3 rd Session

1. 3rd Session

2. Goal of the Firm • Maximize the value of the firm for its owners, that is, to maximize the price of the firm’s common stock. • How to increase the stock price? • Work on factors that determine the price of the company’s stock. • What are the factors that determine the price of the company’s stock? • These factors are: • Size of expected cash flows • Timing of cash flows • Riskiness of the cash flows

3. Financial manager can enhance firm’s stock price (value of the firm for its owners) by taking investment and financing decisions that increase level of expected cash flows, speeding them up and reducing their riskiness.

4. Difference of the goal of stock price maximization from profit maximization • Goal of maximizing net income does not take into account the size of expected cash flows, their timing and their riskiness. • Suppose a company follows the profit maximization strategy and undertakes certain actions to increase its net income, but if the market believes these actions compromise future earnings the stock price will decrease.

5. Concept of ‘profit maximization – short-term focus (today’s earnings and cash flows) • Concept of ‘stock price maximization’ – long-term focus (level, timing and the riskiness of the future expected cash flows)

6. Agency Relationships • Goal of stockholder: Stock price maximization • Goal of managers: • Relaxed lifestyle: No direct benefit from stock price maximization • More perks: Costs borne by stockholders • This creates ‘conflict of interest between the agent (manager) and principal (stockholders).

7. 1. Stockholders versus managers • How to make managers work in stockholder’s best interest? • By using a mixture of reward and punishment strategies: • Managerial Compensation • Direct intervention by stockholders • Threat of firing • Threat of takeover

8. Managerial Compensation • Managerial compensation package must meet two objectives: • Attract and retain able managers • Offer executives incentives to take actions that will enhance shareholder wealth(stock price maximization) • ‘Performance shares’ and ‘Executive stock option’ may be used as incentive to align manager’s actions with stockholders interests.

9. ii. Direct intervention by stockholders • Today institutional investors hold a large portion of company’s stock and can intervene to give suggestions. iii. Threat of firing • Institutional opposition can lead to firing of underperforming managers. iv. Threat of takeover • Occurs when: • A firm's stock is undervalued relative to its potential because of inadequate management • Acts as a check on manager performance because: • In a hostile takeover, the senior managers of the acquired firm are typically dismissed, and those who are retained lose the independence they had prior to the acquisition.

10. 2. Stockholders (through managers) versus creditors • Conflict of interest may also exist between stockholders and creditors. • Stockholders through managers may take steps that tend to maximize shareholder value but decreases value of outstanding debt. • Invest in risky projects – if successful all benefits go to stockholders if unsuccessful creditors bear the risk.

11. Practical Illustration >

12. Evolution of Finance • How technology is redefining the way of financial services are offered to consumers? • Article reading • Submit the answers at the end of the article on 18th February.