Part One: Value

Introduction to Corporate Finance

This book is about how corporations make financial decisions. We start by explaining what these decisions are and what they are intended to accomplish.

Corporations invest in real assets, which generate income. Some of these assets, such as plant and machinery, are tangible; others, such as brand names and patents, are intangible. Corporations finance their investments by borrowing, by retaining and reinvesting cash flow, and by selling additional shares of stock to the corporation’s shareholders. Thus, the financial manager faces two broad financial questions: First, what investments should the corporation make? Second, how should it pay for those investments? The investment decision involves spending money; the financing decision involves raising it.

A large corporation may have hundreds of thousands of shareholders. These shareholders differ in many ways, including their wealth, risk tolerance, and investment horizon. Yet we shall see that they usually share the same financial objective. They want the financial manager to increase the value of the corporation and its current stock price.

Thus, the secret of success in financial management is to increase value. That is easy to say but not very helpful. Instructing the financial manager to increase value is like advising an investor in the stock market to “buy low, sell high.” The problem is how to do it.

There may be a few activities in which one can read a textbook and then just “do it,” but financial management is not one of them. That is why finance is worth studying. Who wants to work in a field where there is no room for judgment, experience, creativity, and a pinch of luck? Although this book cannot guarantee any of these things, it does cover the concepts that govern good financial decisions, and it shows you how to use the tools of the trade of modern finance.

This chapter begins with specific examples of recent investment and financing decisions made by well-known corporations. The middle of the chapter covers what a corporation is and what its financial managers do. We conclude by explaining why increasing the market value of the corporation is a sensible financial goal.

Financial managers increase value whenever the corporation earns a higher return than shareholders can earn for themselves. The shareholders’ investment opportunities outside the corporation set the standard for investments inside the corporation. Financial managers, therefore, refer to the opportunity cost of the capital contributed by shareholders.

Managers are, of course, human beings with their own interests and circumstances; they are not always the perfect servants of shareholders. Therefore, corporations must combine governance rules and procedures with appropriate incentives to make sure that all managers and employees—not just the financial managers—pull together to increase value.

Good governance and appropriate incentives also help block out temptations to increase stock price by illegal or unethical means. Thoughtful shareholders do not want the maximum possible stock price. They want the maximum honest stock price.

This chapter introduces five themes that occur again and again throughout the book:

1. Corporate finance is all about maximizing value.

2. The opportunity cost of capital sets the standard for investment decisions.

3. A safe dollar is worth more than a risky dollar.

4. Smart investment decisions create more value than smart financing decisions.

5. Good governance matters.

1-1Corporate Investment and Financing Decisions

To carry on business, a corporation needs an almost endless variety of real assets. These do not drop free from a blue sky; they need to be paid for. The corporation pays for its real assets by selling claims on them and on the cash flow that they will generate. These claims are called financial assets or securities. Take a bank loan as an example. The bank provides the corporation with cash in exchange for a financial asset, which is the corporation’s promise to repay the loan with interest. An ordinary bank loan is not a security, however, because it is held by the bank and is not traded in financial markets.

Take a corporate bond as a second example. The corporation sells the bond to investors in exchange for the promise to pay interest on the bond and to pay off the bond at its maturity. The bond is a financial asset, and also a security, because it can be held and traded by many investors in financial markets. Securities include bonds, shares of stock, and a dizzying variety of specialized instruments. We describe bonds in Chapter 3, stocks in Chapter 4, and other securities in later chapters.

This suggests the following definitions:

Investment decision = purchase of real assets

Financing decision = sale of securities and other financial assets

But these equations are too simple. The investment decision also involves managing assets already in place and deciding when to shut down and dispose of assets when they are no longer profitable. The corporation also has to manage and control the risks of its investments. The financing decision includes not just raising cash today but also meeting its obligations to banks, bondholders, and stockholders that have contributed financing in the past. For example, the corporation has to repay its debts when they become due. If it cannot do so, it ends up insolvent and bankrupt. Sooner or later the corporation will also want to pay out cash to its shareholders.¹

Let’s go to more specific examples. Table 1.1 lists 10 corporations from all over the world. We have chosen very large public corporations that you are probably already familiar with. You may have used Facebook to chat with your friends, eaten at McDonald’s, or used Crest toothpaste.

Company	Recent Investment Decisions	Recent Financing Decisions
Ahold Delhaize (Netherlands)	Invests €1.4 billion in supermarkets in the U.S. and Europe.	Announces a €1 billion share repurchase program.
ExxonMobil (U.S.)	Announces decision to proceed with development of a huge offshore oil discovery in Guyana.	Reinvests $8.5 billion of the cash that it generates from operations.
Facebook (U.S.)	Acquires Two Big Ears, a British virtual reality audio company.	Leases large new office building in San Francisco.
Fiat Chrysler (Italy)	Spins off its Ferrari luxury car unit.	Repays $1.8 billion of bank debt.
GlaxoSmithKline (U.K.)	Spends $3.6 billion on research and development for new drugs.	Issues additional short-term euro debt.
Lenovo (China)	Announces plans to build a new manufacturing facility in India to produce PCs and smartphones.	Issues $850 million of 5-year dollar bonds.
McDonald’s (U.S.)	Announces plans to sell 2,000 restaurants in China.	Issues C$1 billion of Canadian dollar bonds.
Procter & Gamble (U.S.)	Spends over $7 billion on advertising.	Buys back $4.6 billion of stock and pays a $7.2 billion dividend.
Tesla Motors (U.S.)	Starts battery cell production at its new Gigafactory in Nevada.	Raises about $250 million by the sale of new shares.
Vale (Brazil)	Loads first shipment from its new $14.3 billion iron-ore mine in the Amazon rainforest.	Lines up a 5-year revolving credit facility, allowing it to borrow up to $2 billion from a group of international banks.

TABLE 1.1 Examples of recent investment and financing decisions by major public corporations

Investment Decisions

The second column of Table 1.1 shows an important recent investment decision for each corporation. These investment decisions are often referred to as capital budgeting or capital expenditure (CAPEX) decisions because most large corporations prepare an annual capital budget listing the major projects approved for investment. Some of the investments in Table 1.1, such as ExxonMobil’s new oil field or Lenovo’s factory, involve the purchase of tangible assets—assets that you can touch and kick. However, corporations also need to invest in intangible assets, such as research and development (R&D), advertising, and computer software. For example, GlaxoSmithKline and other major pharmaceutical companies invest billions every year on R&D for new drugs. Similarly, consumer goods companies such as Procter & Gamble invest huge sums in advertising and marketing their products. These outlays are investments because they build know-how, brand recognition, and reputation for the long run.

