Chapter 01 – Introduction to Corporate Finance
1.1. The Agency Problem and Control of the Corporation
A. Agency Relationships – The relationship between stockholders and
management is called the agency relationship. This occurs when
one party (principal) hires another (agent) to act on their behalf.
The possibility of conflicts of interest between the parties is termed
the agency problem.
B. Management Goals
Agency costs
direct costs – compensation and perquisites for management
indirect costs – cost of monitoring and sub-optimal decisions
Ethics Note: When shareholders elect a board of directors to
oversee the corporation, the election serves as a control
mechanism for management. The board of directors bears legal
responsibility for corporate actions. However, this responsibility is
to the corporation itself and not necessarily to the stockholders.
Although the following happened several years ago, it still makes
for an interesting discussion of directors’ and managers’ duties:
In 1986, Ronald Perelman engaged in an unsolicited takeover
offer for Gillette. Gillette’s management filed litigation against
Perelman and subsequently entered into a standstill agreement
with Perelman. This action eliminated the premium that Perelman
offered shareholders for their stock in Gillette.
A group of shareholders filed litigation against the board of
directors in response to its actions. It was subsequently discovered
that Gillette had entered into standstill agreements with ten
additional companies. When questioned regarding the rejection of
Perelman’s offer, management responded that there were projects
on line that could not be discussed (later revealed to be the
“Sensor” razor, which was one of the most profitable new ventures
in Gillette’s history up to that time). Thus, despite appearances,
management’s actions may have been in the best interests of the
firm. This case indicates that management may consider factors
other than the bid when considering a tender offer.
C. Do Managers Act in the Stockholders’ Interests?
Managerial compensation can be used to encourage managers to
act in the best interest of stockholders. One commonly cited tool is
stock options. The idea is that if management has an ownership
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interest in the firm, they will be more likely to try to maximize
owner wealth.
Lecture Tip: A 1993 study performed at the Harvard Business
School indicates that the total return to shareholders is closely
related to the nature of CEO compensation; specifically, higher
returns were achieved by CEOs whose pay package included more
option and stock components. (See The Wall Street Journal,
November 12, 1993, p. B1). However, this may not be the best way
to encourage managers to act in the stockholders’ best interest.
Stern Stewart & Company has developed a tool called EVA®,
discussed later in the text, which measures how much “economic
value” is being added to a corporation by management decisions.
According to Stern-Stewart’s web site (www.sternstewart.com),
companies that tie management compensation to EVA®
significantly outperform competitors that do not. They are
conducting ongoing studies to measure this performance, but data
up through November 2004 indicate that the stock returns for these
companies have outperformed their competitors by 84% over a
five-year period.
Both of these examples illustrate that carefully crafted
compensation packages can reduce the conflict between
management and stockholders. It should be noted that in 2007 it
was widely publicized that many firms had “backdated” options in
an attempt to provide “in-the-money” compensation to executives
—does this system provide the desired incentive?
Lecture Tip: According to The National Center for Employee
Ownership, broad based stock option plans have increased
dramatically, not only for technology firms, but also for non-tech
firms such as Starbucks and the Gap. They estimate that as of
2001, over 10 million employees in the United States will have
received stock options. Some firms have found a way to provide
stock-based incentive to employees without giving them equity
ownership at all. As reported in the October 26, 1998 issue of
Fortune, “phantom stock” is used by private companies such as
Kinko’s and Mary Kay, Inc., as well as public companies, to
provide employees with an incentive to work harder. Generally, an
employee is awarded “shares” on a bonus basis, and the share
values increase if the value of the business increases. (For a
private firm, this means obtaining outside appraisals of value
based on earnings multiples, etc.) At some future point, the
employee has the right to cash in his “shares.”
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Stockholders technically have control of the firm, and dissatisfied
shareholders can oust management via proxy fights, takeovers, etc.
However, this is easier said than done. Staggered elections for
board members often make it difficult to remove the board that
appoints management. Poison pills and other anti-takeover
mechanisms make hostile takeovers difficult to accomplish.
Stakeholders are other groups, besides stockholders, that have a
vested interest in the firm and potentially have claims on the firm’s
cash flows. Stakeholders can include creditors, employees, and
customers.
Ethics Note: A discussion of stakeholder interests leads very nicely
into a discussion of ethical decision making. Theories of ethical
behavior focus on the rights of all parties affected by a decision,
not just one or two. The “utilitarian” model defines an action as
acceptable if it maximizes the benefit, or minimizes the harm, to
stakeholders in the aggregate. The “golden rule” model deems a
decision ethical if all stakeholders are treated as the decision
maker would wish to be treated. Finally, the Kantian “basic
rights” model defines acceptable actions as those that minimize
the violation of stakeholders’ rights.
