Contents 1. Who owns a corporation ....................................................................................................................... 2 Shareholders ............................................................................................................................................. 3 Beneficial Ownership ............................................................................................................................... 3 Ownership Rights ..................................................................................................................................... 3 Stock Certificates ...................................................................................................................................... 4 2. Can the goal of maximizing the value of the stock conflict with other goals ....................................... 5 3. Suppose you own stock in a company .................................................................................................. 6 4. In recent years, large financial institutions such as mutual funds and pension funds have become the dominant owners of stock in many countries................................................................................................ 7 5. Why might the revenue and cost figures shown on a standard income statement not represent the actual cash inflows and outflows that occurred during a period ............................................................................. 8 6. Reference ................................................................................................................................................ 10 1. Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise? Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits. A corporation is a legal entity that is separate from its owners, the shareholders. A corporation typically consists of directors, officers, and at least one shareholder, each with different levels of responsibility, legal duties, and control. A stock corporation is authorized to issue shares of stock to raise capital and usually is organized for profit. A non-stock corporation is not authorized to issue shares of stock and usually is organized for not-for-profit purposes. A corporation is owned by its stockholders and that management has a duty to maximize stockholder wealth. Shareholders do not typically actively manage a corporation; shareholders instead elect or appoint a board of directors to control the corporation in a fiduciary capacity. A corporation is, at least in theory, owned and controlled by its members. In a joint-stock company the members are known as shareholders, and each of their shares in the ownership, control, and profits of the corporation is determined by the portion of shares in the company that they own. Thus a person who owns a quarter of the shares of a joint-stock company owns a quarter of the company, is entitled to a quarter of the profit (or at least a quarter of the profit given to shareholders as dividends) and has a quarter of the votes capable of being cast at general meetings. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm. In another kind of corporation, the legal document which established the corporation or which contains its current rules will determine the requirements for membership in the corporation. What these requirements are depends on the kind of corporation involved. In a worker cooperative, the members are people who work for the cooperative. In a credit union, the members are people who have accounts with the credit union. Shareholders Choosing a business name for the corporation is an important first step when one start a corporation. It needs to include a corporate designation—a word that identifies the business as a corporation— such as "Incorporated" or "Limited" or "Corporation" (or the abbreviated version of these terms). Addition to selecting a marketable name that works with the brand, it will also need to ensure that the name is legally available. This means it will need to choose a name that's not already being officially used by another corporation in the state. Owners typically appoint directors, and in many cases owners will appoint themselves as directors However, while an owner can be a director, a director need not be an owner Beneficial Ownership It will need to find, complete, and file articles of incorporation with state's Secretary of State Office. Depending on state, the articles of incorporation may instead be known as certificates of incorporation or charter. Bylaws set out the rules governing how the corporation will be run. Generally, corporate bylaws will cover things like the stocks which the corporation is authorized to issue, the number of directors required and procedures related to meetings and record-keeping. Ownership Rights While optional, a shareholders' agreement is a document it’ll want on hand in the event of the death or retirement of an owner, or some other event which causes an owner to need to transfer ownership of his or her shares in the corporation. Whether the corporation has several directors or just one, an initial board of directors meeting should be held to deal with a variety of matters, including the adoption of bylaws, appointment of corporate officers and the authorization to issue stock. Stock Certificates Once the board of directors have authorized the issuance of stock, one can issue stock certificates if required. It need to obtain certain business permits and licenses. Requirements will vary depending on state and local government, as well as the industry in which the business operates. It's important that corporation has a bank account that's separate from the bank accounts of its owners Agency relationship exists in the corporate form of