Finance Textbook Notes – Chapter 2: Maximizing Stockholders’ Welfare

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Notes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao
Subject: Finance
  1. Assets have two values in that they have a book, or accounting value based on the historical cost of the asset and its carrying value given certain accounting conventions and assumptions, and a market value which is based on the amount by which the asset could be sold in an exchange. When looking at economic value, assets have an exchange value and an in-use value, the sum of which is an asset’s total economic value.
  2. The accounting balance sheet ignores, for the most part, market values. It depicts assets at their historical costs and liabilities and equities irrespective of any market appreciation. The economic balance sheet is market-value oriented and considers the exchange value of assets, plus any wealth created by the firm’s use of those assets (value in exchange plus wealth = value in use). Liabilities and equities are stated at their fair value as determined by the marketplace.
  3. Because it is often difficult (or impossible) to determine directly the wealth created by a firm’s use of assets, the claims definition of firm value, which is based on the market value of claims against the firm’s assets and readily determinable via the exchange, is most often used over the assets definition.
  4. Stockholders are concerned with the value in-use of a firm’s assets because that value equates to the market value of the firm in the marketplace and directly determines the firm’s stock price. To the extent that value in-use increases (and the value of debt remains fairly constant), the increase accrues to the shareholders.
  5. In general, non-cash expenses, like depreciation, that don’t involve an actual cash outlay can cause accounting profits to differ from cash flows. Also, changes in certain accounts, like accounts receivable, inventories, etc., may not be reflected in accounting profits but are actually cash flows.
  6. The managers of a company are primarily responsible to the stockholder, but are also agents of the company’s stakeholders, which can be employees, suppliers or society as a whole.
  7. Agency costs are (1) pecuniary (salary, retirement, benefits, etc.), or (2) non-pecuniary (increased prestige or lifestyle). Pecuniary benefits are derived from a manager’s employment contract. Non-pecuniary benefits are derived from the manager’s power to make decisions. Examples of agency “leaks” are as follows:
    • Excessive perquisites (perks)
    • Informational asymmetry (inside information not available to principals)
    • Short horizons (a manager’s tenure may be limited – encouraged to improve welfare in the short-term only)
    • Human capital expropriation (jumping ship after a firm invests in training)
    • Risk aversion (managers are less likely to make risky decisions – might effect their own welfare)
    • Excessive retention (securing job status by having excess retention as a cushion for the future)
  8. Agents pay for agency costs because in the long run their own value will be comprised by their self-serving behavior as the principles have some influence (through some managerial decisions and the option of selling stock) over the behaviors of agents. If the self-serving activities of an agent cause a detriment to the principals, eventually these parties will eliminate the agent in favor of another. However, if this activity results in a detriment to the principals (say, in terms of a loss on stock) then both the agent and the principals pay. However, in the long run, it is the agents that ultimately pay for agency costs. It is in both parties’ best interest to write contracts that minimize agency costs and maximize firm value.
  9. Monitoring costs are incurred to ensure that agents adhere to their employment contract and do not take excessive advantage of their perks. Bonding costs are different in that they are incurred by the agent to reassure stockholders that he/she will adhere to employment contracts. This would involve considerable time spent developing firm-specific skills that may not be in demand elsewhere. This reduces the value of the agent to other firms and encourages he/she to act in the best interest of the firm and its principals.
  10. The corporation is the most dominant entity in business, despite agency costs, for the following reasons:
    • Capital accumulation (firms have far greater access to capital – owners have limited liability and free exchange)
    • Efficient risk reduction (investors can invest small amounts in a variety of different companies)
    • Specialization (managers that specialize in certain aspects of a business can be hired)
  11. Internal and external devices to control agency costs are as follows:
    • Internal – governance (formal rules), competition/monitoring of mgmt., separation of mgmt. and control
    • External – takeover threat, managerial competition, institutional investors, government regulations, and lawsuits
  12. The management function performs the day-to-day operation and running of the firm. The control function consists of actions that ensure that the managers are functioning in the best interest of the stockholders. This separation can reduce agency costs because board (control function) is encouraged to act in the best interest of the stockholders. Members are elected and can be removed by the stockholders. Therefore, management must convince the board that certain decisions are in the best interest of the stockholders. The board can reject proposals that are not in the stockholders’ best interest.
  13. The officers of a firm have a fiduciary responsibility to the stockholders. This responsibility involves an agreement to perform all duties they are assigned with due diligence and with the skill that they represented themselves as possessing when they secured that position. As a fiduciary, the agents must act solely in the best interest of the stockholders and not in their own self-interest or the interest of other parties. Agents agree to be obedient and accountable for their decisions. The board has a fiduciary responsibility as well, in that it is representing the shareholders. However, directors are permitted to withhold certain info that would hurt the firm’s competitive position.

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