A foremost concept in finance concerns how individuals interact in order to allocate resources (capital) and/or shift consumption across time by borrowing or investing

1. 1-1
FINANCIAL ISSUES & INCENTIVES
IN MODERN ORGANIZATIONS
Asso.Prof.Dr. NGUYEN THU THUY
Faculty of Business Administration
FOREIGN TRADE UNIVERSITY
Email: thuynguyen0202@gmail.com

2. 1-2
Finance?
A foremost concept in finance concerns how individuals
interact in order to allocate resources (capital) and/or
shift consumption across time by borrowing or investing.
If you receive $1 million today then what decision would
you make regarding consumption and investment?
 Suppose you spend (consume) $100,000 now.
 This leaves you with $900,000. You can postpone consumption
to future time periods by investing the $900,000 today.
On the other hand, what if you have $20,000 but need to
consume $30,000. You can borrow the $10,000 and pay
it back in a future period along with the interest.

3. 1-3
Two examples of common corporate
financial decisions
A firm must spend $100 million for the required assets if
a proposed project is approved. Important issues are:
 Should the project be accepted or rejected? What do investors
demand as a (minimum acceptable) project rate of return?
 What are the project’s forecasted future cash flows? How risky
are these forecasted cash flows?
 Where will the $100 million come from, i.e., what mix of equity
and debt financing should be used?
If a firm has $200 million of cash flow, but needs reinvest
$120 million, what should be done with the remaining
$80 million of cash.
 Pay it out as a dividend or repurchase some stock?

4. 1-4
Example of common investments type
financial decisions
A mutual fund manager that manages a
fund with $10 billion portfolio receives an
additional $100 million in cash from new
investors.
Which stocks or bonds to purchase?
How will any proposed new investments affect
the expected return and risk of the overall
portfolio?

5. 1-5
Corporate finance vs.
Investments
Board of Directors
CEO
Assets
Equity
Debt Issue Fixed Income Products (Bonds)
Issue Shares
Stock
Holders
Debt
Holders
Investors
CFO

6. 1-6
I: Corporate Finance
 Imagine you are the CFO of a company with $2
billion in excess cash.
What can the firm do with the cash?
1. Invest in a new project
2. Find an acquisition candidate
3. Invest in financial assets
4. Repay debt
5. Repurchase shares of a stock
6. Pay a dividend

7. 1-7
II: Investments
Investment theory tries to answer questions
like:
in which combination of securities should
investors put their money?
what is the relation between risk & return?
what return can you expect on a portfolio?
is it possible to outperform the market?

8. 1-8
Corporate finance decisions - summary
 Capital budgeting decision
 investment projects  physical plants,
equipment
 brand building (intangible assets)
 R&D
 Financing decision:
 Funding sources
 Long-term financing mix  capital structure
decision

9. 1-9
Two Main Functions of Corporate Finance
Current Assets
Cash
Marketable Securities
Account Receivables
Inventory
Fixed Assets
Buildings
Equipment
Land
Intangible Assets
Brand Names
Trademarks and Patents
Distribution Networks
Customer Loyalty
Loyal and Skilled Work Force
Current Liabilities
Accounts Payable
Short-Term Debt
Product Warranties
Long-Term Liabilities
Long-Term Debt
Pension Obligations
Deferred Taxes
Leases
Equity
Proceeds from Stock Sales
Retained Earnings
Value Created by Investments
Intangible Liabilities
No-Layoff Policy
Commitment to Quality
Products and Services
Need to Advertise and Promote
The Investment/Capital
budgeting Decision:
Assets
The Financing Decision:
Liabilities and Equity

10. 1-10
Check:
Capital budgeting or Financing decisions?
Intel decides to spend $500 mil to develop a new
microprocessor
Volkswagen decides to raise 350 mil euros through a
bank loan
Exxon constructs a pipeline to bring natural gas on shore
from the Gulf of Mexico
Pierre Lapin sells shares to finance expansion of his
newly formed securities trading firm.
Norvatis buys a license to produce and sell a new drug
developed by a biotech company
Maersk issues new shares to help pay for the purchase
of two new vessels.

