Class 2 CF: The end game in business
Maximise shareholders' returns but with agency problems.
Lab Experiment via Applied Corporate Finance
We learn CF through case studies (or lab experiment as Prof calls it) on real life companies.
The first lab experiment (this class session) is on Disney since everyone knows Disney, especially with a comeback story of the CEO. Second company is Vale, the largest iron ore mining company in the world (quaisi-owned by government), as different as Disney as you could get.
Next is Tata Motors, 1 of the 160 companies’ part of the Tata family conglomerate. It used to be a mass market India car producer, to become a global upscale carmaker after acquisition of Land Rover from Ford. Large part of companies in Asia are usually part of a family group even if they are listed, potential agency problems.
Fourth is Baidu, search engine from China, second largest search engine in the world. A business in China but with a Cayman shell company listed in US. If you are a shareholder in Baidu, what do you really own?
Fifth is Deutsche Bank because Prof likes horror story. Financial service companies are strange beast due to regulatory requirements. How does CF be applied in these companies?
Sixth is a privately owned bookstore called Bookscape (name changed from an actual bookstore). CF principles should apply here as well but with other different constraints.
Each of them will be discussed on risks, hurdle rates, funding mix & decisions making.
Class group assignment: Each member in a group to pick 1 company that will go through the lab experiment as above with a broad theme.
The End Game
Milton Friedman: to create a product/service that people will pay for it and you make money. < - straight forward answer
Adam Smith: That’s not enough, there must be a broader moral objective. < - but there’s more than just money.
To sum it up, businesses today are faced with the following Theocratic trifecta:
1st critique - we need to create sustainable business
2nd critique - what about taking care of all stakeholders, instead of just shareholders
3rd critique - the biggest & latest 3-letter word of ESG
A business has many stakeholders:
Shareholders, lenders, employees, customers, suppliers & society (& even competitors). Do all interests converge? Who should company take care?
CF has historically to maximise the value of the firm, with a narrow view of maximising shareholders’ wealth (by share price even though there are tons of problem with it).
Why only shareholder wealth?
There can be only 1 objective for a business. Just like in operational research, you can only maximise 1 thing with many other variables as constraints. But why can’t you maximise lender’s interest or employee’s benefits?
“Answer is simple: every stakeholder has a contractual claim on the business, except for shareholders which can only have residue claims (after everyone has done claiming).”
Hence, we put shareholders as priority (with the share price as a central focus) as they are down in the pecking order.
In 1 extreme, this also means everything else needs to give in (despite contractual claim) especially in earlier young markets or in markets with few rules.
Some critiques:
Maximising share price is not the same as maximising employees’ salaries/benefits. False - a company with growing share price will provide better compensation for employees especially today with options & RSUs.
Maximising share price means does not mean customers are not cared for. False - keeping customers happy & satisfied is a function of generating more revenue which improves earnings & share price. Antitrust regulation today has difficulties with monopolies as big corporates are charging very little to nothing on their products/services.
Maximising share price does not mean company is a social outlaw / immoral. False - companies that are evil will end up losing business eventually. When companies are doing well, they can afford to spread wealth around. In reverse, companies not doing well won’t spread wealth. For companies that scored high in ESG, are they doing good?
Not a Glorified Accounting Class
Classical CF was borne 60 years ago, traced back on a paper written by Merton Miller and Franco Modigliani in 1958 (famously known for Modigliani–Miller theorem). Before that, it was just a glorified accounting class.
Utopian version (suspend your reality for the moment) of CF is as follows:
Managers - they run the firms and make decision by maximising shareholders value. They reveal information to the markets, honestly, and on-time. Markets will then response appropriately, efficiently.
Shareholders - choose managers (via directors) & directors annually. Directors are to put shareholders interest first.
Lenders - protect themselves via covenants
No social costs - every business create a cost but, in this world, it is safe to maximise stock price.
However,
Managers - are self-serving, with information advantage over directors. They delay bad news and sometimes outright lie.
Shareholders - little power over managers
Lenders - matter of time business will abuse lenders despite covenants
No social costs - social costs can be huge, e.g. tobacco companies
Let’s tear down each of them.
I - Shareholders & directors vs managers
Neither annual meeting nor directors elections are effective in solving this. Even when you don’t vote, a non-vote in a general meeting actually means counted as vote for incumbent managers. Most meetings are also well controlled.
Institutional investors talk the talk but don’t walk the walk. They are passive and mostly will vote for incumbent management rather than oppose. They sell the shares rather than face against management.
CEO always have a say on electing directors in reality. When John Mack becomes CEO of Morgan Stanley, the 1st 3 directors he nominated were actually from his country club. Directors also own shares for free and get paid handsomely.
What happens in a directors’ meeting is usually where everyone is a team player, no devil’s advocate. Though there are independent directors, sometimes important questions are not asked as they are affected by authoritative figure of the CEO.
In 1990s, Disney was run by Michael Eisner, here’s everything he did wrong on board governance, it’s a rubber stamp board:
He created a board of directors of 17 people (too big of a board).
8 of them are insiders.
Chairman is the CEO himself.
Ms. Baur was the principal of the school where Eisner’s kids went to.
Leo Donovan, President of Georgetown University, is also where Eisner’s son went to and gave donation.
Irwin Russel, attorey-a-law, was Eisner’s personal lawyer.
Disney was the only S&P500 at that time that failed board independence test.
Michael Eisner was actually hired from Paramount and he bought over Jeffrey Katzenberg to head Disney Animation, a dismal division at that time. Eisner also promised a 5% of revenue on movies that he successfully marketed.
Katzenberg actually succeeded in anyone’s wildest dream, growing revenue from $300 million to $3 billion. The imperialist CEO of Eisner felt threatened and fired Katzenberg through the board, and the board didn’t object it.
Katzenberg then sued and received $150 million which he uses as a seed to start Dreamworks. This is why Shrek was created (by Dreamworks) to satire Disney’s characters.
The Board Goverance Test
On the company chosen by you, does it fit the following test?
How many are insiders (current or ex-employees)?
Any independance disclosure?
How does the company ranks on external benchmark? For e.g., as obtained from Yahoo Finance’s Profile Page of both Disney & Apple
Is there tangible evidence that a board stops the CEO from doing something? Check news stories. // Class 2 of Corporate Finance ends