Things Are Not Always Fair in Love
that the wholesale price of peanut butter has increased
What constitutes fair behavior by companies? One sur-
and immediately raises the price on the current stock of
vey asked a number of individuals to state whether they
regarded a particular action as acceptable or unfair. Be-
5. A hardware store has been selling snow shovels for $15.
fore we tell you how they responded, think how you
The morning after a large snowstorm, the store raises the
would rate each of the following actions:
price to $20.
1a. A small photocopying shop has one employee who has
6. A store has been sold out of the popular Beanie Baby
worked in the shop for 6 months and earns $9 per hour.
dolls for a month. A week before Christmas a single doll
Business continues to be satisfactory, but a factory in the
is discovered in a storeroom. The managers know that
area has closed and unemployment has increased. Other
many customers would like to buy the doll. They an-
small shops in the area have now hired reliable workers
nounce over the storeâ€™s public address system that the
at $7 an hour to perform jobs similar to those done by the
doll will be sold by auction to the customer who offers to
photocopying shop employee. The owner of the photo-
pay the most.
copying shop reduces the employeeâ€™s wage to $7.
Now compare your responses with the responses of
1b. Now suppose that the shop does not reduce the em-
a random sample of individuals:
ployeeâ€™s wage but he or she leaves. The owner decides to
pay a replacement $7 an hour.
Percent Rating the Action As:
2. A house painter employs two assistants and pays them $9
per hour. The painter decides to quit house painting and Action Acceptable Unfair
go into the business of providing landscape services,
1a 17 83
where the going wage is lower. He reduces the workersâ€™ 1b 73 27
wages to $7 per hour for the landscaping work. 2 63 37
3a 23 77
3a. A small company employs several workers and has been
3b 68 32
paying them average wages. There is severe unemploy-
4 21 79
ment in the area and the company could easily replace its
5 18 82
current employees with good workers at a lower wage. 6 26 74
The company has been making money. The owners re-
duce the current workersâ€™ wages by 5 percent.
Source: Adapted from D. Kahneman, J. L. Knetsch, and R. Thaler,
3b. Now suppose instead that the company has been losing
â€śFairness as a Constraint on Profit Seeking: Entitlements in the Mar-
money and the owners reduce wages by 5 percent. ket,â€ť American Economic Review 76 (September 1986), pp. 728â€“741.
4. A grocery store has several monthsâ€™ supply of peanut but- Reprinted by permission of American Economic Association and the
ter in stock on shelves in the storeroom. The owner hears authors.
DO MANAGERS REALLY MAXIMIZE FIRM VALUE?
Owner-managers have no conflicts of interest in their management of the business.
They work for themselves, reaping the rewards of good work and suffering the penal-
ties of bad work. Their personal well-being is tied to the value of the firm.
In most large companies the managers are not the owners and they might be tempted
to act in ways that are not in the best interests of the owners. For example, they might
buy luxurious corporate jets for their travel, or overindulge in expense-account dinners.
They might shy away from attractive but risky projects because they are worried more
about the safety of their jobs than the potential for superior profits. They might engage
in empire building, adding unnecessary capacity or employees. Such problems can arise
22 SECTION ONE
because the managers of the firm, who are hired as agents of the owners, may have their
own axes to grind. Therefore they are called agency problems.
Think of the companyâ€™s net revenue as a pie that is divided among a number of
Conflict of interest between
claimants. These include the management and the work force as well as the lenders and
the firmâ€™s owners and
shareholders who put up the money to establish and maintain the business. The gov-
ernment is a claimant, too, since it gets to tax the profits of the enterprise. It is common
to hear these claimants called stakeholders in the firm. Each has a stake in the firm and
their interests may not coincide.
with a financial interest in the
All these stakeholders are bound together in a complex web of contracts and under-
standings. For example, when banks lend money to the firm, they insist on a formal
contract stating the rate of interest and repayment dates, perhaps placing restrictions on
dividends or additional borrowing. Similarly, large companies have carefully worked
out personnel policies that establish employeesâ€™ rights and responsibilities. But you
canâ€™t devise written rules to cover every possible future event. So the written contracts
are supplemented by understandings. For example, managers understand that in return
for a fat salary they are expected to work hard and not spend the firmâ€™s money on un-
warranted personal luxuries.
