stock prices. In other words, I want to take away all the bad ways in which you can increase your stock price. Let's face it. You could increase the stock prices of your stockholders by going out, going out and ripping off your bondholders. You can increase your stock price by lying to financial markets. You can increase stock prices by creating huge social costs. You can't do any of those things in the utopian world that I've just described. So that's the world from which traditional corporate finance is born. Now let's think about what can go wrong. In fact, the title for this slide should really be what cannot go wrong because in a sense, everything that can go wrong will go wrong. Let's take each of the linkages. First, remember what I assumed about stockholders and managers. I assume that stockholders have complete power over managers. The two mechanisms that stockholders have to exercise power are the annual meeting and the board of directors, and neither unfortunately is very effective at keeping managers in line. First, let's take the annual meeting. Most stockholders don't show up at annual meetings and it's not in their economic best interest to do so because if you own a thousand shares, showing up at an annual meeting will wipe out a big chunk of your profits. So most of us get proxies, which we can vote, even though we're not at the meeting. It allows us to vote in absentia. Unfortunately, though, most stockholders don't return their proxies and here's what happens. In companies where proxies don't get returned, in most companies, managers get to vote those proxies. Effectively, that means that an annual meeting if you're the if you're the incumbent manager, you might start off at 45, 50 or 55% of the votes already in your favor. It is very difficult to get a vote against incumbent managers at an annual meeting. You're saying what about the board of directors? Well, think about it. Who comes up with the names of the people who served in the board of directors of a publicly traded company? It's not some independent group of people who really don't care about what the top management think. In most cases, it's either the CEO or a committee that thinks about what the CEO would like to see there. In most companies, the people who serve in the board of directors are people that the CEO wants in the board. In fact, let me show you an example of a really bad board. Here, in my view, is one of the worst corporate boards created, and it's Disney's board in 1997. Let me explain why I think this is such a bad board. First, there are 17 members in the board. That's way too many for a board. In fact, studies show that once you get past about nine or 10 members, it becomes counterproductive. That's just too many people to make a decision. Second, eight of the 17 members in this board are insiders. They either work for Disney or used to work for Disney. In other words, they work for the company that they oversee. This is the board after all that is supposed to keep an eye on top management. The third issue with the board is the chairman of the board, Michael Eisner, happens to be the CEO of Disney. Now, remember what this board is supposed to do. It's supposed to keep an eye on the top management and the person heading the board is the top manager himself. Well, good luck with that. The fourth and final factor is even if you look at the nine outsiders, the board, they're really not outsiders. They all have connections to Michael Eisner in one way or the other. In fact, as you go down the list, you will see Michael Eisner's personal attorney on the board. You'll see the head head mistress of the of the elementary school that his kids went to. You'd see somebody from Georgetown University that his son attended. In other words, the the tangle of conflicts of interest here is pretty deep and this is the board that's supposed to keep an eye on Michael Eisner. There is little chance that it will accomplish that objective. This is a rubber stamp board and unfortunately, in most companies, the board of directors acts as a rubber stamp for top management. So let me go back to the previous page and and return to my story. Stockholders have little power now over managers because the annual meeting is not very effective and the board of directors works more for the managers than it does for the stockholders. So you're saying, so what? Well, managers, given a choice, will then put their interests over stockholder interest. Again, I'm going to move forward a couple of slides to illustrate some examples of managers putting their interest over stockholder interest. The first is what's called greenmail. What's greenmail? It's just like blackmail, but it's a lot more money and it's legal. It's often in response to a hostile acquisition where the managers do not want the company to be acquired. Here's what they do. They go to the acquirer and offer him 50, 100, 150 million dollars more to just go away. Often, they use stockholder wealth to fight off the hostile acquisition. The only interest being served in greenmail are the interests of the managers, not the stockholders. Second is golden parachutes. Golden parachutes are special deals put into compensation contracts by managers after they've been targeted in a