by Satya Gabriel
The core object of study in this course is the “C” corporation. All corporations, including "C" corporations, exist by virtue of government permission (granted under the laws of the issuing state). Corporations do not exist as "natural" entities. Corporations are sometimes referred to as a fictive (or legal) person, existing only because state laws allow them to exist. In other words, corporations are products of political processes by which state laws were formed. State law and related judicial rulings on state law determines the specific rights and responsibilities of corporate boards of directors, acting as fiduciaries legally responsible for adopting policies that "maximize shareholder value." Because both corporations and the state are shaped by ever changing political, cultural, economic, and environmental processes, these rights and responsibilities are not fixed but constantly changing.
In the United States, by law, the primary responsibility of the board of directors of a “C” corporation is to create policies designed to maximize shareholder value, in the form of the value created by the corporation’s activities and measured on the corporation’s financial statements. The directors can, in fact, be held legally responsible for corporate activities that destroy shareholder value if a court finds the directors’ actions responsible for such activities having occurred. The board of directors appoints senior executive officers (president and/or chief executive officer or CEO, chief financial officer or CFO, and various senior vice presidents) to manage the corporation’s personnel in the day-to-day activities necessary to fulfill the aforementioned shareholder maximizing policies.
The primary purpose of the corporate form of ownership is to provide a means for raising significant sums of capital, by offering to owners a collective means of ownership coupled with limited liability. Corporations raise capital either from internally generated cash flows or by tapping the capital markets. In the case of capital markets, corporations can issue shares of equity, borrow funds from banks, or issue bonds in the bond market.
The corporation was also created, to a significant extent, as a means of commoditizing ownership. Ownership is divided into shares with these shares bought and sold on equity markets. This allows wealth holders to more easily diversify their ownership holdings.
Corporations generate internal value by the cash flow generated by selling products and services and/or the cash flow potential created by acquiring assets or by inventing or innovating new products or services. The value of these cash flows depends upon both their absolute magnitude and the timing of their receipt.
Corporations generate external value by impacting the larger society in ways that are not reflected on the financial statements of the corporation. These externalities result in government regulations that, in part, influence corporate decisions/activities that generate the externalities.
Capital Markets: Stocks and Bonds
Capital markets are created as sites for the buying and selling of corporate securities, including equity shares and bonds (which are corporate loans). By serving as the site of securities transactions, capital markets connect corporations to households.
In addition to public capital markets, corporations may raise funds by private transactions. Private placements of equity or bonds are exempt from the registration requirements with the Securities & Exchange Commission (SEC) for public placements of securities. Public securities, however, have the advantage of being traded on public secondary markets, such as the New York Stock Exchange or the National Association of Securities Dealers Automated Quotations System (NASDAQ). These public secondary capital markets facilitate the relatively easy transfer of ownership of securities. The ease at which securities can be turned into cash (high level of liquidity) facilitates participation in the capital markets and, therefore, leads to deeper capital markets, that is, capital markets with more participants and a larger amount of transactions.
Another factor that influences the depth of capital markets is the perception of that market's relative integrity. If investors trust that a market is fair, they are more likely to participate in that market. It is the role of regulatory authorities to contribute to this sense of fairness by enforcing rules against insider trading and other unfair practices. In the U.S., the primary regulatory agency overseeing the equity markets is the SEC.
While common equity shares collectively retain the rights of ownership (with liability limited to the value of equity shares held), bonds (and shorter term loans in the form of commercial paper) create very concrete obligations for the corporation. The obligation to pay interest and principal on bonds, for instance, means that the corporate directors must put the claims of bondholders above the rights of shareholders to dividends or other cash distributions. Dividends can be paid only after all loan obligations have been met. The same is true for lease obligations (since leases have similar characteristics to bonds, except that the “loan” is in the form of physical property rather than cash).
Typical bonds require semi-annual payments of interest. These semi-annual payments are called coupon payments because at one time the bond came with coupons that had to be clipped and then turned in to receive the interest payment. The principal had to be repaid when the bond matured. Because the cash flows necessary to meet bond obligations must legally be met, it is imperative the corporation generate sufficient sales to meet these cash flow requirements.
