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Financial management complete summary: lecture notes and readings
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Financial management complete summary: lecture notes and readings
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Topic 1: IntroductionImportant information:
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- Assignment due 19 November 2021 at 11pm (25% grade) – no resit possible
Introduction to the course
- There are four pillars: Corporate landscape, managers and shareholders, managers and
stakeholders, behavioural finance and financial management
- Today: introduction to the course
- After the 2007/08 Financial crisis, people lost their confidence in capitalism. During the
financial crisis 9 million people lost their jobs, 10 million lost their homes. The richest 28
people owned the same wealth as the 3/8 billion poorest citizens in the world.
- This highlights that there might be a conflict of interest between people. So we will focus on
this conflict and ask ourselves whether traditional Financial management fails
- Traditional financial management says that maximizing shareholders’ value is the essence,
but in this course we will also focus on different value definition and firm goals, getting a
broader perspective
- Is this course we will wonder:
1. Can corporations create profit for investors AND value for society?
2. Do the different parties in a corporation have the same long run goal?
3. Are leaders inspiring and do they engage their workforce?
4. What is the role of human behaviour for corporations?
- New perspectives include as main objective ‘maximizing the pie’, instead of only the
shareholders’ value. Growing the pie, both the shareholders and stakeholders’ value will be
maximized.
- In traditional financial management there is a manager (agent) that has a goal: maximizing
the value of the business and she deals with 3 things:
1. Investment decision: invest in assets that earn a return greater than the minimum
acceptable hurdle rate (= minimum rate of return on a project/investment required by a
manager or investor)
2. Financial decision: find optimal kind of debt/equity mix
3. Payout decision: if no good investment option, distribute cash to owners
- What we will question in this course is: what is the value of the business? What value are we
talking about?
- The objective of the firm is something that is very relative and depends a lot on the type of
firm
- Apple for example, this company increased its stock value multiple times. This comes from
the fact that Apple wasn’t only aiming at profit. Steve Jobs and the team have followed a
radically different approach to business: creating profits for investors and value for society
- When the German government blocked foreign takeover attempt of the license for the new
corona vaccine, by investing 300 million euros in the company (23% stake), the objective was
not profitability, there was a social motive
- In august 2015 the price of HIV medication increased by 5500% 🡪 patients are suffering
The company producing the drug was managed by Martin Shkreli, who only followed the
logic of profit maximization.
, In this case nothing was illegal, but his logic, even if it increased shareholder’s value,
decreased the pie.
- William Campbell, working for a company called Merck, discovered a cure for river blindness
and in the 80s there was the need for this cure, as West Africa suffered from this. The
company needed urgent money to set up a distribution channel to West Africa, but no one
wanted to invest.
What the firm did is giving away the medication license for free, curing 2.7 billion people
across the world, with an huge impact. The scientist discovering the medication got the
Nobel prize and the company grew a lot (average return 13%)
� The objective of this firm was the long term objective of growing the pie
(same thing as Apple, green companies…)
- This is different from Corporate Social Responsibility (CSR). CSR policies focus on not
harming society, whereas these kinds of policies focus on growing the pie.
- The pie is made of: investors, colleagues, customers, suppliers, environment, government
and communities. If we only consider investors we miss out on a lot of value that we need to
take into consideration.
- If we ignore the pie, there will be more conflict and more pressure on regulators. If we only
focus on shareholders maximization, the trust on capitalism may decay from the other
parties. So, there must be a trade-off
- The pie mentality is becoming more and more important, new generations care more and
more about making a positive difference in the world
- In finance, it is also important to include the human element, because contrary to what
traditional financial management claims, people are not completely rational 🡪 they might not
have optimal saving/spending behavior or perhaps also care about social responsibility and
social status.
Topic 2
- Before we start studying corporate governance, we need to understand who is the owner of
the firm. Some people think that shareholders are the owners, others think that
stakeholders are. In the US and UK most people think that shareholders are the owner, while
in Japan and continental Europe, most people think stakeholders are.
- The definition of ownership is perceived differently in different countries. There is no
universal agreement on the goal of a corporation, it depends on culture, electoral system,
legal tradition, governments’ political orientation and so on
- In corporate governance, there are 4 main types of conflicts: shareholders vs. managers,
shareholders vs. debtholders, shareholders vs. non-financial shareholders, large
shareholders vs. minor shareholders
- Corporate governance tries to mitigate these types of conflict, as conflict creates friction.
Corporate governance system is the combination of mechanism which ensures that the
management runs the firm for the benefit of one or several stakeholders. According to this
definition, even shareholders are part of the stakeholders list.