11. 1-11
Managerial Issues
How to measure the project’s worth for the
company?
Are companies' market prices justified?
Example: dot-coms
How to choose among the projects given the
budget constraint and externalities?
How to account for risks associated with the
project?
Are risks always bad? Is it good to have volatile
oil prices?
Should we invest now in an unprofitable project?
Should we invest now in a profitable project?

12. 1-12
Managerial Issues (cont.)
Does it matter how to finance the project: by
debt or by equity?
Would you like the company to have much debt?
Should the company borrow more money from
banks or issue bonds?
Would you like the company to pay high
dividends?
Example: Microsoft
How will the market react to the share buyback?
How will the market react to the new equity
issue?

13. 1-13
Managerial Issues (cont.)
Should we give managers higher salaries or
higher bonuses?
How should the company communicate with the
market?
What drives the company’s decision to go
public?
Would you like the company to grow via
acquisitions?

14. 1-14
Forms of Business Organization 
impact on financial decisions
Sole proprietorship
Partnership
Corporation
Evaluate by
The owners' liability
The life of the entity
The ability to raise capital

15. 1-15
Sole Proprietorship
Advantages
Ease of organization
Subject to fewer government regulations
Disadvantages
Unlimited personal liability
Inability to raise large amounts of money
Life of the business is limited to the life of the
proprietor

16. 1-16
Partnership
Advantages
Ease of organization
Able to raise more money than the sole
proprietor
Disadvantages
Unlimited personal liability
Difficult to transfer ownership
Ability to raise capital is limited by the
partner’s personal wealth

17. 1-17
Corporation
Advantages
Limited liability
Easy transfer of ownership
Unlimited life
Ability to raise large amounts of money
Disadvantages
Start-up can be costly
Earnings subject to double taxation
Separation of control and ownership

18. 1-18
Characteristics of business organizations
Sole Proprietorship Partnership Corporation
Who owns the
business? The manager Partners Shareholders
Are managers and
owner(s) separate? No No Usually
What is the owner's
liability? Unlimited Unlimited Limited
Are the owner and
business taxed
separately? No No Yes

19. 1-19
Check:
Which form of business organization
might best suit the following? Why?
A consulting firm with several senior
consultants and support staff.
A pharmaceutical company with sales of $
300 mil and 1,500 employees.
An advertisement design firm owned and
operated by a (industrial design) college
student who occasionally hires friends for
manual help.

20. 1-20
About corporations:
Book versus Market values
The book value of an asset is determined based
on accounting rules.
The book value is at best a rough approximation
of the asset’s replacement cost.
The market value of an asset is that investors
are willing to pay today for stocks and bonds in
order to receive a risky stream of future
expected cash flows.
Market values are forward looking.
Stocks and bonds represent claims on the future cash
flows that a firm’s assets generate.

21. 1-21
Book versus market values
Market value of a firm
Mkt. value of equity
Mkt. value of debtMarket value of the
asset’s earning
power (as a going
concern)
Liabilities + EquityAssets

22. 1-22
Book versus market values
The Book value of a firm often contrasts
sharply with the Market value.
Book equity
Book debtPhysical assets at
historical book value
Liabilities + EquityAssets

23. 1-23
Book versus market values: a
hypothetical example
A firm begins with $2000 of debt and $4000 of
equity in order to purchase $6000 of assets.
These become the original accounting book
values.
In contrast, Market values are based on today’s
expectations of future performance, i.e., what
cash amounts are expected to be paid out and
the perception of risk. Assume the following:
Investors are willing to pay $2000 for the bonds.
Investors are willing to pay $10,000 for the equity.

24. 1-24
Book versus market values for the
hypothetical example
Book values of firm:
Market values of firm: $4,000 Book equity
$2,000 Book debt$6,000 physical
assets
Liabilities + EquityAssets
$10,000 M.V.
equity
$2,000 M.V. debt$12,000 M.V. as a
going concern
Liabilities + EquityAssets

25. 1-25
A question:
What can you tell from a market-to-book
ratio?
 large/small ratios
 > 1
 < 1
What shall you do if you observe/think
that your shares are undervalued?