Most corporations issue their securities through investment bankers. Investment or merchant bankers typically provide advice to corporate boards on the best types of securities to issue, the pricing of such securities, and the timing of the sale on public (or private) markets. The investment bank serves as an intermediary by purchasing the securities at a wholesale price and then reselling at a retail price. The arrangement between the issuing corporation and the investment bank is a contractual one and can take any form agreed upon by both parties (and consistent with existing securities laws and regulations). If the investment bank is willing to accept some of the market risk associated with a new issue of securities, then it may sign a firm commitment agreement with the issuing corporation. Under a firm commitment agreement, the investment bank buys the securities issue at the wholesale price and bears the risk that market conditions could change adversely before the securities are sold at retail, in which case it is possible for the retail price to be below the wholesale price and the investment bank lose money on the arrangement. Alternatively, if the issuing corporation is in a relatively weak bargaining position, the investment bank may only agree to sign a best efforts offering (BEO). In a BEO, the issuing corporation and investment bank agree to a price and a minimum and maximum number of equity shares to be sold. If the investment bank is unable to sell the minimum number of shares within a specified time frame, the issue is canceled. Under this arrangement the investment bank bears no risk of losing money on the issue.
When a corporation first issues equity shares on the public capital markets, this activity is known as an initial public offering (IPO). When a publicly traded corporation issues additional equity shares, this activity is known as a seasoned equity offering (SEO).
The market value of a publicly traded company is the product of the market price of the corporation's equity shares and the number of shares outstanding. Because publicly traded equity shares are continuously bought and sold during the trading day (NYSE hours are 9:30AM to 4PM), the market provides a continuous report card on the market's perception of the value of publicly traded companies. As of the time of this text's writing, the market was signaling that Apple Computer (ticker symbol: AAPL) was the most valuable corporation in the United States.
The price of equity shares is sensitive to a wide range of variables. Anything that influences the price that investors are willing to pay for a share of stock is, therefore, an influence on the market value of the company. Product decisions, costs of doing business, public relations, the price elasticity of demand for the company's products, and the perceived strength of competitors are all factors influencing the price of equity shares.
Mergers and acquisitions, where corporation A merges with corporation B or corporation A buys corporation B, are facilitated by the public trading of equity shares.
The Struggle over Corporate Control: Information Asymmetries and Agency Costs
One of the most prominent consequences of the commoditization of ownership in the modern publicly traded corporation is the separation of ownership from management. While the board of directors is elected to serve as representative of the owners, in practice most boards of directors are more closely allied to the professional executive managers of the corporation. Often the senior executives, such as the chief executive officer (CEO) and the chief financial officer (CFO), will also sit on the board of directors and in many cases the CEO will also serve as chair of the board of directors.
The separation of ownership from management leads to information asymmetries whereby management has information about the firm not necessarily available to owners. This is particularly the case for very large firms with large numbers of widely distributed shares.
The combination of information asymmetries and effective corporate control by managers can and often does lead to what are called agency costs. These agency costs come from decisions of managers that are often in their own interest and lead to reductions in the overall value of the firm. The destruction of shareholder because of agency costs can be a serious problem and can take a variety of forms: 1) senior management compensation could be much higher than is necessary to secure the required management services, 2) management perquisites, such as travel by private corporate jets and limousines, golf club memberships, and excessive expense accounts, 3) shirking by senior managers, 4) over staffing because managers receive more status by managing a larger staff, and 5) mergers and acquisitions activities that strengthen the position of managers and the board of directors even if the value of the firm is diminished in the process.
Valuing the Corporation
How do we determine the value of a corporation? The value of a corporation is the same as the value of an individual asset. Assets are valued on the basis of their future cash flows, properly discounted to reflect the timing of receipt of cash flows and relative risks to those cash flows. Thus, a corporation generates cash flows by corporate activities, the result of corporate investments. Unfortunately, we do not usually know with certainty these future cash flows or even the magnitude of risk. Thus, we develop valuation techniques that make use of expected cash flows and estimates of risk.
Cash flow analysis
Expected cash flows are determined by analysis of financial statements of the corporation. These cash flows provide the means by which corporate bills are paid, including wages, salaries, and benefits to employees and management, costs of inputs to production, interest and principal payments on loans, rent to landlords, and taxes to various governments. Failure of a corporation to generate sufficient cash flows to meet cash obligations may result in bankruptcy. Indeed, failure to meet debt obligations gives the debt holders (banks or bondholders) the right to force the corporation into bankruptcy, where a judge may force liquidation of assets to meet those debt obligations. Cash flows in excess of the various costs of doing business represent surplus cash flows that are technically the property of the owners. Thus, the value of the corporation to the owners (and potential buyers) must be based on these surplus cash flows. In other words, to have a positive valuation, a corporation must have positive future surplus cash flows. A corporation with no expectation of generating positive future surplus cash flows is worthless or of negative value, even if the equity markets indicate otherwise. In other words, a company may have stock that trades at a positive value when the actual value of the company is zero or negative. Such stocks trade on the basis of the “greater fool theory,” the idea that there exists a bigger fool willing to pay the current stockholder for her/his worthless shares. Stock market bubbles are also based on this “greater fool theory.”