Today’s capital investments generate future cash returns. Sometimes the cash inflows last for decades. For example, many U.S. nuclear power plants, which were initially licensed by the Nuclear Regulatory Commission to operate for 40 years, are now being re-licensed for 20 more years and may be able to operate efficiently for 80 years overall.

Of course, not all investments have such distant payoffs. For example, Walmart spends about $50 billion each year to stock up its stores and warehouses before the holiday season. The company’s return on this investment comes within months as the inventory is drawn down and the goods are sold.

In addition, financial managers know (or quickly learn) that cash returns are not guaranteed. An investment could be a smashing success or a dismal failure. For example, the Iridium communications satellite system, which offered instant telephone connections worldwide, soaked up $5 billion of investment before it started operations in 1998. It needed 400,000 subscribers to break even, but attracted only a small fraction of that number. Iridium defaulted on its debt and filed for bankruptcy in 1999. The Iridium system was sold a year later for just $25 million. (Iridium has recovered and is now profitable, however.)²

Among the contenders for the all-time worst investment was Hewlett-Packard’s (HP) purchase of the British software company Autonomy. HP paid $11.1 billion for Autonomy. Just 13 months later, it wrote down the value of this investment by $8.8 billion. HP claimed that it was misled by improper accounting at Autonomy. Nevertheless, the acquisition was a disastrous investment, and HP’s CEO was fired in short order.

In some cases, the costs and risks of an investment can be huge. For example, the cost of developing the Gorgon natural gas field in Australia has been estimated at more than $40 billion. But do not think of the financial manager as making such large investments on a daily basis. Most investment decisions are smaller and simpler, such as the purchase of a truck, machine tool, or computer system. Corporations make thousands of these smaller investment decisions every year. The cumulative amount of small investments can be just as large as that of the occasional big investments.

Also, financial managers do not make major investment decisions in solitary confinement. They may work as part of a team of engineers and managers from manufacturing, marketing, and other business functions.

Financing Decisions

The third column of Table 1.1 lists a recent financing decision by each corporation. A corporation can raise money from lenders or from shareholders. If it borrows, the lenders contribute the cash, and the corporation promises to pay back the debt plus a fixed rate of interest. If the shareholders put up the cash, they do not get a fixed return, but they hold shares of stock and therefore get a fraction of future profits and cash flow. The shareholders are equity investors, who contribute equity financing. The choice between debt and equity financing is called the capital structure decision. Capital refers to the firm’s sources of long-term financing.

The financing choices available to large corporations seem almost endless. Suppose the firm decides to borrow. Should it borrow from a bank or borrow by issuing bonds that can be traded by investors? Should it borrow for 1 year or 20 years? If it borrows for 20 years, should it reserve the right to pay off the debt early? Should it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars in New York?

Corporations raise equity financing in two ways. First, they can issue new shares of stock. The investors who buy the new shares put up cash in exchange for a fraction of the corporation’s future cash flow and profits. Second, the corporation can take the cash flow generated by its existing assets and reinvest that cash in new assets. In this case the corporation is reinvesting on behalf of existing stockholders. No new shares are issued.

What happens when a corporation does not reinvest all of the cash flow generated by its existing assets? It may hold the cash in reserve for future investment, or it may pay the cash back to its shareholders. Table 1.1 shows that Procter & Gamble paid back $4.6 billion to its stockholders by repurchasing shares. This was in addition to $7.2 billion paid out as cash dividends. The decision to pay dividends or repurchase shares is called the payout decision. We cover payout decisions in Chapter 16.

In some ways, financing decisions are less important than investment decisions. Financial managers say that “value comes mainly from the asset side of the balance sheet.” In fact, the most successful corporations sometimes have the simplest financing strategies. Take Microsoft as an example. It is one of the world’s most valuable corporations. In December 2017, Microsoft shares traded for about $88 each. There were 7.7 billion shares outstanding. Therefore Microsoft’s overall market value—its market capitalization or market cap—was $88 × 7.7 = $680 billion. Where did this market value come from? It came from Microsoft’s product development, from its brand name and worldwide customer base, from its research and development, and from its ability to make profitable future investments. The value did not come from sophisticated financing. Microsoft’s financing strategy is very simple: It carries no debt to speak of and finances almost all investment by retaining and reinvesting cash flow.

Financing decisions may not add much value, compared with good investment decisions, but they can destroy value if they are stupid or if they are ambushed by bad news. For example, after a consortium of investment companies bought the energy giant TXU in 2007, the company took on an additional $50 billion of debt. This may not have been a stupid decision, but it did prove nearly fatal. The consortium did not foresee the expansion of shale gas production and the resulting sharp fall in natural gas and electricity prices. In 2014, the company (renamed Energy Future Holdings) was no longer able to service its debts and filed for bankruptcy.

Business is inherently risky. The financial manager needs to identify the risks and make sure they are managed properly. For example, debt has its advantages, but too much debt can land the company in bankruptcy, as the buyers of TXU discovered. Companies can also be knocked off course by recessions, by changes in commodity prices, interest rates and exchange rates, or by adverse political developments. Some of these risks can be hedged or insured, however, as we explain in Chapters 26 and 27.

What Is a Corporation?

We have been referring to “corporations.” Before going too far or too fast, we need to offer some basic definitions. Details follow in later chapters.

A corporation is a legal entity. In the view of the law, it is a legal person that is owned by its shareholders. As a legal person, the corporation can make contracts, carry on a business, borrow or lend money, and sue or be sued. One corporation can make a takeover bid for another and then merge the two businesses. Corporations pay taxes—but cannot vote!

In the United States, corporations are formed under state law, based on articles of incorporation that set out the purpose of the business and how it is to be governed and operated.³ For example, the articles of incorporation specify the composition and role of the board of directors.⁴ A corporation’s directors are elected by the shareholders. They choose and advise top management and must sign off on important corporate actions, such as mergers and the payment of dividends to shareholders.