What enforces these understandings? Is it realistic to expect managers always to act
on behalf of the shareholders? The shareholders canâ€™t spend their lives watching
through binoculars to check that managers are not shirking or dissipating company
funds on the latest executive jet.
A closer look reveals several arrangements that help to ensure that the shareholders
and managers are working toward common goals.
Compensation Plans. Managers are spurred on by incentive schemes that provide
big returns if shareholders gain but are valueless if they do not. For example, when
Michael Eisner was hired as chief executive officer (CEO) by the Walt Disney Com-
pany, his compensation package had three main components: a base annual salary of
$750,000; an annual bonus of 2 percent of Disneyâ€™s net income above a threshold of
â€śnormalâ€ť profitability; and a 10-year option that allowed him to purchase 2 million
shares of stock for $14 per share, which was about the price of Disney stock at the time.
Those options would be worthless if Disneyâ€™s shares were selling for below $14 but
highly valuable if the shares were worth more. This gave Eisner a huge personal stake
in the success of the firm.
As it turned out, by the end of Eisnerâ€™s 6-year contract the value of Disney shares had
increased by $12 billion, more than sixfold. Eisnerâ€™s compensation over the period was
$190 million.13 Was he overpaid? We donâ€™t know (and we suspect nobody else knows)
how much Disneyâ€™s success was due to Michael Eisner or how hard Eisner would have
worked with a different compensation scheme. Our point is that managers often have a
strong financial interest in increasing firm value. Table 1.4 lists the top-earning CEOs
in 1998. Notice the importance of stock options in the total compensation package.
The Board of Directors. Boards of directors are sometimes portrayed as passive sup-
porters of top management. But when company performance starts to slide, and man-
agers donâ€™t offer a credible recovery plan, boards do act. In recent years, the chief ex-
ecutives of IBM, Eastman Kodak, General Motors, and Apple Computer all were forced
This discussion is based on Stephen F. Oâ€™Byrne, â€śWhat Pay for Performance Looks Like: The Case of
Michael Eisner,â€ť Journal of Applied Corporate Finance 5 (Summer 1992), pp. 135â€“136.
The Firm and the Financial Manager 23
Highest earning CEOs in 1998
Total Earnings Option Component
Individual Company (in millions) (in millions)
Michael Eisner Walt Disney $575.6 $569.8
Sanford Weill Citigroup 166.9 156.6
Steven Case America Online 159.2 158.1
John Welch Jr. General Electric 83.6 46.5
M. Douglas Ivester Coca-Cola 57.3 37.0
Charles Heimbold Jr. Bristol-Myers Squibb 56.3 30.4
Philip Purcell Morgan Stanley Dean Witter 53.4 40.1
Reuben Mark Colgate-Palmolive 52.7 42.2
Source: Republished with permission of Dow Jones, from the Wall Street Journal, April 8, 1999, p. R1: permission conveyed
through Copyright Clearance Center, Inc.
out. The nearby box points out that boards recently have become more aggressive in
their willingness to replace underperforming managers.
If shareholders believe that the corporation is underperforming and that the board of
directors is not sufficiently aggressive in holding the managers to task, they can try to
replace the board in the next election. The dissident shareholders will attempt to con-
vince other shareholders to vote for their slate of candidates to the board. If they suc-
ceed, a new board will be elected and it can replace the current management team.
Takeovers. Poorly performing companies are also more likely to be taken over by an-
other firm. After the takeover, the old management team may find itself out on the
Specialist Monitoring. Finally, managers are subject to the scrutiny of specialists.
Their actions are monitored by the security analysts who advise investors to buy, hold,
or sell the companyâ€™s shares. They are also reviewed by banks, which keep an eagle eye
on the progress of firms receiving their loans.