organization is that there is potential for mischief when the interests of owners and managers diverge. In those circumstances, and for a variety of reasons, managers may be able to exact higher rents than are reasonable or than the owners of the firm would otherwise accord them. While that foundational element of agency theory is secure, other elements derived directly from agency theory are far less settled. The corporate form of organization, replete with limited liability, perpetual life, and efficient markets for transfers of ownership, first appeared some 400 years ago. Owners no longer presided over these firms; instead, professional managers increasingly held those roles. Owners no longer presided over these firms; instead, professional managers increasingly held those roles. Corporations have functional, liability, and tax advantages compared to other business entities. Corporations are costly and time consuming to start and operate. Incorporating requires start-up costs, operating costs, and tax costs that are not typically required to form other business entities. Furthermore, because corporations are highly regulated by federal, state, and in some cases local agencies, there are increased paperwork and recordkeeping duties associated with this entity. 2. Can the goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer. Would the goal of maximizing the value of the stock differ for financial management in a foreign country? Why or why not? The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions. The goal of maximizing the value of the stock avoids the problems associated with the different goals such as maximizing profits, maximizing sales or market share, minimizing costs, beating the competition, surviving, avoiding financial distress and bankruptcy, maintaining steady earnings growth etc. There are also many other goals and these present problems as a goal for financial manager. Ensuring the sustainability of the business is the first and foremost ethical duty for any business. Ethics in a business do not limit themselves to CSR, but maximizing the stakeholder’s value is also deemed as an ethical duty for a business. We have seen examples of companies like Enron, WorldCom, Adelphia, and Tyco, where too much focus on maximizing stock value led the company’s management to indulge in unethical or illegal activities. But the issue there was not merely their focus on stock value maximization, but their myopic focus on the same. Ethics and ethical business doesn’t need their focus to shift from maximizing the stock value, rather they need to focus on stock value maximization but not in solidarity but inclusively, ensuring their decisions are not going to negatively affect the stock value in the long term. To ensure long term focus, unethical and illegal activities cannot be supported to justify of stock value maximization. The goals of financial management is to maximize stock value for the company, but unethical or illegal decisions crop in when the focus is shortsighted and long term share value impact of the decisions are not taken into consideration. Not-for-profit organization pursue social and/or political mission, so there goals are not similar to that of for-profit organizations like increasing the market value of their equity. Their goals are to offer their services at the minimum possible cost or expense to the society, thus ethical framework and ethics focus enables them to achieve this goal by maximizing the benefit to the society through their decisions and actions. As a financial manager in a not-for-profit firm though, the goal is still of maximizing the value of their equity, and hence, ethical focus is essential to their long term focus on equity enhancement. 3. Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company’s management immediately begins fighting off this hostile bid. Is management acting in the shareholders’ best interests? Why or why not? Corporate ownership varies around the world. Historically, individuals have owned the majority of shares in public corporations in the Ethiopia. Also in Germany and Japan, however, banks, other large financial institutions, and other companies own most of the stock in public corporations. Do you think agency problems are likely to be more or less severe in Germany and Japan than in Ethiopia? The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bid come in, then management is not acting in the interest of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this. We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individual ownership. Ownership of the large public corporation in Germany and Japan differs markedly from that in the Ethiopia. Here, senior managers hold the reins of power; scattered individuals and institutions own the stock. Differences in the ownership of large firms in Germany and Japan, on the one hand, and those in the Ethiopia, on the other, are startling. Stock in large German and Japanese firms is held in big voting blocks. In Ethiopia , in contrast, even after the concentration and institutionalization of recent years, the largest five shareholders rarely together control as much as low part of a large firm's stock. Despite significant legal differences between Germany and Japan, both nations have ownership structures that provide for a sharing of power so that no person or institution has complete control. 