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Zipcar’s articles

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A corporation is owned by its shareholders but is legally distinct from them. Therefore the shareholders have limited liability, which means that they cannot be held personally responsible for the corporation’s debts. When the U.S. financial corporation Lehman Brothers failed in 2008, no one demanded that its stockholders put up more money to cover Lehman’s massive debts. Shareholders can lose their entire investment in a corporation, but no more.

When a corporation is first established, its shares may be privately held by a small group of investors, such as the company’s managers and a few backers. In this case, the shares are not publicly traded and the company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, its shares are traded in public markets such as the New York Stock Exchange. These corporations are known as public companies. Most well-known corporations in the U.S. are public companies with widely dispersed shareholdings. In other countries, it is more common for large corporations to remain in private hands, and many public companies may be controlled by just a handful of investors. The latter category includes such well-known names as Volkswagen (Germany), Alibaba (China), Softbank (Japan), and the Swatch Group (Switzerland).

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Zipcar’s bylaws

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A large public corporation may have hundreds of thousands of shareholders, who own the business but cannot possibly manage or control it directly. This separation of ownership and control gives corporations permanence. Even if managers quit or are dismissed and replaced, the corporation survives. Today’s stockholders can sell all their shares to new investors without disrupting the operations of the business. Corporations can, in principle, live forever, and in practice, they may survive many human lifetimes. One of the oldest corporations is the Hudson’s Bay Company, which was formed in 1670 to profit from the fur trade between northern Canada and England. The company still operates as one of Canada’s leading retail chains.

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Other Forms of Business Organization

Corporations do not have to be prominent, multinational businesses such as those listed in Table 1.1. You can organize a local plumbing contractor or barber shop as a corporation if you want to take the trouble. But most corporations are larger businesses or businesses that aspire to grow. Small “mom-and-pop” businesses are usually organized as sole proprietorships.

What about the middle ground? What about businesses that grow too large for sole proprietorships but don’t want to reorganize as corporations? For example, suppose you wish to pool money and expertise with some friends or business associates. The solution is to form a partnership and enter into a partnership agreement that sets out how decisions are to be made and how profits are to be split up. Partners, like sole proprietors, face unlimited liability. If the business runs into difficulties, each partner can be held responsible for all the business’s debts.

Partnerships have a tax advantage. Partnerships, unlike corporations, do not have to pay income taxes. The partners simply pay personal income taxes on their shares of the profits.

Some businesses are hybrids that combine the tax advantage of a partnership with the limited liability advantage of a corporation. In a limited partnership, partners are classified as general or limited. General partners manage the business and have unlimited personal liability for its debts. Limited partners are liable only for the money they invest and do not participate in management.

Many states allow limited liability partnerships (LLPs) or, equivalently, limited liability companies (LLCs). These are partnerships in which all partners have limited liability.

Another variation on the theme is the professional corporation (PC) or professional limited liability company (PLCC), which is commonly used by doctors, lawyers, and accountants. In this case, the business has limited liability, but the professionals can still be sued personally—for example, for malpractice.

Most large investment banks such as Morgan Stanley and Goldman Sachs started life as partnerships. But eventually these companies and their financing requirements grew too large for them to continue as partnerships, and they reorganized as corporations. The partnership form of organization does not work well when ownership is widespread and separation of ownership and management is essential.

The separation of ownership and control can also have a downside, for it can open the door for managers and directors to act in their own interests rather than in the stockholders’ interest. We return to this problem later in the chapter.

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S-corporations

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There are other disadvantages to being a corporation. One is the cost, in both time and money, of managing the corporation’s legal machinery. These costs are particularly burdensome for small businesses. There is also an important tax drawback to corporations in the United States. Because the corporation is a separate legal entity, it is taxed separately. So corporations pay tax on their profits, and shareholders are taxed again when they receive dividends from the company or sell their shares at a profit. By contrast, income generated by businesses that are not incorporated is taxed just once as personal income.

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The financial managers

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Almost all large and medium-sized businesses are corporations, but the nearby box describes how smaller businesses may be organized.

The Role of the Financial Manager

What is the essential role of the financial manager? Figure 1.1 gives one answer. The figure traces how money flows from investors to the corporation and back to investors again. The flow starts when cash is raised from investors (arrow 1 in the figure). The cash could come from banks or from securities sold to investors in financial markets. The cash is then used to pay for the real assets (capital investment projects) needed for the corporation’s business (arrow 2). Later, as the business operates, the assets produce cash inflows (arrow 3). That cash is either reinvested (arrow 4a) or returned to the investors who furnished the money in the first place (arrow 4b). Of course, the choice between arrows 4a and 4b is constrained by the promises made when cash was raised at arrow 1. For example, if the firm borrows money from a bank at arrow 1, it must repay this money plus interest at arrow 4b.

FIGURE 1.1

Flow of cash between financial markets and the firm’s operations. Key: (1) Cash raised by selling financial assets to investors; (2) cash invested in the firm’s operations and used to purchase real assets; (3) cash generated by the firm’s operations; (4a) cash reinvested; (4b) cash returned to investors.

You can see examples of arrows 4a and 4b in Table 1.1. ExxonMobil financed its new projects by reinvesting earnings (arrow 4a). Procter & Gamble decided to return cash to shareholders by paying cash dividends and by buying back its stock (arrow 4b).

Notice how the financial manager stands between the firm and outside investors. On the one hand, the financial manager helps manage the firm’s operations, particularly by helping to make good investment decisions. On the other hand, the financial manager deals with investors—not just with shareholders but also with financial institutions such as banks and with financial markets such as the New York Stock Exchange.

1-2The Financial Goal of the Corporation

Shareholders Want Managers to Maximize Market Value

Major corporations may have hundreds of thousands of shareholders. There is no way that these shareholders can be actively involved in management; it would be like trying to run New York City by town meetings. Authority has to be delegated to professional managers. But how can the company’s managers make decisions that satisfy all the shareholders? No two shareholders are exactly the same. Some may plan to cash in their investments next year; others may be investing for a distant old age. Some may be wary of taking much risk; others may be more venturesome. Delegating the operation of the firm to professional managers can work only if these shareholders have a common objective. Fortunately, there is a natural financial objective on which almost all shareholders agree: Maximize the current market value of shareholders’ investment in the firm.

