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1.+CFP - Study+Guide - v2.0 17

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1.+CFP - Study+Guide - v2.0 17

Uploaded by

Jerlin Preethi
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© © All Rights Reserved
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CORPORATE FINANCE AND PLANNING

The Goal of the Firm

Many mistakenly assume that the goal of the firm is to maximize profit. However, that
is an imprecise goal. What profit do we hope to maximize – short term or long term?
Accounting profits or cashflow?

The goal to maximize profits may lead management to take certain unsustainable
actions such as severe cost cutting, which may boost profits now, but lead to low
growth later.

In Financial Management, the goal is to maximize the current value per share.
Phrased differently, it is to maximize the market value of the existing owners’
equity.

This is known as Wealth Maximization.

As share prices reflect future cash flows, this means the firm has to keep an eye
on the future, as it makes its decisions. This encourages it to think long term.

This does not mean that the firms should do “anything” to maximize shareholder
wealth. It is important to note that unethical behavior does not ultimately benefit
owners.

Agency Issue

The relationship between an owner and the manager is called the agency relationship.
The manager, in this context, is known as the “agent” while the owner is known as the
“principal”.

The conflict of interest between the owner and the manager is called the “agency
conflict”. A business agent is entrusted with the management of the owner’s business
and assets. He is supposed to represent and act in the best interests of the owner.

However, it has been often observed that agents tend to act in their own best interest
rather than the best interest of the owners. The managers may incur expenses that do
not add value to the business but make their own lives more comfortable.

For example, if a CEO decides to incur the company expense of a luxury car as
personal transportation, he may argue that it is for the benefit of the company as the
CEO represents the company. For him to arrive at business events in a luxury car
could thus convey an image of strength and reliability, benefitting the firm.

However, if the CEO incurs the company expense to purchase five luxury cars for
transportation, one for each day of the week, it would be clear that it does not add
value to the firm. Rather, it seems to be for the personal comfort and advantage of the
CEO. This is an agency conflict and the wasteful expenses are known as “agency
costs”.

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CORPORATE FINANCE AND PLANNING

Shareholders are aware of this issue and they often place measures to monitor and
influence the behavior of management. Such measures will consume resources, such
costs are also called “agency costs”.

Some agency costs to monitor and influence the behavior of management:


1) Hiring external auditors to ensure the financial statements that management
provides are accurate
2) Having disclosure requirements such as the quarterly reporting of financial
statements
3) Providing incentives to managers, such as stock options and bonuses, so that
managers start to think and act like shareholders

Stockholders technically have control of the firm and, if dissatisfied, can remove
management. However, this is easier said than done.

Stakeholders of a Company

Stakeholders are other groups, besides stockholders, that have an interest


in the firm and potentially have claims on the firm’s cash flows. Stakeholders
can include creditors, employees, customers and the community in which the company
operates it.

'Sarbanes-Oxley Act Of 2002 - SOX' is an act passed by U.S. Congress in 2002 to


protect investors and stakeholders from the possibility of fraudulent accounting
activities by corporations. The Sarbanes-Oxley Act (SOX) mandated strict reforms to
improve financial disclosures from corporations and prevent accounting fraud. (United
States Government Publishing Office, 2002)4

This was enacted in response to the accounting scandals in the early 2000s. Scandals
such as Enron, Tyco, and WorldCom shook investor confidence in financial statements
and required an overhaul of regulatory standards. This is intended to strengthen
protection against accounting fraud and claims by senior management of having no
knowledge of misdeeds.

Because of its extensive requirements, compliance with the SOX is very costly to
publicly traded firms. Many public firms have chosen to “go dark” which means that
their shares will not be traded in the major stock markets, in which case the Act does
not apply. Many firms choose to go public outside the US as the cost savings from
avoiding SOX are enormous.
(CFO Magazine, 2018)5
Interactions of a Firm and the Financial Markets

A firm has many 2-way interactions with the financial markets.

4
United States Government Publishing Office, 2002 July 30. Public Law 107-204.
https://www.govinfo.gov/content/pkg/PLAW-107publ204/pdf/PLAW-107publ204.pdf

5
CFO Magazine, 2018 Aug 13. 16 Years Later, SOX Compliance Continues to Evolve.
Retrieved from https://www.cfo.com/auditing/2018/08/16-years-later-sox-compliance-continues-to-evolve/

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