- The key concept of corporate governance is that both the shareholder and the stakeholder
want to maximize their utility. Most of the time welfare is best perceived by money, so they
want to maximize their earnings. This can lead to a Moral Hazard problem, so once the
contract is signed it may be interest of the agent to behave badly/less responsibly. The
, agency problem arises when an agent acts on behalf of the principal, but he doesn’t act in
his best interest. For example, put insufficient effort, make extravagant investment,
entrenchment, self-dealing, lack of transparency, accounting manipulations
- To mitigate the P&A problem we need complete contracts, which specify what the managers
must do and the distribution of profits in each future contingency of the world.
- The P&A problem can arise when there is asymmetric information, so the principal cannot
keep track of the agent’s actions at all times and the agent has more information. So
asymmetric information can lead to moral hazard
- The P&A problem arises from the fact that in the beginning the owner is also the manager,
so there is no conflict of interest and the manager has the maximum incentive to work hard,
as any additional revenue will be accrued by him. However, as the firm grows, the owner
sells a percentage of the shares. This is when the conflict of interest starts, as the manager
has less incentive to work harder, because the fruits of hard work will go to the shareholders
- In this scenario there is a principal, with some funds but not enough qualifications to run the
firm. And there is an agent that knows how to run the firm but lacks the funds to finance its
operations. If the manager runs the company in his own interest instead of the principal’s,
agency cost arise
- Agency cost are divided in monitoring costs, bonding costs and residual loss. Monitoring
consists of the principal observing the agent and keeping a record of the agent’s behaviour.
Also intervening in various ways to constraint the agent’s behaviour and to avoid unwanted
actions. Bonding cost is the cost incurred by the agent to signal credibly to the principal that
he will act in the interest of the principal (ex. Buy company’s shares). Residual loss is
incurred by the principal, when the agent doesn’t make decisions to maximize the value of
the firm
- Agency problems arise in two forms: perquisites and empire building. The former refers to
consumption by the management, the latter refers to free cash flow problem, when the
management pursues growth rather than shareholder maximization.
- Perquisites come from management consumption, the benefits accrue to the management
and the cost is borne by the shareholder (ex. CEO mansions, giving job to family members,
corporate jets). It was found that stock price dcreases by 1% after CEO perks are first
disclosed. And over the long run, firms allowing their CEOs to use jets for personal use
underperform by 4%. For instance, Tyco International’s former CEO used 1 million of
company funds for the 40th birthday of his wife.
- Empire building refers to the free cash flow problem, the management pursue growth rather
than shareholder maximization. Management should only invest in projects with positive
NPVs. Projects with negative NPVs destroy shareholder value. While a company may have
limited investment opportunities but shareholders have access to a wide range of
investment opportunities. Managers enjoy increasing the size of the firm, even if it
decreases the total value of the firm, because of power, social status and management
compensation increasing with the company size.
- Agency problems of debt and equity: if I borrow 100 millions for my firm and finance my
project only with debt financing there are 3 possible scenarios. I can get next year 80 million,
120 or 500 million.
In scenario 1, if I get 80 million I have to give all of them to the bank. So 80 million is the
value of my debt. The value of my equity is 0 and I am in very high financial distress (default
case).
In scenario 2, I can pay back the full amount of my debt, 100 million and I am left with 20
million for my equity. I am not in financial distress.
, In scenario 3, I also can pay back the full amount of my debt, and I get a very large amount
for my equity (400 million), and I am in a very good financial position.
Here we see the different incentives between debt and equity holders. Shareholders would
like to get to scenario 3. However, to reach that scenario we must undertake excessive risk.
For the bank, scenario 2 is ideal, because the debt is repaid and the risk is lower.
- From this we learn that debt has seniority on firm assets. So if we get money we firstly have
to pay back our debt. The debtholder has limited claim, up to the value of his debt.
- We also learn that equity holder gets the leftover on firm assets, so he has unlimited gain.
- So debt and equity holders have different incentives
- We see in the graph below that the value of your debt and of your equity change with the
firm value. The value of your debt increases with your firm value, up until the point in which
you are able to pay back your debt. From that point, the value of equity starts increasing,
raising the value of your firm but leaving the value of your debt unchanged
- So highly debt financed firm may gamble with other people’s money. If they fail, the cost is
borne to the debtholder, but if they are successful there will be a massive payoff that goes
to the shareholders
- So the agency cost of debt is very high if you are 100% debt financed, the agency cost of
equity is very high if you are 100% equity financed. So there are agency costs from both debt
and equity and there is an optimal mix of debt and equity which minimizes the sum of the
agency costs of debt and equity
- Until now we have talked about the classical agency problem, but out of the western world
there are usually large shareholders. This creates another conflict: minor vs. large
shareholders.
- These large shareholders can be corporations, families, governments
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