A smart and effective manager makes decisions that increase the current value of the company’s shares and the wealth of its stockholders. This increased wealth can then be put to whatever purposes the shareholders want. They can give their money to charity or spend it in glitzy nightclubs; they can save it or spend it now. Whatever their personal tastes or objectives, they can all do more when their shares are worth more.

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B-corporations

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Maximizing shareholder wealth is a sensible goal when the shareholders have access to well-functioning financial markets.⁵ Financial markets allow them to adjust risks and transport savings across time. Financial markets give them the flexibility to manage their own savings and investment plans, leaving the corporation’s financial managers with only one task: to increase market value.

A corporation’s roster of shareholders usually includes both risk-averse and risk-tolerant investors. You might expect the risk-averse to say, “Sure, maximize value, but don’t touch too many high-risk projects.” Instead, they say, “Risky projects are OK, provided that expected profits are more than enough to offset the risks. If this firm ends up too risky for my taste, I’ll adjust my investment portfolio to make it safer.” For example, the risk-averse shareholders can shift more of their investment to safer assets, such as U.S. government bonds. They can also just say good-bye, selling shares of the risky firm and buying shares in a safer one. If the risky investments increase market value, the departing shareholders are better off than if the risky investments were turned down.

A Fundamental Result

The goal of maximizing shareholder value is widely accepted in both theory and practice. It’s important to understand why. Let’s walk through the argument step by step, assuming that the financial manager should act in the interests of the firm’s owners, its stockholders.

1. Each stockholder wants three things:

a. To be as rich as possible, that is, to maximize his or her current wealth.

b. To transform that wealth into the most desirable time pattern of consumption either by borrowing to spend now or investing to spend later.

c. To manage the risk characteristics of that consumption plan.

2. But stockholders do not need the financial manager’s help to achieve the best time pattern of consumption. They can do that on their own, provided they have free access to competitive financial markets. They can also choose the risk characteristics of their consumption plan by investing in more- or less-risky securities.

3. How then can the financial manager help the firm’s stockholders? There is only one way: by increasing their wealth. That means increasing the market value of the firm and the current price of its shares.

Economists have proved this value-maximization principle with great rigor and generality. After you have absorbed this chapter, take a look at the Appendix, which contains a further example. The example, though simple, illustrates how the principle of value maximization follows from formal economic reasoning.

We have suggested that shareholders want to be richer rather than poorer. But sometimes you hear managers speak as if shareholders have different goals. For example, managers may say that their job is to “maximize profits.” That sounds reasonable. After all, don’t shareholders want their company to be profitable? But taken literally, profit maximization is not a well-defined financial objective for at least two reasons:

1. Maximize profits? Which year’s profits? A corporation may be able to increase current profits by cutting back on outlays for maintenance or staff training, but that may result in lower profits in the future. Shareholders will not welcome higher short-term profits if long-term profits are damaged.

2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns only a modest return on the money.

The Investment Trade-Off

OK, let’s take the objective as maximizing market value. But why do some investments increase market value, while others reduce it? The answer is given by Figure 1.2, which sets out the fundamental trade-off for corporate investment decisions. Suppose the corporation has a proposed investment in a real asset and enough cash on hand to finance the investment. If the corporation does not invest, it can instead pay out the cash to shareholders—say, as an extra dividend. How does the financial manager decide whether to go ahead with the project or to pay out the cash? (The investment and dividend arrows in Figure 1.2 are arrows 2 and 4b in Figure 1.1.)

FIGURE 1.2

The firm can either keep and reinvest cash or return it to investors. (Arrows represent possible cash flows or transfers.) If cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.

Assume that the financial manager is acting in the interests of the corporation’s owners, its stockholders. What do these stockholders want the financial manager to do? The answer depends on the project’s rate of return and on the rate of return that the stockholders can earn by investing in financial markets. If the return offered by the investment project is higher than shareholders can get by investing on their own, then the shareholders would vote for the investment project. If the investment project offers a lower return than shareholders can achieve on their own, they would vote to cancel the project and take the cash instead.

Perhaps the investment project in Figure 1.2 is a proposal for Tesla to launch a new electric car. Suppose Tesla has set aside cash to launch the new model in 2020. It could go ahead with the launch, or it could choose to cancel the investment and instead pay the cash out to its stockholders. If it pays out the cash, the stockholders can then invest for themselves.

Suppose that Tesla’s new project is just about as risky as the U.S. stock market and that investment in the stock market offers a 10% expected rate of return. If the project offers a superior rate of return—say, 20%—then Tesla’s stockholders would be happy for the company to keep the cash and invest it in the new model. If the project offers only a 5% return, then the stockholders are better off with the cash and without the new model; in that case, the financial manager should turn down the project.

As long as a corporation’s proposed investments offer higher rates of return than its shareholders can earn for themselves in the stock market (or in other financial markets), its shareholders will applaud the investments, and its stock price will increase. But if the company earns an inferior return, shareholders boo, stock price falls, and stockholders demand their money back so that they can invest on their own.

In our example, the minimum acceptable rate of return on Tesla’s new car is 10%. This minimum rate of return is called a hurdle rate or cost of capital. It is really an opportunity cost of capital because it depends on the investment opportunities available to investors in financial markets. Whenever a corporation invests cash in a new project, its shareholders lose the opportunity to invest the cash on their own. Corporations increase value by accepting all investment projects that earn more than the opportunity cost of capital.

Notice that the opportunity cost of capital depends on the risk of the proposed investment project. Why? It’s not just because shareholders are risk-averse. It’s also because shareholders have to trade off risk against return when they invest on their own. The safest investments, such as U.S. government debt, offer low rates of return. Investments with higher expected rates of return—the stock market, for example—are riskier and sometimes deliver painful losses. (The U.S. stock market was down 38% in 2008, for example.) Other investments are riskier still. For example, high-tech growth stocks offer the prospect of higher rates of return but are even more volatile.

Also notice that the opportunity cost of capital is generally not the interest rate that the company pays on a loan from a bank. If the company is making a risky investment, the opportunity cost is the expected return that investors can achieve in financial markets at the same level of risk. The expected return on risky securities is well above the interest rate on a bank loan.