26. 1-26
Intrinsic (fundamental) values
Market values are what investors are willing to
either buy or sell an asset for, based on
investors’ expectations of future performance.
Market values are very often publicly observed, e.g., the
transactions in the stock markets.
In contrast, intrinsic values are usually
considered as private estimates of what
something, e.g., a common stock, is actually
worth.
Intrinsic value is not something that you can prove.
If ten analysts are asked to value IBM stock, then there
will likely be ten different intrinsic value estimates!

27. 1-27
Intrinsic (fundamental) values
Assume that a New York Stock Exchange listed
firm has an equity market value of $10 billion.
However, those that manage the firm (insiders)
believe the firm is actually worth $12 billion
(intrinsic value), based on their private or inside
forecasts of future cash flow performance.
For the most part, market prices are driven by
public expectations and consensus, while
intrinsic values represent private forecasts.

28. 1-28
Financial goals of the corporation
The primary financial goal is shareholder
wealth maximization — a function of
future cash flow and risk.
In reality, this is maximizing intrinsic value
 For now we will assume that this is
synonymous with maximizing the market
value, i.e., stock price maximization.
Warren Buffett states that his goal is to
maximize Berkshire Hathaway’s intrinsic
value, and hopefully, the stock’s market
value will be close to the intrinsic value.

29. 1-29
Stock price maximization is NOT profit or
earnings maximization?
Market (and intrinsic) values are driven by risk
and expectations (forecasts) of future cash
flows.
Earnings and other accounting profitability
measures are not cash flows and have limited
use in estimating financial values.
Some actions may cause an increase in
reported earnings, yet cause the stock price to
decrease (and vice versa).

30. 1-30
Wealth maximization and societal welfare
Is the general welfare of society advanced when
individual agents pursue wealth maximization?
Is intrinsic or market value maximization good or bad for
society. Should firms behave ethically?
The following slide contains a quote is from
Adam Smith’s Inquiry into the Nature and
Causes of the Wealth of Nations, 1776.
Adam Smith believed that an economic system in which
individual agents strive to increase their market value
results in the most efficient level of general welfare, as it
facilitates the allocation of resources to their most
productive use.

31. 1-31
Wealth maximization and societal welfare
(Adam Smith, 1776)
“As every individual, endeavours as much as he can
both to employ his capital in the industry, and to
direct that industry that its produce may be of the
greatest value, every individual necessarily labours
to render the annual revenue of the society as great
as he can. In doing so he generally, indeed, neither
intends to promote the public interest, nor knows
how much he is promoting it. By directing that
industry in such a manner as its produce may be of
the greatest value, he intends only his own gain, and
he is in this, as in many other cases, led by an
invisible hand to promote an end which was no part
of his intention. Thus, by pursuing his own interest
he frequently promotes that of the society more
effectually than when he really intends to promote it.
I have never known much good done by those who
pretended to trade for the public good.”

32. 1-32
What is the Objective of the Firm?
Van Horne: "In this book, we assume that the
objective of the firm is to maximize its value to its
stockholders"
Brealey & Myers: "Success is usually judged by
value: Shareholders are made better off by any
decision which increases the value of their stake in
the firm... The secret of success in financial
management is to increase value."
Copeland & Weston: The objective of the firm is to
maximize the wealth of its stockholders."
Brigham and Gapenski: we operate on the
assumption that the management's primary goal is
stockholder wealth maximization which translates
into maximizing the price of the common stock.

33. 1-33
Why Focus on Maximizing Stockholder Wealth?
Shareholders are the legal owners of the business,
management has a responsibility to act in their best
interest
Stockholders provide the risk capital that serves as a
“shock absorber” to the claims of other stakeholders
Focusing on shareholder value avoids value gaps
Undervalued firms are prime targets for a takeover
Profit or earnings per share maximization is inferior:
Shareholders don’t really get profits; the only direct returns
are dividends and stock price appreciation
Accounting measures ignore shareholder opportunity costs
Focusing on expected profits ignores risks

34. 1-34
Why Focus on Maximizing Stock Price?
Stock price is easily observable and constantly
updated
If investors are rational, stock prices reflect the
risks, short term and long term
Maximizing stock price is not incompatible with
meeting other stakeholders' needs/objectives
The objective of stock price performance
provides some elegant theory on:
how to pick projects
how to finance them
how much to pay in dividends

35. 1-35
The Classical Objective Function

36. 1-36
What Can Go Wrong?

