Subhankar Nayak, 2022 EC623/MF703: Financial Economics (Seminar in Corporate Finance) WINTER 2022 Subhankar Nayak, 2022 1: CORPORATIONS – STRUCTURE, DYNAMICS AND DECISION ISSUES Corporations as special business entities; structural model of corporations; dynamics arising thereof & decision issues of corporate executives Subhankar Nayak, 2022 3 Forms of Business Entities 1. Sole Proprietorship or Family Firm owned by a single person or family 100% control, lower taxes but unlimited liability, limited capital, high mortality 2. Partnership high control, more capital, lower risk, expertise sharing but unlimited liability 3. Corporation limited liability, access to lot more capital but higher taxes (double taxation), disclosure and regulation requirements, loss of control, conflict issues Subhankar Nayak, 2022 4 Comparisons Characteristic Sole Proprietorship Partnership Corporation Ownership Sole owner Multiple owners Unlimited ownership Legal requirements and regulation Few; entity easily formed Few; entity easily formed Numerous legal requirements Legal distinction between owner and business None None Legal separation between owners and business Liability Unlimited Unlimited but shared among partners Limited Ability to raise capital Very limited Limited Nearly unlimited Transferability of ownership Non-transferable (except by sale of entire business) Non-transferable Easily transferable Owner expertise in business Essential Essential Unnecessary Subhankar Nayak, 2022 5 Overview Design of corporations & underlying dynamics Foundation for all topics in this course Subhankar Nayak, 2022 6 Demand-Supply Model of Finance Corporations: constitute demand side→ need capital to undertake projects so as to grow Market (consisting of investors): constitute supply side→ retain surplus disposable capital (after paying taxes & meeting consumption needs) → willing to provide capital in order to grow wealth Surplus of wealth supply money Need money for projects etc. demand money Corporations (Net Borrowers) Market (Investors) Invest Cash (buy stocks & bonds) Interest & Dividends Subhankar Nayak, 2022 7 Investors: Debtholders One type of investors or claimants or stakeholders in a corporation Primary Claimants Low risk, low returns form of investors Third party lenders, no ownership stake Guaranteed payoffs on a fixed schedule Subhankar Nayak, 2022 8 Investors: Equityholders Another type of investors or claimants or stakeholders in a corporation Residual Claimants Higher risk, higher returns form of investors Ownership Stake: Shareholders own the company Flexible & discretionary payoffs Subhankar Nayak, 2022 9 Fundamental Issue 1 1. Why do investors invest (provide capital to corporations) Because expect (their) capital to grow (to reflect risk & time commitment) Expected (Interests + Dividends) > Cash investments Concept of Asset Pricing Surplus of wealth supply money Need money for projects etc. demand money Corporations (Net Borrowers) Market (Investors) Invest Cash (buy stocks & bonds) Interest & Dividends Subhankar Nayak, 2022 10 Fundamental Issue 2 (1st Part) 2. How do investors know how much to pay (for stocks/bonds) Requirements: a) investors possess all pertinent info at low cost b) prices are “fair” Concept of Market Efficiency Surplus of wealth supply money Need money for projects etc. demand money Corporations (Net Borrowers) Market (Investors) Invest Cash (buy stocks & bonds) Interest & Dividends Subhankar Nayak, 2022 11 Fundamental Issue 2 (2nd Part) 2. How do investors know how much to pay (for stocks/bonds) Requirements: c) investors know how much the corporation is worth Concept of Corporate Valuation Surplus of wealth supply money Need money for projects etc. demand money Corporations (Net Borrowers) Market (Investors) Invest Cash (buy stocks & bonds) Interest & Dividends Subhankar Nayak, 2022 12 Fundamental Issue 3 3. How do shareholders take charge Shareholders own the corporations But a public company has too many shareholders to run the corporation on their own behalf Concepts of (a) Separation of Ownership & Control + (b) Delegation of Authority Surplus of wealth supply money Need money for projects etc. demand money Corporations (Net Borrowers) Market (Investors) Invest Cash (buy stocks & bonds) Interest & Dividends Subhankar Nayak, 2022 13 Separation of Ownership & Delegation of Authority Shareholders Board of Directors Corporate Management Team(actual owners; but too numerous to run the firm) (2-15 member boards headed by a Chairman; may not be independent) (CEO + CFO + COO + other management) SHAREHOLDER VOTING NOMINATION Apple Inc. Shares authorized = 50.40 billion Shares outstanding = 16.41 billion Float = 16.39 billion % insider ownership = 0.07% % institutional ownership = 58.70% % retail ownership = 41.23% Apple BoD 9 members 1 insider (CEO), 8 independent Chairman: independent All committees: independent Efficient governance Apple Inc. 17 member executive team Subhankar Nayak, 2022 14 Separation of Ownership & Delegation of Authority 1. Separation of ownership & control: Shareholders → are owners; management → retain control 2. Delegation of authority: from left to right, i.e., from shareholders to management Fundamental philosophy of corporate existence: 1. Protection of shareholder interests 2. Maximization of shareholder value Shareholders Board of Directors Corporate Management Team SHAREHOLDER VOTING NOMINATION Subhankar Nayak, 2022 15 Fundamental Issue 4 4. What if the managers violate the fundamental philosophy Managers have information asymmetry, greater power & self- interests different from investors Management may try to benefit itself at the cost of investors Concepts of Information Asymmetry & Agency Problems Surplus of wealth supply money Need money for projects etc. demand money Corporations (Net Borrowers) Market (Investors) Invest Cash (buy stocks & bonds) Interest & Dividends Subhankar Nayak, 2022 16 Fundamental Issue 5 5. How do investors/market mitigate agency problems, i.e., ensure proper usage of invested capital by corporate managers Through effective monitoring & incentivization Concepts of A. Suitable contract design B. Effective performance measurement & incentive design Surplus of wealth supply money Need money for projects etc. demand money Corporations (Net Borrowers) Market (Investors) Invest Cash (buy stocks & bonds) Interest & Dividends Subhankar Nayak, 2022 17 Mitigating Agency Problems – I Debtholders 1. Design Indentures 2. Impose detailed Debt Covenants 3. Use Trustees 4. Possess power to initiate Bankruptcy if indentures/covenants violated Subhankar Nayak, 2022 18 Mitigating Agency Problems – II Equityholders 1. Proper performance measurement measure and monitor performance of management to ensure whether managerial actions are optimal & aligned with shareholder interests 2. Efficient incentive design and structuring of executive compensation design incentive and structure compensation for management such that they are suitably motivated & managerial actions become aligned with shareholder interests Subhankar Nayak, 2022 19 Decisions By Corporate Managers 1. Investment Decisions: what projects to undertake to make the corporation “grow” → Capital Budgeting 2. Financing Decisions: in what form to raise capital (for projects) & how to compete in the marketplace for scarce capital → Capital Structure & Raising Capital 3. Payout Decisions: How to “pay back” (compensate) investors (for capital borrowed) → Payout Policy 4. Restructuring Decisions: how to redesign the corporation for enhanced efficiency & value → Corporate Restructuring Additional responsibilities of corporate managers to assuage information asymmetry & agency problems : A. Signalling: to convey “credible” info about quality & responsibility B. Corporate Governance: suitable design of corporation, its culture, mechanisms & all relationships