Managers look to the financial markets to measure the opportunity cost of capital for the firm’s investment projects. They can observe the opportunity cost of capital for safe investments by looking up current interest rates on safe debt securities. For risky investments, the opportunity cost of capital has to be estimated. We start to tackle this task in Chapter 7.

Should Managers Look After the Interests of Their Shareholders?

So far we have assumed that financial managers should act on behalf of shareholders by trying to maximize their wealth. But perhaps this begs the questions: Is it desirable for managers to act in the selfish interests of their shareholders? Does a focus on enriching the shareholders mean that managers must act as greedy mercenaries riding roughshod over the weak and helpless?

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Ethical dilemmas

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Most of this book is devoted to financial policies that increase value. None of these policies requires gallops over the weak and helpless. In most instances, little conflict arises between doing well (maximizing value) and doing good. Profitable firms are those with satisfied customers and loyal employees; firms with dissatisfied customers and a disgruntled workforce will probably end up with declining profits and a low stock price.

Most established corporations can add value by building long-term relationships with their customers and establishing a reputation for fair dealing and financial integrity. When something happens to undermine that reputation, the costs can be enormous.

So, when we say that the objective of the firm is to maximize shareholder wealth, we do not mean that anything goes. The law deters managers from making blatantly dishonest decisions, but most managers should not be simply concerned with observing the letter of the law or with keeping to written contracts. In business and finance, as in other day-to-day affairs, there are unwritten rules of behavior. These rules make routine financial transactions feasible because each party to the transaction has to trust the other to keep to his or her side of the bargain.⁶

When something happens to damage that trust, the costs can be enormous. Volkswagen (VW) is a case in point. VW had installed secret software that cut back pollution from its diesel cars, but only when the cars were tested. Discovery of the software in 2015 caused a tidal wave of opprobrium. VW’s stock price dropped by 35%. Its CEO was fired. VW diesel vehicles piled up unsold in car dealers’ lots. In the United States alone, the scandal is likely to cost the company more than $20 billion in fines and compensation payments.

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Ethical Disputes in Finance

Short-Selling

Investors who take short positions are betting that securities will fall in price. Usually they do this by borrowing the security, selling it for cash, and then waiting in the hope that they will be able to buy it back cheaply.* In 2007, hedge fund manager John Paulson took a huge short position in mortgage-backed securities. The bet paid off, and that year Paulson’s trade made a profit of $1 billion for his fund.^†

Was Paulson’s trade unethical? Some believe that he was not only profiting from the misery that resulted from the crash in mortgage-backed securities, but that his short trades accentuated the collapse. It is certainly true that short-sellers have never been popular. For example, following the crash of 1929, one commentator compared short-selling to the ghoulishness of “creatures who, at all great earthquakes and fires, spring up to rob broken homes and injured and dead humans.”

Investors who sell their shares are often described as doing the Wall Street Walk. Short-selling is the Wall Street Walk on steroids. Not only do short-sellers sell all the shares they may have previously owned, they borrow more shares and sell them too, hoping to buy them back for less when the stock price falls. Poorly performing companies are natural targets for short-sellers, and the companies’ incumbent managers naturally complain, often bitterly. Governments sometimes listen to such complaints. For example, in 2008 the U.S. government temporarily banned short sales of financial stocks in an attempt to halt their decline.

But defendants of short-selling argue that to sell securities that one believes are overpriced is no less legitimate than buying those that appear underpriced. The object of a well-functioning market is to set the correct stock prices, not always higher prices. Why impede short-selling if it conveys truly bad news, puts pressure on poor performers, and helps corporate governance work?

Corporate Raiders

In the movie Pretty Woman, Richard Gere plays the role of an asset stripper, Edward Lewis. He buys companies, takes them apart, and sells the bits for more than he paid for the total package. In the movie Wall Street, Gordon Gekko buys a failing airline, Blue Star, in order to break it up and sell the bits. Real corporate raiders may not be as ruthless as Edward Lewis or Gordon Gekko, but they do target companies whose assets can be profitably split up and redeployed.

This has led many to complain that raiders seek to carve up established companies, often leaving them with heavy debt burdens, basically in order to get rich quick. One German politician has likened them to “swarms of locusts that fall on companies, devour all they can, and then move on.”

But sometimes raids can enhance shareholder value. For example, in 2012 and 2013, Relational Investors teamed up with the California State Teachers’ Retirement System (CSTRS, a pension fund) to try to force Timken Co. to split into two separate companies, one for its steel business and one for its industrial bearings business. Relational and CSTRS believed that Timken’s combination of unrelated businesses was unfocused and inefficient. Timken management responded that the breakup would “deprive our shareholders of long-run value—all in an attempt to create illusory short-term gains through financial engineering.” But Timken’s stock price rose at the prospect of a breakup, and a nonbinding shareholder vote on Relational’s proposal attracted a 53% majority.

How do you draw the ethical line in such examples? Was Relational Investors a “raider” (sounds bad) or an “activist investor” (sounds good)? Breaking up a portfolio of businesses can create difficult adjustments and job losses. Some stakeholders, such as the company’s employees, may lose. But shareholders and the overall economy can gain if businesses are managed more efficiently.

Tax Avoidance

In 2012, it was revealed that during the 14 years that Starbucks had operated in the U.K., it paid hardly any taxes. Public outrage led to a boycott of Starbucks shops, and the company responded by promising that it would voluntarily pay to the taxman about $16 million more than it was required to pay by law. Several months later, a U.S. Senate committee investigating tax avoidance by U.S. technology firms reported that Apple had used a “highly questionable” web of offshore entities to avoid billions of dollars of U.S. taxes.

Multinational companies, such as Starbucks and Apple, have reduced their tax bills using legal techniques with exotic names such as the “Dutch Sandwich,”

“Double Irish,” and “Check-the-Box.” But the public outcry over these revelations suggested that many believed that their use, though legal, was unethical. If they were unethical, that leaves an awkward question: How do companies decide which tax schemes are ethical and which are not?

†The story of Paulson’s trade is told in G. Zuckerman, The Greatest Trade Ever, Broadway Business, 2009. The trade was controversial for reasons beyond short-selling. See the nearby Beyond the Page feature “Goldman Sachs causes a ruckus.”