Ethics Note: The antitrust case against Microsoft can generate a
healthy discussion of ethical behavior, innovation, and the
government’s role in monitoring business practices. The basic idea
behind the case is that: (1) Microsoft stifled competition by
imposing stiff penalties on computer manufacturers that chose to
install operating systems other than Windows on some of their
machines; (2) Microsoft tried to put Netscape out of business by
incorporating Internet Explorer into the operating system; and, (3)
Microsoft has an unfair advantage in the applications
programming area because their programmers have access to the
source code for the operating system. There were other issues as
well, but these were the major ones. The Judge in the case
originally found that Microsoft did violate antitrust laws and that
they continued to operate in a monopolistic fashion. He ordered
the break-up of Microsoft into an “operating system” company
and an “applications” company. The Judge also ordered that
Microsoft allow programmers from the Company’s competitors to
come to a secured location and view the source code for Microsoft
Windows. Microsoft contended that this would allow other
companies to determine the direction that Microsoft is moving with
their software and eliminate the competitive advantage that their
research and development has afforded the company. The case was
appealed and Microsoft was still found in violation of antitrust
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laws, but not to the extent found in the original case.
The Final Judgment was issued on November 12, 2002, and has
the following components: (1) Microsoft cannot retaliate against
an Original Equipment Manufacturer (OEM) if the OEM “is or is
contemplating developing, distributing, promoting, using, selling
or licensing any software that competes with Microsoft Platform
Software” or ships a computer with more than one operating
system; (2) Microsoft must publish and use a consistent licensing
agreement schedule with all covered OEMs; (3) Microsoft cannot
restrict OEMs from selling computers that include competing
products, display competing product icons on the desktop, and
launch competing products when a Microsoft application would
normally be launched; (4) Microsoft must allow Independent
Software Vendors (ISVs), Independent Hardware Vendors (ISDs),
Internet Access Providers (IAPs), Internet Content Providers
(ICPs) and OEMs access to Windows Operating System Product
source code as necessary to develop products that will work
effectively with the operating system – these companies must
demonstrate why they need access and they are limited to access to
that code that is required for “interoperating” with the operating
system; (5) Microsoft is not required to disclose any intellectual
property rights related to security or that is designed to prevent
software piracy.
The Final Judgment called for the appointment of a technical
committee that will assist in the enforcement and compliance with
the judgment and Microsoft was required to appoint an internal
compliance officer to make sure that all employees of the firm
understand and comply with the judgment. Reports on compliance
are routinely filed with the Department of Justice and can be
found, along with the Final Judgment at
http://www.usdoj.gov/atr/cases/ms_index.htm.
1.2. Financial Markets and the Corporation
A. Cash Flows to and from the Firm
A firm issues securities (stocks and bonds) to raise cash for
investments (usually in real assets). The operating cash flows
generated from the investment in assets allows for the payment of
taxes, reinvestment in new assets, payment of interest and principal
on debt, and payment of dividends to stockholders.
Video Note: Financial Markets – This video discusses how capital is raised in financial
markets and shows an open-outcry market at the Chicago Board of Trade.
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B. Primary versus Secondary Markets
Primary market – the market in which securities are sold by the
company. Public and private placements of securities, SEC
registration, and underwriters are all part of the primary market.
Lecture Tip: Students are often curious about the nature of the
information that is made public at the time of a primary offering.
An interesting example of full disclosure appeared in The Wall
Street Journal several years ago in the form of excerpts from a
prospectus for a company called Indian Bingo, Inc.
“To hear Indian Bingo tell it, prospective investors
should think carefully before deciding to shell out $1
per share for the company’s proposed initial public
offering of five million common shares.”
”Indian Bingo says in a preliminary registration
statement filed with the Securities and Exchange
Commission that it wants to get into the business of
operating bingo games on Indian reservations. But,
Indian Bingo points out that the company would be a
‘high-risk’ investment. Among the reasons: the
company is a month old, such bingo games may be held
illegal, third-party studies of such activities haven’t
been made, the company doesn’t yet have any source of
income, and the underwriter hasn’t any experience as a
securities dealer.”
Also, “one of [the firm’s] main consultants has served
time in prison for obstruction of justice, and another
has served time for conspiracy and mail fraud. Both
have also received civil sanctions from the SEC for
allegedly fraudulent activities, according to federal
court records and SEC documents. Together, the two
consultants and their family will control more than
50% of Indian Bingo’s stock.”
Secondary market – the market where securities that have already
been issued are traded between investors. The stock exchanges,
such as the New York Stock Exchange, and the over-the-counter
market, such as the NASDAQ, are part of the secondary market.
Dealer versus Auction Markets – A dealer market is one where you
have several traders that carry an inventory and provide prices at
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which they stand ready to buy (bid) and sell (ask) the securities.
The Nasdaq market is an example of a dealer market. An auction
market has a physical location where buyers and sellers are
matched, with little dealer activity.
1.3. Summary and Conclusions
Why Share-Owner Value?
At The Coca-Cola Company, our publicly stated mission is to create value over
time for the owners of our business. In fact, in our society, that is the mission of any
business: to create value for its owners.
Why? The answer can be summed up in three reasons.
