Ch.1, part 3, CFO goals and agency problem - YouTube

Goal of financial management.

So, in a corporation - and now we're just gonna focus on the corporate form of business

- stockholders are the people who own that corporation but due to the separation of ownership

and management they are not the people who manage the company.

So they are not directly making any business decisions.

It's whoever manages that corporation.

Stockholders participate in electing the Board of Directors who in turn hire managers than

represent the owners' interests.

So what should be the goals of the chief financial officer?

CFO?

If you think about it the chief financial manager, or officer, should be making such

decisions that would make the owners of the corporation - whose interests he represents

- happy!

Right?

And to make them happy it makes sense to say that the CFO should be making such decisions

that would be increasing the current value of shares of stock, making the current value,

today's value, as high as possible.

If you think about why that actually makes sense is because the stockholders are only

receiving the so-called residual money.

They are the residual owners of the corporation, because they're getting their money, their

dividends - right? - on their shares after everybody else has been paid their dues.

And by "everybody else" we mean employees in the company, suppliers to the company,

lenders who gave money to the company, the IRS who is entitled to get taxes on corporate

income, and so on.

So the stockholders get only what's left.

And so what's... if what's left is a large amount of money then it implies that everybody

else who has stakes in the company, such as employees, suppliers, and so on, are also

happy.

...Umm...

Unfortunately because the managers and the owners are, you know, do not overlap, it's

two different groups of people, there is something called an agency relationship which has some

problems.

In general, agency relationship means there is a Principal and there's an Agent.

Principle hires an Agent to represent his or her interests.

In the corporate setting, stockholders ...umm... the Principal, and they hire managers, or

an Agent, to runthe company and represent their interests.

The problem is known as the so-called Agency Problem.

It's a conflict of interest between the Principal and the Agent, between the stockholders who

own the corporation and the managers who manage it.

So, what kind of... why is there a problem?

Why would there be a conflict of interests?

Let's say, me, professor Chernobai, right?

Who am I?

A Principal or an Agent?

Well, I have a job at Cal Poly is the Principal that hired me.

I become the Agent.

Why did Cal Poly hire me? to teach, or at least that's the main part of my job, right?

So I was hired to teach for you, guys.

What may be a conflict of interest between Cal Poly and me?

Well, I might want to get as high of a paycheck as possible and do as little work as possible,

hypothetically, of course, and on Cal Poly side, my employer, it's actually, hypothetically,

something similar.

Cal Poly wants to pay me as little as possible, hypothetically, and have me do as much work

as possible, right?

Of course, it's all kind of a joke but you can probably think of similar situations in

a workplace, in general.

So what are examples of conflicts of interest between the owners and the managers of a corporation?

For example, the owners may want… it may be the owners' interest that the company makessome

big decision by the managers are against it.

For example, it's actually known fact if you look at the real life data on mergers and

acquisitions, you would see that typically companies that are being acquired by somebody

else, right after the acquisition the stock price goes up.

And so it makes sense that stockholders of the companythat has is being acquired should

be in favor of this takeover attempt.

Right?

Because their stock price will go up.

It will make them richer, wealthier.

Often times the management would oppose the takeover.

Or on one the other side, the company that is the acquiring firm, right?

Managers - again if you look in the data on how companies acquire other companies, let's

say their competitors - you would see that typically companies pay a premium.

So, more than what the other company is actually worth today.

And that premium comes from where?

Well, it kind of comes out of what the stockholders of the acquiring firm would have received

as dividends.

Right?

So the managers overpay to take over another firm which reduces cash remaining for the

owners of the acquiring firm, which is again an example of a conflict of interests.

And even think of other examples like ...umm... corporate, you know, managers buy corporate

jets, and other, you know, make other expensive purchases which are viewed as, you know, just

for themselves.

You know, they pay themselves high bonuses at the end of the year, things like that.

But clearly it comes at the corporate owners' expense.

Are there any ways to, you know, eliminate the conflict of interests, the so-called Agency

Problem?

Well, the managers' and the stockholders' interests need to be aligned somehow.

Are there any ways to do that?

There are a couple of ways.

For example, there may be job prospects for managers successfully pursuing stockholders'

goals.

So, a manager might be hired and offered promotion, you know, in a few years if the stock price

goes up.

Which makes managers work harder to increase stock value in order to receive that promotion

in the future.

Another way this could be... the interests between the two groups of people could be

aligned is to offer the managers a compensation that would include the base salary plus the

so-called stock options.

This is actually pretty complicated, beyond the scope of this class.

But stock options are financial securities that are determined by how much stock shares

are worth.

And the idea is: the higher the value of stock shares the higher the value of those stock

options that the managers might own, you know, personally.

And so again it gives an incentive to the managers to work in the interest of the stockholders,

make sure they make the right decisions, that would result in increasing stock price which

will thenincrease the value of their stock options that they can sell later after a few

required, you know, years of the waiting time and, you know, benefit financially.