Charlatans and swindlers are often able to hide behind booming markets. It is only “when the tide goes out that you learn who’s been swimming naked.”⁷ The tide went out in 2008, and a number of frauds were exposed. One notorious example was the Ponzi scheme run by the New York financier Bernard Madoff.⁸ Individuals and institutions put about $65 billion in the scheme before it collapsed in 2008. (It’s not clear what Madoff did with all this money, but much of it was apparently paid out to early investors in the scheme to create an impression of superior investment performance.) With hindsight, the investors should not have trusted Madoff or the financial advisers who steered money to Madoff.

Madoff’s Ponzi scheme was (we hope) a once-in-a-lifetime event.⁹ It was astonishingly unethical, illegal, and bound to end in tears. That much is obvious. The difficult ethical problems for financial managers lurk in the grey areas. Look, for example, at the nearby Finance in Practice box that presents three ethical problems. Think about where you stand on these issues and where you would draw the ethical red line.

BEYOND THE PAGE

The great Albanian Ponzi scheme

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What is the underlying source of unethical business behavior? Sometimes it is simply because an employee is dishonest. But frequently the behavior stems from a culture in the firm that encourages high-pressure selling or unscrupulous dealing. In this case, the root of the problem lies with top management that promotes such values. (Click on the nearby Beyond the Page feature for an interesting demonstration of this in the banking industry.)

BEYOND THE PAGE

Goldman Sachs causes a ruckus

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Agency Problems and Corporate Governance

We have emphasized the separation of ownership and control in public corporations. The owners (shareholders) cannot control what the managers do, except indirectly through the board of directors. This separation is necessary but also dangerous. You can see the risks. Managers may be tempted to buy sumptuous corporate jets or to schedule business meetings at tony resorts. They may shy away from attractive but risky projects because they are worried more about the safety of their jobs than about maximizing shareholder value. They may work just to maximize their own bonuses, and therefore redouble their efforts to make and resell flawed subprime mortgages.

BEYOND THE PAGE

Business culture and unethical behavior

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Conflicts between shareholders’ and managers’ objectives create agency problems. Agency problems arise when agents work for principals. The shareholders are the principals; the managers are their agents. Agency costs are incurred when (1) managers do not attempt to maximize firm value and (2) shareholders incur costs to monitor the managers and constrain their actions.

Agency problems can sometimes lead to outrageous behavior. For example, when Dennis Kozlowski, the CEO of Tyco, threw a $2 million 40th birthday bash for his wife, he charged half of the cost to the company. This of course was an extreme conflict of interest, as well as illegal. But more subtle and moderate agency problems arise whenever managers think just a little less hard about spending money when it is not their own.

Later in the book we will look at how good systems of governance ensure that shareholders’ pockets are close to the managers’ hearts. This means well-designed incentives for managers, standards for accounting and disclosure to investors, requirements for boards of directors, and legal sanctions for self-dealing by management. When scandals happen, we say that corporate governance has broken down. When corporations compete effectively and ethically to deliver value to shareholders, we are comforted that governance is working properly.

1-3Preview of Coming Attractions

Figure 1.2 illustrates how the financial manager can add value for the firm and its shareholders. He or she searches for investments that offer rates of return higher than the opportunity cost of capital. But that search opens up a treasure chest of follow-up questions.

· How do I calculate the rate of return? The rate of return is calculated from the cash inflows and outflows generated by the investment project. See Chapters 2 and 5.

· Is a higher rate of return on investment always better? Not always, for two reasons. First, a lower-but-safer return can be better than a higher-but-riskier return. Second, an investment with a higher percentage return can generate less value than a lower-return investment that is larger or lasts longer. In Chapter 2, we show how to calculate the present value (PV) of the stream of cash flows from an investment. Present value is a workhorse concept of corporate finance that shows up in almost every chapter.

· What determines value in financial markets? We cover valuation of bonds and common stocks in Chapters 3 and 4. We will return to valuation principles again and again in later chapters. Sometimes the financial manager may be lucky, and may find an almost identical asset whose value is already known.¹⁰ But there is no identical asset to ExxonMobil’s offshore oil field in Guyana or Facebook’s new investment in virtual reality. For most major financial decisions, the manager needs some fundamental principles to help him to determine value.

· What are the cash flows? The future cash flows from an investment project should be the sum of all cash inflows and outflows caused by the decision to invest. Cash flows are calculated after corporate taxes are paid. They are the free cash flows that can be paid out to shareholders or reinvested on their behalf. Chapter 6 explains free cash flows in detail.

· How does the financial manager judge whether cash-flow forecasts are realistic? As Niels Bohr, the 1922 Nobel Laureate in Physics, observed, “Prediction is difficult, especially if it’s about the future.” But good financial managers take care to assemble relevant information and to purge forecasts of bias and thoughtless optimism. See Chapters 6 and 9 through 11.

· How do we measure risk? We look to the risks borne by shareholders, recognizing that investors can dilute or eliminate some risks by holding diversified portfolios (Chapters 7 and 8).

· How does risk affect the opportunity cost of capital? Here we need a theory of risk and return in financial markets. The most widely used theory is the Capital Asset Pricing Model (Chapters 8 and 9).

· Where does financing come from? Broadly speaking, from borrowing or from cash invested or reinvested by stockholders. But financing can get complicated when you get down to specifics. Chapter 14 gives an overview of financing. Chapters 23 through 25 cover sources of debt financing, including financial leases, which are debt in disguise.

· Debt or equity? Does it matter? Not in a world of perfect financial markets. But in the real world, the choice between debt and equity does matter for many possible reasons, including taxes, the risks of bankruptcy, information differences, and incentives. See Chapters 17 and 18.

FINANCE IN PRACTICE

Fintech and the Changing World of Finance*

The financial world is continually changing. A number of markets that barely existed a few decades ago are now trillion-dollar businesses. In some cases, the innovation may be nothing more than someone spotting an untapped demand; in others, it may stem from new economic ideas. But change may also be a result of technological advances. The application of technology to financial markets is commonly known as fintech. Here are four ways that fintech is changing financial practice.

Payment Systems Not that many years ago, cash or checks were the principal way to pay for purchases, but in many countries, cash is fast disappearing. For example, in Sweden cash transactions make up barely 2% of the value of all payments. You can’t use cash to buy a bus ticket or a ticket on the Stockholm metro, and retailers are not legally obliged to accept coins and notes. The majority of Sweden’s bank branches no longer keep cash on hand or take cash deposits—and many branches no longer have ATMs. Instead of cash, Swedes use either a card or a mobile phone app to transfer money from one bank account to another in real time.