While the information necessary to estimating cash flows is in the corporation's financial statements, it must be remembered that financial statements are based on generally accepted accounting principles and are not designed to focus on valuation. In particular, the income statement, a key financial document, is designed to calculate an accounting based variable, profit. Profit is not cash flow. In fact, a company generating negative profits may be significantly cash flow positive and quite valuable, while a company generating positive profits may be significantly cash flow negative and ultimately worthless to long-term shareholders.
The first step in calculating the value of the corporation is translating profits (or earnings) into surplus cash flows. This requires that we understand the difference between accounting profits and cash flows. In order to understand this difference, we should familiarize ourselves with certain relevant rules under generally accepted accounting principles (GAAP).
Financial Accounting: Revenues, Costs, and Depreciation
GAAP are accounting rules and standards established by the Financial Accounting Standards Board (FASB). The goal is not to serve valuation purposes, however, but to provide a uniform set of standards for the reporting of financial data to shareholders and regulatory authorities. The key principles in GAAP address the recognition of revenues (or sales) in the income statement, the assignment of costs to those revenues (or sales), and acceptable deductions from revenues to account for the consumption of fixed equipment or property over time and to allocate the costs of such fixed equipment and property to discrete time periods in the future when payment for such fixed equipment or property was made up front/in the present or past (depreciation).
The first of these principles is called revenue recognition. Revenue recognition states that a sale must be recorded at the time a transaction is consummated between the corporation selling the product or service and the party purchasing said product or service. Because our primary concern is with estimating cash flows for the purpose of valuing the firm, it is important to note that the consummation of a sale does not necessarily involve a cash flow. It may simply be that the corporation making the “sale” and the party making the “purchase” have agreed to terms (for example, the quantity and specifications of the product to be transferred to the buyer and the amount of cash to be eventually/hopefully paid by the purchaser and the timing of this cash transfer). However, GAAP allows the corporation making the “sale” to book the entire amount of the cash purchase price as revenues on the income statement.
The matching principle
The method of allocating costs to associated revenues is called the matching principle. Corporate managers purchase inputs and pay laborers in order to generate products or secure the performance of services that are sold to generate revenues. However, the actual outlay of cash to secure inputs or the talents of workers is rarely correlated directly to the consummation of sales. Thus, the relationship between these costs and the revenues generated is not an objective one and in order to determine the allocation of costs associated with revenues requires accounting rules. The matching principle requires that the corporation's accountants select one of three methods of accounting for the allocation of inputs to associated revenues: first in first out inventory allocation, last in first out inventory allocation, or average cost inventory allocation. In all three of these options, accountants must determine the amount of inputs embodied in sold units of output or performed services, as well as the embodied unit labor costs. In order to understand FIFO and LIFO inventory accounting it is best to think of the purchased inputs as lined up in a queue, with the first purchased inputs at the front of the queue and the most recently purchased inputs in the rear. In FIFO inventory accounting, the embodied inputs are priced based on the inputs purchased at the front of the queue, that is, purchased earliest. In an inflationary environment, costs will be higher for any given reporting period with LIFO accounting than with FIFO. This will cause earnings to be relatively lower under LIFO than under FIFO for the same quarterly reporting periods, even though the actual cash flows will be the same. The third method of accounting for costs is to simply take the average cost of inventory and use this as the basis for matching costs to revenues and determining earnings.
Depreciation is a method of accounting for the cost of long-lived equipment. Typically, this equipment is paid for in a single period but its costs are deducted from earnings over a series of periods in the future. The length of time over which these costs are deducted and the fraction of the total cost that can be deducted in any given period is established by accounting principles and, more importantly, tax codes. For example, in the United States, computer equipment can be depreciated over three years, vehicles over five years, and buildings over ten years. Please note that while depreciation reduces the magnitude of earnings (profit) in any given year, it does not involve an actual cash outlay. However, because corporate earnings (profit) are taxed, the amount of depreciation will directly impact an actual cash flow, the taxes that corporate management must pay. The higher the depreciation, the lower the total profits, the lower the corporate income tax due. Thus, while depreciation appears to be a negative on corporate income statements, it actually results in a positive cash flow to the corporation. This is an important point in the calculating the value of corporate investments, so please remember this relationship between depreciation and corporate income taxes.