First, increasing share-owner value over time is the job our economic system
demands of us. We live in a democratic capitalist society, and here, people create
specific institutions to help meet specific needs. Governments are created to help meet
civic needs. Philanthropies are created to help meet social needs. And companies are
created to help meet economic needs. Business distributes the lifeblood that flows
through our economic system not only in the form of goods and services, but also in the
form of taxes, salaries and philanthropy.
Creating value is a core principle on which our economic system is based; it is
the job we owe to those who have entrusted us with their assets. We work for our share
owners. That is – literally – what they have put us in business to do.
Saying that we work for our share owners may sound simplistic – but we
frequently see companies that have forgotten the reason they exist. They may even try in
vain to be all things to all people and serve many masters in many different ways. In any
event, they miss their primary calling, which is to stick to the business of creating value
for their owners.
Furthermore, we must always be mindful of the fact that while a healthy company
can have a positive and seemingly infinite impact on others, a sick company is a drag on
the social order of things. It cannot sustain jobs, much less widen the opportunities
available to its employees. It cannot serve customers. It cannot give to philanthropic
causes.
And it cannot contribute anything to society, which is the second reason we work
to create value for our share owners: If we do our jobs, we can contribute to society in
very meaningful ways. Our Company has invested millions of dollars in Eastern Europe
since the fall of the Berlin Wall, and people there will not soon forget that we came early
to meet their desires and needs for jobs and management skills. In the process, they are
becoming loyal consumers of our products, while we are building value for our share
owners – which was our job all along.
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Certainly, we – as a Company – take it upon ourselves to do good deeds that
directly raise the quality of life in the communities in which we do business. But the real
and lasting benefits we create don’t come because we do good deeds, but because we do
good work – work focused on our mission of creating value over time for the people who
own the Company. Among those owners, for example, are university endowments,
philanthropic foundations and other similar nonprofit organizations. If The Coca-Cola
Company is worth more, those endowments are similarly enriched to further strengthen
the educational institutions’ operations; if The Coca-Cola Company is worth more, those
foundations have more to give, and so on. There is a beneficial ripple effect throughout
society.
Please note that I said creating value “over time,” not overnight. Those two
words are at the heart of the third reason behind our mission: Focusing on creating value
over the long term keeps us from acting shortsighted.
I believe share owners want to put their money in companies they can count on,
day in and day out. If our mission were merely to create value overnight, we could
suddenly make hundreds of decisions that would deliver a staggering short-term windfall.
But that type of behavior has nothing to do with sustaining value creation over time. To
be of unique value to our owners over the long haul, we must also be of unique value to
our consumers, our customers, out bottling partners, our fellow employees and all other
stakeholders – over the long haul.
Accordingly, that is how the long-term interests of the stakeholders are served –
as the long-term interests of the share owners are served. Likewise, unless the long-term
interests of the share owners are served, the long-term interests of the stakeholders will
not be served. The real possibility for conflict, then, is not between share owners and
stakeholders, but between the long-term and the short-term interests of both. Ultimately,
everyone benefits when a company takes a long-term view. Ultimately, no one benefits
when a company takes a short-term view.
The creation of unique value for all stakeholders, including share owners, over
the long haul, presupposes a stable, health society. Only in such an environment can a
company’s profitable growth be sustained. Thus, the exercise of what is commonly
referred to as “corporate responsibility” is a supremely rational, logical corollary of a
company’s essential responsibility to the long-term interests of its share owners. A
company will only exercise this essential responsibility effectively if it promotes that
social well-being necessary for a healthy business environment. It is as irrational to
suppose that a company is primarily a welfare agency as it is to suppose that a company
should not be concerned at all about the social welfare. Both views sacrifice the long-
term common good to short-term benefits – whether share-owner benefits or stakeholder
benefits.
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Certainly, harsh competitive situations can sometimes call for harsh medicine.
But in the main, our share owners look to us to deliver sustained, long-term value. We do
that by building our businesses and growing them profitably.
At The Coca-Cola Company, we have built our business and grown it profitably
for more than 110 years, because we have remained disciplined to our mission.
Not long ago, we came up with an interesting set of facts: A billion hours ago,
human life appeared on Earth. A billion minutes ago, Christianity emerged. A billion
seconds ago, the Beatles changed music forever. A billion Coca-Colas ago was yesterday
morning.
The question we ask ourselves now is: What must we do to make a billion Coca-
Colas ago be this morning? By asking that question, we discipline ourselves to the long-
term view.
Ultimately, the mission of this Atlanta soft-drink salesman – and my 26,000
associates – is not simply to sell an extra case of Coca-Cola. Our mission is to create
value over the long haul for the owners of our Company.
That’s what our economic system demands of us. That’s what allows us to
contribute meaningfully to society. That’s what keeps us from acting shortsighted. As
businessmen and businesswomen, we should never forget that the best way for us to serve
all our stakeholders – not just our share owners, but our fellow employees, our business
partners and our communities – is by creating value over time for those who have hired
us.
That, ultimately, is our job.
Roberto C. Goizueta
Chairman, Board of Directors,
and Chief Executive Officer
February 20, 1997
[This essay originally appeared in the Coca-Cola Company’s 1997 annual report.]
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