Peer-to-Peer (P2P) Lending Peer-to-peer lending platforms directly link individuals willing to lend money with people seeking to borrow. For example, in the United States would-be borrowers can apply to Lending Club for a personal loan of up to $40,000 or a business loan of up to $300,000. The company then assigns a credit score to that customer, and on the basis of this score, potential investors can choose whether to participate in the loan. Thus, Lending Club cuts banks out of the lending equation entirely. It does not lend itself; instead, it verifies the identity of borrowers and lenders, uses the credit score to set the interest rate for the loan, and services the loan.

Robo Advice Providing investment advice to individuals and tailoring portfolios to their particular needs can be a costly business. Robo advisers seek to reduce these costs by automating the process. You will first need to complete an online questionnaire describing your personal situation and your risk tolerance. The robo adviser will then recommend a portfolio, usually a basket of low-cost funds. Then, once you deposit money in the account, the robo adviser will buy the investments and rebalance your portfolio to maintain your ideal mix of assets.

Blockchains A blockchain consists of a network of computers that simultaneously update a ledger of transactions or other data. This ledger doesn’t exist in one place but is distributed across many participants in the network. Many believe that the technology offers a major advance in the speed and security of financial record-keeping. Stock exchanges around the world have begun to experiment with blockchains as a method for companies to list and trade their shares, and to ballot their shareholders. The effect should be lower costs of trading, faster transfers of ownership, and more accurate records.

That’s enough questions to start, but you can see certain themes emerging. For example, corporate finance is “all about valuation,” not only for the reasons just listed, but because value maximization is the natural financial goal of the corporation. Another theme is the importance of the opportunity cost of capital, which is established in financial markets. The financial manager is an intermediary, who has to understand financial markets as well as the operations and investments of the corporation.

SUMMARY

Corporations face two principal financial decisions. First, what investments should the corporation make? Second, how should it pay for the investments? The first decision is the investment decision; the second is the financing decision.

The stockholders who own the corporation want its managers to maximize its overall value and the current price of its shares. The stockholders can all agree on the goal of value maximization, so long as financial markets give them the flexibility to manage their own savings and investment plans. Of course, the objective of wealth maximization does not justify unethical behavior. Shareholders do not want the maximum possible stock price. They want the maximum honest share price.

How can financial managers increase the value of the firm? Mostly by making good investment decisions. Financing decisions can also add value, and they can surely destroy value if you screw them up. But it’s usually the profitability of corporate investments that separates value winners from the rest of the pack.

Investment decisions involve a trade-off. The firm can either invest cash or return it to shareholders, for example, as an extra dividend. When the firm invests cash rather than paying it out, shareholders forgo the opportunity to invest it for themselves in financial markets. The return that they are giving up is therefore called the opportunity cost of capital. If the firm’s investments can earn a higher return than the opportunity cost of capital, stock price increases. If the firm invests at a return lower than the opportunity cost of capital, stock price falls.

Managers are not endowed with a special value-maximizing gene. They will be tempted to consider their own personal interests, which may create a conflict of interest with outside shareholders. This conflict is called a principal-agent problem. Any loss of value that results is called an agency cost.

Investors will not entrust the firm with their savings unless they are confident that management will act ethically on their behalf. Successful firms have governance systems that help to align managers’ and shareholders’ interests.

Remember the following five themes, for you will see them again and again throughout this book:

1. Corporate finance is all about maximizing value.

2. The opportunity cost of capital sets the standard for investment decisions.

3. A safe dollar is worth more than a risky dollar.

4. Smart investment decisions create more value than smart financing decisions.

5. Good governance matters.

PROBLEM SETS

Select problems are available in McGraw-Hill’s Connect. Answers to questions with an “*” are found in the Appendix.

1. Investment and financing decisions Read the following passage: “Companies usually buy (a) assets. These include both tangible assets such as (b) and intangible assets such as (c). To pay for these assets, they sell (d) assets such as (e). The decision about which assets to buy is usually termed the (f) or (g) decision. The decision about how to raise the money is usually termed the (h) decision.”

Now fit each of the following terms into the most appropriate space: financing, real, bonds, investment, executive airplanes, financial, capital budgeting, brand names.

2. Investment and financing decisions* Which of the following are real assets, and which are financial?

a. A share of stock.

b. A personal IOU.

c. A trademark.

d. A factory.

e. Undeveloped land.

f. The balance in the firm’s checking account.

g. An experienced and hardworking sales force.

h. A corporate bond.

3. Investment and financing decisions Vocabulary test. Explain the differences between:

a. Real and financial assets.

b. Capital budgeting and financing decisions.

c. Closely held and public corporations.

d. Limited and unlimited liability.

4. Corporations* Which of the following statements always apply to corporations?

a. Unlimited liability.

b. Limited life.

c. Ownership can be transferred without affecting operations.

d. Managers can be fired with no effect on ownership.

5. Separation of ownership In most large corporations, ownership and management are separated. What are the main implications of this separation?

6. Corporate goals* We can imagine the financial manager doing several things on behalf of the firm’s stockholders. For example, the manager might:

a. Make shareholders as wealthy as possible by investing in real assets.

b. Modify the firm’s investment plan to help shareholders achieve a particular time pattern of consumption.

c. Choose high- or low-risk assets to match shareholders’ risk preferences.

d. Help balance shareholders’ checkbooks.

But in well-functioning capital markets, shareholders will vote for only one of these goals. Which one? Why?

7. Maximizing shareholder value Ms. Espinoza is retired and depends on her investments for her income. Mr. Liu is a young executive who wants to save for the future. Both are stockholders in Scaled Composites LLC, which is building SpaceShipOne to take commercial passengers into space. This investment’s payoff is many years away. Assume it has a positive NPV for Mr. Liu. Explain why this investment also makes sense for Ms. Espinoza.

8. Opportunity cost of capital F&H Corp. continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H’s CFO:

We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends. Unlike those confirmed doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns around 8% on investment. That’s a far better return than F&H earns on its cash holdings. The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only a 4% rate of return.

a. Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short-term U.S. government securities? Why or why not?

b. Is F&H’s opportunity cost of capital 4%? How in principle should the CFO determine the cost of capital?