37. 1-37
Solutions
Choose a different mechanism for corporate
governance
Choose a different objective
Maximizing earnings / revenues / firm size / market
share
The key thing to remember is that these are
intermediate objective functions
Maximize stock price, but reduce the potential
for conflict and breakdown:
Making managers and employees into stockholders
Providing information honestly and promptly to financial
markets

38. 1-38
Counter Reaction

39. 1-39
The Modified Objective Function
For publicly traded firms in reasonably efficient markets,
where bondholders (lenders) are protected:
 Maximize stock price: this will also maximize firm value
For publicly traded firms in inefficient markets, where
bondholders are protected:
 Maximize stockholder wealth: this will also maximize firm
value, but might not maximize the stock price
For publicly traded firms in inefficient markets, where
bondholders are not fully protected
 Maximize firm value, though stockholder wealth and stock
prices may not be maximized at the same point.
For private firms, maximize stockholder wealth (if lenders
are protected) or firm value (if they are not)

40. 1-40
Agency relationships — the separation of
ownership and control
An agency relationship exists whenever a
principal (owner of a resource) hires an agent to
act on their behalf. Examples are:
Citizen (principal) and elected official (agent)
Stockholder (principal) and corporate manager (agent)
Within a corporation, agency relationships exist
between:
Shareholders and managers
Shareholders and creditors

41. 1-41
Shareholders versus Managers
Managers are naturally inclined to act in
their own best interests.
But the following factors affect managerial
behavior:
Managerial compensation plans
Direct intervention by shareholders
The threat of firing
The threat of corporate takeover

42. 1-42
Shareholders versus Creditors
Shareholders (through managers) could
take actions to maximize stock price that
are detrimental to creditors, i.e., actions
that result in a wealth transfer from
creditors to stockholders.
In the long run, such actions will raise the
cost of debt and ultimately lower the stock
price.

43. 1-43
Case study
Michael Eisner – CEO of The Walt Disney
Company (Sep 1984 – Sep 2005)
Discuss the paper by Stephen F. O’Byrne
“What pay for performance looks like: the
case of Michael Eisner", Journal of
Applied Corporate Finance 5 (summer
1992), pp. 135-136

44. 1-44
Another example:
The compensation for Mr. Palmisano, Chairman and CEO
of IBM Corp., during 2003-2005 (Source: IBM Notice of
2006 Annual Meeting and Proxy Statement)
Year Annual compensation (US$) Long-term compensation (US$)
Salary Bonus Others
Restricted
stock
award
Stock
option
Others
2005 1,680,000 5,175,000 103,302 990,674 230,325 4,241,981
2004 1,660,000 5,175,000 104,406 250,000 1,676,480
2003 1,550,000 5,400,000 11,037 250,000 769,095

45. 1-45
To mitigate the agency problems in
practice (1)
 Compensation schemes (to tie the
fortune of the manager to that of the firm)
 Example: Walt Disney offers its CEO with a
package that includes
A base annual salary
An annual bonus (2% of Disney’s net income above
a threshold of “normal” profitability)
A (10-year) option that allows the CEO to purchase
stocks (e.g., 2 mils shares for $14 per share)

46. 1-46
To mitigate the agency problems in
practice (2)
Monitoring by lenders, stock market
analysts, and investors
Independent board members
Takeover threats
 Labor market forces:
 Threat that poor performance will result in the
removal of the manager
 Bad reputation/remuneration for managers if
badly performing

47. 1-47
Summary –
Keep in mind the differences between:
 Real vs. financial assets
 Capital budgeting and financing decision
 Closely held vs. public corporations
 Limited and unlimited liability

48. 1-48
Đọc case study và trả lời các câu hỏi
sau đây:
1. Đại ý của bài là gì? Tác giả muốn ca ngợi
cái gì?
2. Phân tích tình hình Walt Disney Co. trước
khi M.Eisner trở thành CEO.
3. Các đặc điểm nào trong hợp đồng 6 năm
của M.Eisner có tính chất khuyến khích
người lao động làm việc hiệu quả nhất?
4. So sánh các điểm khác biệt của HĐ 10
năm với HĐ 6 năm.