Separation of ownership and control ppt

LECTURE 1 Introduction

(Chapter 1)
Corporation
Major characteristics

Agency relationships
Sole proprietorship
Partnership
Corporation
Alternative Forms of

Business Organization

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Shareholders
Managers
Debtholders
Other parties
Parties in a Corporation

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Separation of Ownership and Control

Ownership: the shareholders are the owners of the corporation.

Control: ultimate control rests with the shareholders, but the managers control the day to day operations.

Features of Corporation (#)

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Risk Bearing: While all parties associated with the corporation bear the risk, shareholders bear all residual risk, and

receive only the residual return.

Features of Corporation (#)

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The separation of ownership and control improves efficiency, but also creates agency problem between shareholders and managers.

Residual risk creates agency problem between shareholders and other parties especially creditors.

Ownership, control and residual bearing are interrelated.

Features of Corporation (#)

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The primary goal is shareholder wealth maximization, which translates to maximizing stock price.
Should firms behave ethically? YES!
Do firms have any responsibilities to society at large? YES! Shareholders are also members of society.
Goals of Corporation

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Better defined than accounting profits,

Considers timing of cash flows in future,

Considers differences in risk among

alternative investments or other managerial decisions.

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Advantages:
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages:
Double taxation
Cost of set-up and report filing
Other Features of Corporation

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Dealing with the financial decisions corporations make and the tools and analysis used to make these decisions.
Goals: consistent with the goals of a corporation.
Corporate Finance

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Include decisions on investment, capital structure, capital raising, dividend payout, restructuring, governance, risk management, etc.
These decisions may affect equity value by changing the magnitudes and/or the riskness of a firm’s cash flows.
Financial Decisions in a Corporation

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An agency relationship exists whenever a principal hires an agent to act on his or her behalf.
Within a corporation, agency relationships exist between:
Shareholders and managers
Shareholders and creditors
Agency Relationships

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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 takeover
High dividends or more short-term debts that help reduce redundant cash holdings.
Shareholders versus Managers

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Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors.
Underinvestment, risk-shifting and debt dilution.
In the long run, such actions will raise the cost of debt and ultimately lower stock price.
Restrictive covenants of debt help reduce the conflict.
Shareholders versus Creditors (#)