We do not want to leave the impression that corporate life is a series of squabbles
and endless micromanagement. It isnâ€™t, because practical corporate finance has evolved
to reconcile personal and corporate interestsâ€”to keep everyone working together to in-
crease the value of the whole pie, not merely the size of each personâ€™s slice.
The agency problem is mitigated in practice through several devices:
compensation plans that tie the fortune of the manager to the fortunes of the
firm; monitoring by lenders, stock market analysts, and investors; and
ultimately the threat that poor performance will result in the removal of the
Corporations are now required to make public the amount and form of compensation
(e.g., stock options versus salary versus performance bonuses) received by their top ex-
ecutives. Of what use would that information be to a potential investor in the firm?
FINANCE IN ACTION
Thank You and Goodbye
three times as likely to be fired as one appointed before
When it happens, says a wise old headhunter, it is usu-
ally a quick killing. It takes about a week. â€śNobody is
What has changed? In the 1980s, the way to dispose
more powerful than a chief executive, right up until the
of an unsatisfactory boss was by a hostile takeover.
end. Then suddenly, at the end, he has no power at all.â€ť
Nowadays, legal barriers make those much harder to
In the past few months, some big names have had
mount. Indeed, by the beginning of the 1990s, chief ex-
the treatment: Eckhard Pfeiffer left Compaq, a com-
ecutives were probably harder to dislodge than ever be-
puter company; Derek Wanless has left NatWest, a big
fore. That started to change when, after a catastrophic
British bank that became a takeover target. Others,
fall in the companyâ€™s share of the American car market,
such as Martin Grass, who left Rite Aid, an American
the board of General Motors screwed up the courage in
drugstore chain, resigned unexpectedly without a job to
1992 to replace Robert Stempel.
The result seems to be that incompetent chief exec-
It used to be rare for a board to sack the boss. In
utives in large companies are rarer than they were in
many parts of the world, it still is. But in big American
1990 . . . In Silicon Valley, sacking the boss has become
and British companies these days, bosses who fail
so routine that some firms find that they spend longer
seem to be more likely to be sacked than ever before.
looking for a chief executive than the new boss does in
Rakesh Khurana of the Sloan School of Management at
Massachusetts Institute of Technology has recently ex-
amined 1,300 occasions when chief executives of For-
tune 500 firms left their jobs. He found that, in a third of Source: Â© 1999 The Economist Newspaper Group, Inc. Reprinted
cases, the boss was sacked. For a similar level of per- with permission. www.economist.com.
formance, a chief executive appointed after 1985 is
SNIPPETS OF HISTORY
Now letâ€™s lighten up a little. In this material we are going to describe how financial de-
cisions are made today. But financial markets also have an interesting history. Look at
the accompanying box, which lays out bits of this history, starting in prehistoric times,
when the growth of bacteria anticipated the mathematics of compound interest, and
continuing nearly to the present.
What are the advantages and disadvantages of the most common forms of business
organization? Which forms are most suitable to different types of businesses?
Businesses may be organized as proprietorships, partnerships, or corporations. A
corporation is legally distinct from its owners. Therefore, the shareholders who own a
corporation enjoy limited liability for its obligations. Ownership and management of
corporations are usually separate, which means that the firmâ€™s operations need not be
disrupted by changes in ownership. On the other hand, corporations are subject to double
taxation. Larger companies, for which the separation of ownership and management is more
important, tend to be organized as corporations.
The Firm and the Financial Manager 25
What are the major business functions and decisions for which the firmâ€™s financial
managers are responsible?
The overall task of financial management can be broken down into (1) the investment, or
capital budgeting, decision and (2) the financing decision. In other words, the firm has to
decide (1) how much to invest and what assets to invest in and (2) how to raise the
necessary cash. The objective is to increase the value of the shareholdersâ€™ stake in the firm.
The financial manager acts as the intermediary between the firm and financial markets,