Introduction to Corporate Finance

PART 1: INTROdUCTION

Several market forces constrain the behaviour of a company’s managers. In recent years, large investors

have become more active in management. This is particularly true for institutional investors such as

mutual funds, life insurance companies and pension funds, which often hold large blocks of shares.

Activist institutional investors use their influence to put pressure on underperforming management

teams, occasionally applying enough pressure to replace the CEO.

An even more powerful form of market discipline is the hostile takeover, which involves the acquisition

of one company (the target) by another (the acquirer) through an open-market bid for a majority of the

target’s shares. By definition, a takeover attempt is hostile if the target company’s senior managers resist

(or simply do not support) the acquisition. Bidders in hostile deals may believe that they can improve

the value of the target company, and thereby make a profit on their investment, by replacing incumbent

management. Managers naturally find this threatening, and erect a variety of barriers to thwart potential

acquirers. Nevertheless, the constant threat of a takeover provides additional motivation for managers to

act in the interests of the company’s owners.

In addition to these market forces, other devices exist that encourage managers to behave

in the shareholders’ interests or that limit the consequences when managers misbehave. These

may include monitoring expenditures paid for audits and control procedures that alert shareholders

when managers pursue their own interests too aggressively. Managers and directors of companies

can also accept that a portion of their total remuneration is to be received in the form of delayed

compensation, such as receiving access to some of their pay in the company several years after a

profitable year.

Use of Compensation Plans to Control Agency Costs

Another way to align managerial and shareholder interests is through executive compensation plans. The

objective is to design such plans to give managers the incentive to act in the best interests of the owners.

Incentive compensation plans tie managerial wealth to the company’s share price by paying managers

with shares in the company, or share options. Share options give the manager the right to purchase shares

at a fixed price, usually the market price of the shares at the time the manager receives the options. The

key idea is that managers will have an incentive to take actions that maximise the share price, because

this will increase their wealth along with that of the other shareholders.

Although tying management compensation to performance seems like an effective way to motivate

managers, compensation plans have come under intense scrutiny in recent years. Individual and

institutional investors have publicly questioned whether the multimillion-dollar compensation packages

granted to executives really are linked to performance. It is not hard to find examples of CEOs who receive

millions in compensation when their companies are underperforming. In addition, average levels of CEO

compensation in other developed countries tend to be much lower – a fact that critics of CEO pay in the

United States, in particular, do not miss. In the last two years in Australia, there have been several publicly

listed companies in which the senior executive teams were advised by their boards of directors that bonuses

would not be paid due to underperformance of the company over the previous year.

1-4c WHY ETHICS ARE IMPORTANT IN CORPORATE FINANCE

In recent years, the media and others have questioned the legitimacy of actions taken by certain

businesses. Examples range from the $1.2 million that former Merrill Lynch CEO John Thain spent

redecorating his office, shortly after Bank of America acquired Merrill in 2008, to the billions stolen by

Bernard Madoff through his massive Ponzi scheme. The global financial crisis focused attention on a

wide range of ethical issues. Did mortgage lenders lower their credit standards in order to make a quick

executive compensation plans

Incentives offered to a manager

to encourage her to act in the

best interests of the owners

share options

Outright grants of shares to top

managers, or, more commonly,

grants the rights to purchase

shares at a fixed price

hostile takeover

The acquisition of one company

(the target ) by another (the

acquirer ) through an open-

market bid for a majority of

the target’s shares if the target

company’s senior managers

do not support (or, more likely,

actively resist) the acquisition

Andy Bryant, Executive Vice

President of Technology,

Manufacturing, and Enterprise

Services, Intel Corp.

‘I never thought that ethics

would be a value add to

a company, but today I

believe it counts as part of

your market cap.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

COURSEMATE

SMART VIdEO

When you read or hear about a

company in the media, does the

company explain the primary

goal of its actions? For a publicly

listed company, does its annual

report outline its primary goal?

thinking cap
question