4. In recent years, large financial institutions such as mutual funds and pension funds have become the dominant owners of stock in many countries, and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control? Corporate Governance is the system by which business corporations are directed and controlled. Therefore corporate control is just one aspect of corporate governance. Corporate control can be explained as the process of controlling as well as monitoring activities within a company. Corporate control mechanisms are designed to ensure that planned objectives are reached. Furthermore it reduces and corrects any arising deflections and inefficiencies as a result of the agency problem. Significant free cash flow can lead to agency problems if it is not distributed. Managers may become tempted to pursue empire building or otherwise spend the excess cash in ways not in the shareholders’ best interests. Thus, firms come under pressure to make distributions rather than horde cash. And, consistent with what we observe, we expect large firms with a history of profitability to make large distributions. Conflicts of interest between managers' and shareholders' interests and separation of management and ownership cause the agency problem. An option to combat the agency problem is by offering compensation or stock packages to managers' decisions and the outcomes effects on shareholders. Conflicts of interest can arise if the agent personally gains by not acting in the principal's best interest. One can overcome the agency problem in the business by requiring full transparency, placing restrictions on the agent's capabilities, and tying compensation structure to the well-being of the principal. Especially in companies with a separation of ownership control, the agency problem is a widespread phenomenon and corporate control mechanisms are needed. In such companies the management as the agent and the shareholders as the principal follow different objectives and additionally there does exist an information asymmetry between the principal and the agent. The information asymmetry results in agency costs, which are defined as the costs that arise in the management and shareholder relationship.[13] Shareholders as an example, usually want to maximize the return on their investment, whereas the management makes decisions to increase their performance-based income. To reduce the agency problem and to increase the control within a company, a company can make use of corporate control mechanisms. Talking about corporate control mechanisms, we can split them into both internal monitoring systems and external monitoring systems.[14] Internal monitoring systems include remuneration, the monitoring by shareholders and the monitoring by the board of directors. Internal control mechanisms monitor and act to meet the company’s goals. External monitoring “helps to reduce information asymmetry in markets, such as the managerial labor market and the market for corporate control. Such measures will improve the functioning of those markets and, consequently, help to reduce the agency problem. 5. Why might the revenue and cost figures shown on a standard income statement not represent the actual cash inflows and outflows that occurred during a period? How do financial cash flows and the accounting statement of cash flows differ? Which is more useful for analyzing a company? Why is it not necessarily bad for the cash flow from assets and operating to be negative for a particular period? The Income Statement deals only with revenues and expenses. The Cash Flow Statement includes any form of cash flow, be it revenues, expenses, the sale or purchase of assets, payment or proceeds from liabilities, etc etc. Hence the income statement does not provide a complete picture of the entity's cash activities. Revenue and expense on the income statement does not exactly line up with the cash inflows and outflows for the period, particularly as it relates to transactions occurring at the beginning or end of the period. Cash flow is the net amount of cash and cash equivalents being transferred into and out of a business. Cash received represents inflows, while money spent represents outflows. A cash flow statement is a financial statement that provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources. It also includes all cash outflows that pay for business activities and investments during a given period. The cash flow statement is the name commonly used by practicing accountants for the statement of cash flows. The cash flow statement reveals the quality of a company's earnings (i.e. how much came from cash flow as opposed to accounting treatment), and the firm's capacity to pay interest and dividends. A company's financial statements offer investors and analysts a portrait of all the transactions that go through the business, where every transaction contributes to its success. The cash flow statement is believed to be the most intuitive of all the financial statements because it follows the cash made by the business in three main ways—through operations, investment, and financing. The sum of these three segments is called net cash flow. So, Financial Cash Flows, could be a normal daily lingo between certain groups of people. While, Accounting Statement of Cash Flow, when use in this manner, denote the accounting side of cash flow, and is one of the Financial Statements that a company produces for regulatory purpose. Financial Statements of a company consists of the Balance Sheet, Profit and Loss Statement, and the Cash Flow Statement (some call it the Statement of Cash Flow). Financing cash flows arise from a company raising funds through debt or equity and repaying debt. Negative cash flow doesn't necessarily mean a company's financial performance was bad. There are many reasons why a business might show a profit on an income statement and still have little money in the bank Reference 1. Tricker, B. (2012): Corporate Governance Principles, Policies, and Practices, Oxford, p.3 2. Douma, S. and Schreuder, H. (2013): Economic Approaches to Organisations, London, p.364. 3. Stephen A. Ross . . . [et al.]. (2011) corporate finance: core principles & applications, 3rd ed.