hostile acquisition. The only purpose again of golden parachutes is to protect the managers in case the company gets taken over. Again, stockholder interests are way down the line. The third example is poison pills. A poison pill is something you introduce into your company to make it unpalatable to acquire. Basically, it makes hostile acquisitions much more difficult and in the process, makes it less likely that your stockholders will get a premium on their stock price. The fourth are shark repellents. These are special anti-takeover amendments put into a company. At least on these, the stockholders get to vote, but as we've said earlier, because most stockholders do not show up at annual meetings, many of these anti-takeover amendments find their way into the corporate charter. Here's a simple one. Instead of having to acquire 51% to buy a company, there are some companies where the threshold can be raised to 60, 70 or even 80%. And finally, and here's where you see incumbent managers and stockholder interests really clash. If you're the acquiring company in an acquisition and you're using stockholder money to do the acquisitions, in the case of many CEOs, their ego and self-interest will drive them to do acquisitions which really make no sense from a stockholder perspective. But all of this again relates back to a fundamental problem, which is that stockholders have little power over managers. So again, going back two pages, what can go wrong? If stockholders have little power over managers, managers are going to do things that are not in stockholders interest. And you can't blame them. Self-interest is the dominant paradigm when it comes to human behavior. Let's take the second linkage. I assume that lenders lend money to a company and they don't protect themselves. What can go wrong? Lots. As we see in stories that happen all around us, when banks and bondholders lend money to firms and they don't protect themselves, they are often exploited. Let me give you an example. RJ Nabisco. Company that had been around a long time in the early 1980s, a lot of people who bought RJ Nabisco bonds saying, hey, it's a well-established company. It's got a great reputation. What can go wrong? Four years later, RJ Nabisco was targeted in a leveraged buy out. You're saying what's that? Well, KKR, a private equity firm in New York, targeted RJ Nabisco and they quadrupled Nabisco's debt. In the process, they impoverished existing bondholders and lenders. In fact, on the day of the LBOP, Nabisco bond prices dropped by 20%. In fact, I've introduced a word into the finance lexicon that I call Nibisco. If you bought, if you lend money to a company and you don't protect yourself, you are begging to be Nibisco. Let's take the linkage between firms and financial markets. I assume that firms reveal information to financial markets honestly and on time. In what universe? The universe that I live in, companies constantly delay bad news. They might not lie, but they're errors of omission rather than errors of commission. Once in a while, you do get companies that cross the line and commit outright fraud. In other words, information does not get to financial markets freely and on time. And in response, markets are not angelic either. The trading room that I described, full of polite intellectuals. Well, that's not exactly the trading room you see in the real world. Traders tend to be short-term, they tend to be reactive, and often they make decisions on bad information. So markets are not that cool and not that rational. And finally, we know that companies create social costs, not just bad companies, but all businesses create social costs. It's unavoidable. So the assumption that there are no social costs is laughable. This is the world we live in. If you go out and ask CEOs to maximize stock prices in this particular world, you can see that terrible things can happen to companies. And terrible things can happen to people around companies. You can maximize stock prices by doing all the wrong things. That is, of course, a problem because traditional corporate finance puts so much weight on market prices. So here's what I'd like to do. I'd like to at least set the process going by thinking about any company. And I'm going to take my companies through this process. And I'd encourage you to pick a company on your own and take it through this process. What I'm going to try to do is look at where the power in my company lies or put differently. If I as a stockholder in this company, whatever that company might be, will have any say in how the company's run. Power of boards a vacuum and in in any publicly traded company, it's going to go somewhere. And here are your choices. It can rest with the managers. It can rest with stockholders, but it might rest with inside stockholders. Who are inside stockholders? Well, in many big companies, these might be the people who own large stakes of stock and have a say in the management of the company. It might sometimes be without side stockholders. In some odd cases, it might rest with the government, it might lie with lenders and even employees might have a say in how a company's run. One of the first things you do before you look at the numbers in a company is to look to see where the power