Session 3: The Objective in Corporate Finance - Reality

Summary

In this third session of a corporate finance class, the lecturer delves into the traditional objective of maximizing stock prices, exploring its benefits and flaws. Alternatives are presented, such as new corporate governance models and different business objectives like growth and market share. While acknowledging the limitations of market-based solutions, the lecturer emphasizes their self-correcting nature. Using examples like Japan's cross-holding systems and Disney's management changes, the session argues that stockholder-driven corrections, including activist investors and corporate accountability, are essential in addressing governance issues and maximizing long-term value.

Takeaways

• 😀 Maximizing stock prices is a central objective in corporate finance, but it can lead to several problems, including managerial misconduct and inefficient markets.
• 😀 Corporate governance mechanisms, such as cross-holdings between companies, can serve as alternatives to the traditional stockholder-based system, but they may have limitations in addressing systemic issues.
• 😀 In Japan, cross-holding systems among companies worked to replace bad managers, but failed when it came to dealing with broader economic problems, highlighting the risks of elitist governance mechanisms.
• 😀 Using intermediate objectives like maximizing market share, growth, or margins can be misleading if they are not tied back to the ultimate goal of maximizing business value.
• 😀 The market-based approach to corporate governance, despite its flaws, has self-correcting mechanisms, allowing for accountability when mistakes are made by managers.
• 😀 Stockholders, when unhappy with management, can take corrective actions, such as supporting activist investors or even initiating hostile takeovers, as seen in the case of Disney and Michael Eisner.
• 😀 In the case of companies like Nabisco, bondholders learned to protect themselves against managerial abuses by incorporating clauses that allowed them to pull back bonds if necessary.
• 😀 While markets can make mistakes, they are usually corrected quickly, as seen with the collapse in stock prices when companies lie or mislead investors. This self-correction is a strength of market mechanisms.
• 😀 Social costs, such as lawsuits or taxes, can act as external pressure points that force companies to change, especially when society perceives their actions as harmful, as seen with the tobacco industry.
• 😀 CEO power can become imperial over time, which can negatively affect corporate governance. Regular turnover of CEOs, similar to term limits for legislators, could help prevent this from happening.
• 😀 The case of Disney shows how stockholder dissatisfaction can lead to significant changes in leadership and governance, even when a CEO initially resists change. Long-term CEO tenure can eventually lead to corporate governance problems.

Q & A

What is the main objective in corporate finance according to the speaker?

The main objective in corporate finance, as stated by the speaker, is to maximize stock prices. This is traditionally seen as the central goal in corporate finance.

What are some potential issues with the objective of maximizing stock prices?

The issues with maximizing stock prices include managers acting in their own interests rather than for the benefit of stockholders, lack of control for stockholders, irrational markets, misleading information from firms, and large social costs.

What alternatives to maximizing stock prices does the speaker suggest?

The speaker suggests three alternatives: 1) A different corporate governance system, where managers are held accountable by other mechanisms rather than stockholders. 2) Changing the objective to maximizing revenues, growth, market share, or margins. 3) Improving the existing system of maximizing stock prices by addressing its flaws.

How do corporate governance systems in Germany and Japan differ from the U.S. system?

In both Germany and Japan, the corporate governance systems are based on cross-holdings where companies own shares in each other, and managers are responsible for keeping each other in line. In contrast, the U.S. system places the responsibility of holding managers accountable on the stockholders.

What is the main issue with the cross-holding governance model as observed in Japan and Germany?

The main issue with the cross-holding governance model is that it works well in dealing with poorly managed individual companies but fails to address systemic problems. For example, in Japan, companies with bad loans were protected by the system, which perpetuated economic issues.

What does the speaker mean by ‘maximizing market share’ and its potential issues?

Maximizing market share refers to increasing a company's share in the market, but if pursued without a clear connection to profitability, it can be harmful. If companies focus solely on increasing market share, they might end up selling below cost, which is unsustainable and can lead to losses.

Why does the speaker argue that maximizing stock prices is still the best objective?

The speaker argues that maximizing stock prices is still the best objective because markets are self-correcting. When stockholders or other stakeholders are dissatisfied, they can push for change, and market mistakes are quickly corrected, which makes the market-based system effective in the long term.

How does the market self-correct when stockholders are unhappy with management?

When stockholders are dissatisfied with management, they may engage in actions like voting proxies, organizing shareholder activism, or even initiating hostile takeovers. These corrective actions hold management accountable for their performance.

What is the significance of the example of Disney in the speaker's argument?

The example of Disney illustrates how stockholder discontent can lead to management changes. In 2003, Disney stockholders became dissatisfied with CEO Michael Eisner's performance, and this pressure eventually led to his resignation in 2005. The example demonstrates how market forces and stockholder activism can correct corporate governance.

What does the speaker suggest about term limits for CEOs?

The speaker suggests that CEOs may acquire too much power over time, leading to ineffective governance. He proposes that, similar to term limits for legislators, CEOs could also benefit from term limits to prevent them from becoming too entrenched in their position and to ensure more responsive governance.