in a company lies. So with my companies, let me try. Here's what I'm going to do. I'm going to take each of my companies and look at who owns shares in the companies and then ask a question. As a stockholder in that company, can I look at this list and expect any of the people on this list to watch out for my interest? So let me start with Disney. In 2003, I was a stockholder in 2003 and as I looked at this list that year, my stomach dropped. Because out of the out of the 17 top stockholders in Disney, and these were the 17 top stockholders in Disney in 2003, 16 were institutional investors, mutual funds and pension funds. You're saying, so what? Well, we know how institutional investors react to disappointment. If they don't like the way a company's run, rather than stand and fight or get the company to change the way it's run, they walk away. They sell and move on. So that's what I'd expect these 16 institutional investors to do. They're not going to be looking out for my interest. The only individual on that list is Roy Disney and at least in 2003, he was still part of Disney's top management. So I don't have much hope resting on him either. The case of Disney, I'm afraid is an individual stockholder, I don't see much hope in 2003. The second company I'm going to look at is Vale. Vale has two classes of shares and that already makes me a little unhappy. As a stockholder in Vale, I own the shares with the few voting rights. The higher voting right shares are basically held by seven entities which control Vale. One of them is an entity called Valaspar, which appoints most of the directors for Vale. They effectively run the company. One added one added feature in Vale that might make it an issue in corporate governance. They have a golden share. What's a golden share? A golden share is a share with veto power and the Brazilian government owns it. What it effectively gives the Brazilian government the power to do is make a judgment on big decisions and say no. Again as a stockholder in Vale, I have to I have to walk in with open eyes and recognize that sometimes there will be things that I want Vale to do that they will not be able to do because of that golden share. Third case, I looked at Tata Motors and I looked at the top stockholders and I noticed quite a few Tata companies on that list. Remember I said Tata Motors was part of a family group called the Tata Group. The way these companies preserve control for the family is by holding shares in each other. It becomes almost impossible for outsiders to change the way these companies are run. So the case of Tata Motors, here's what I expect to see as we go through this process. I expect to see a lot of decisions made by the company that are in the best interest of the group, but may not be in my best interest as a Tata Motors stockholder. The fourth company that I looked at was Baidu. And Baidu has a very unique holding structure. When you buy shares in Baidu, you're not buying shares in Baidu, the Chinese search engine. You're buying shares in Baidu, the Cayman Islands, shell company. That company has a legal arrangement with the operating company in China, allowing it to run the company and collect the profits. But that legal arrangement might be subject to oversight by the Chinese government. The Chinese government might decide tomorrow or the day after that that legal arrangement does not hold up. I'm in a very weak position when it comes to Baidu because I don't control the real company and I definitely don't control the management of the company. But that again is something you have to factor in when you look at corporate finance decisions. And here's the final slide I want to show you.
[20:38]I showed you what Disney looked like in 2003. Fast forward six years, here's what Disney's top 17 stockholders look like in 2009. Notice a very big difference. Who's on top of the list? Steve Jobs, right? How did Steve Jobs become the largest stockholder in Disney? Will he own 60% of Pixar and when Disney bought Pixar, he became the largest stockholder in Disney. As a stockholder in Disney, doesn't matter to me. I think so. I feel a little more comfortable with these stockholders in 2009 than I did in 2003. Not because Steve Jobs is watching out for me. But because I have a feeling that he will push the company to change if it needs change. In other words, we want somebody rocking the boat as stockholders because existing management is stuck with inertia. And as far as I'm concerned, Steve Jobs is going to be my agent for change in 2009. So what you're looking at in a company is basically things that might change the way the company's run. And whether any of the managers in this company can be forced to do things differently, not because you own a thousand shares, but because there's somebody on this list who's activist enough, powerful enough to make changes. So it might be a Carl I can, it might be a Bill Ackman, it might be a Berkshire Hathaway. But you want somebody pushing for your interest because you really don't have the power to make the change yourself. So as we go through this process, remember the objective in corporate finance might be maximizing stock prices, but there are multiple interests at play in a modern corporation. Thank you.