9. Ethical issues The Beyond the Page feature, “Goldman Sachs causes a ruckus,” describes the controversial involvement of Goldman Sachs in a mortgage-backed securities deal in 2006. When this involvement was revealed, the market value of Goldman Sachs’ common stock fell overnight by $10 billion. This was far more than any fine that might have been imposed. Explain.

10. Ethical issues Most managers have no difficulty avoiding blatantly dishonest actions. But sometimes there are gray areas, where it is debatable whether an action is unethical and unacceptable. Suggest an important ethical dilemma that companies may face. What principles should guide their decision?

11. Ethical issues The Finance in Practice box in Section 1-2 describes three corporate practices that have been criticized as unethical. Select one of these and discuss at what point (if any) does the practice slide into unethical behavior.

12. Agency issues Why might one expect managers to act in shareholders’ interests? Give some reasons.

13. Agency issues Many firms have devised defenses that make it more difficult or costly for other firms to take them over. How might such defenses affect the firm’s agency problems? Are managers of firms with formidable takeover defenses more or less likely to act in the shareholders’ interests rather than their own? What would you expect to happen to the share price when management proposes to institute such defenses?

APPENDIX

Why Maximizing Shareholder Value Makes Sense

We have suggested that well-functioning financial markets allow different investors to agree on the objective of maximizing value. This idea is sufficiently important that we need to pause and examine it more carefully.

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Foundations of NPV

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How Financial Markets Reconcile Preferences for Current vs. Future Consumption

Suppose that there are two possible investors with entirely different preferences. Think of A as an ant, who wishes to save for the future, and of G as a grasshopper, who would prefer to spend all his wealth on some ephemeral frolic, taking no heed of tomorrow. Suppose that each has a nest egg of exactly $100,000 in cash. G chooses to spend all of it today, while A prefers to invest it in the financial market. If the interest rate is 10%, A would then have 1.10 × $100,000 = $110,000 to spend a year from now. Of course, there are many possible intermediate strategies. For example, A or G could choose to split the difference, spending $50,000 now and putting the remaining $50,000 to work at 10% to provide 1.10 × $50,000 = $55,000 next year. The entire range of possibilities is shown by the green line in Figure 1A.1.

FIGURE 1A.1

The green line shows the possible spending patterns for the ant and grasshopper if they invest $100,000 in the capital market. The maroon line shows the possible spending patterns if they invest in their friend’s business. Both are better off by investing in the business as long as the grasshopper can borrow against the future income.

In our example, A used the financial market to postpone consumption. But the market can also be used to bring consumption forward in time. Let’s illustrate by assuming that instead of having cash on hand of $100,000, our two friends are due to receive $110,000 each at the end of the year. In this case, A will be happy to wait and spend the income when it arrives. G will prefer to borrow against his future income and party it away today. With an interest rate of 10%, G can borrow and spend $110,000/1.10 = $100,000. Thus the financial market provides a kind of time machine that allows people to separate the timing of their income from that of their spending. Notice that with an interest rate of 10%, A and G are equally happy with cash on hand of $100,000 or an income of $110,000 at the end of the year. They do not care about the timing of the cash flow; they just prefer the cash flow that has the highest value today ($100,000 in our example).

Investing in Real Assets

In practice, individuals are not limited to investing in financial markets; they may also acquire plant, machinery, and other real assets. For example, suppose that A and G are offered the opportunity to invest their $100,000 in a new business that a friend is founding. This will produce a one-off surefire payment of $121,000 next year. A would clearly be happy to invest in the business. It will provide her with $121,000 to spend at the end of the year, rather than the $110,000 that she gets by investing her $100,000 in the financial market. But what about G, who wants money now, not in one year’s time? He too is happy to invest, as long as he can borrow against the future payoff of the investment project. At an interest rate of 10%, G can borrow $110,000 and so will have an extra $10,000 to spend today. Both A and G are better off investing in their friend’s venture. The investment increases their wealth. It moves them up from the green to the maroon line in Figure 1A.1.

Why can both A and G spend more by investing $100,000 in their friend’s business? Because the business provides a return of $21,000, or 21%, whereas they would earn only $10,000, or 10%, by investing their money in the capital market.

A Crucial Assumption

The key condition that allows A and G to agree to invest in the new venture is that both have access to a well-functioning, competitive financial market, in which they can borrow and lend at the same rate. Whenever the corporation’s shareholders have equal access to competitive financial markets, the goal of maximizing market value makes sense.

It is easy to see how this rule would be damaged if we did not have such a well-functioning financial market. For example, suppose that G could not easily borrow against future income. In that case he might well prefer to spend his cash today rather than invest it in the new venture. If A and G were shareholders in the same enterprise, A would be happy for the firm to invest, while G would be clamoring for higher current dividends.

No one believes unreservedly that financial markets function perfectly. Later in this book we discuss several cases in which differences in taxation, transaction costs, and other imperfections must be taken into account in financial decision making. However, we also discuss research indicating that, in general, financial markets function fairly well. In this case maximizing shareholder value is a sensible corporate objective. But for now, having glimpsed the problems of imperfect markets, we shall, like an economist in a shipwreck, simply assume our life jacket and swim safely to shore.

QUESTIONS

1. Maximizing shareholder value Look back to the numerical example graphed in Figure 1A.1. Suppose the interest rate is 20%. What would the ant (A) and grasshopper (G) do if they both start with $100,000? Would they invest in their friend’s business? Would they borrow or lend? How much and when would each consume?

2. Maximizing shareholder value Answer this question by drawing graphs like Figure 1A.1. Casper Milktoast has $200,000 on hand to support consumption in periods 0 (now) and 1 (next year). He wants to consume exactly the same amount in each period. The interest rate is 8%. There is no risk.

a. How much should he invest, and how much can he consume in each period?

b. Suppose Casper is given an opportunity to invest up to $200,000 at 10% risk-free. The interest rate stays at 8%. What should he do, and how much can he consume in each period?

¹We have referred to the corporation’s owners as “shareholders” and “stockholders.” The two terms mean exactly the same thing and are used interchangeably. Corporations are also referred to casually as “companies,” “firms,” or “businesses.” We also use these terms interchangeably.

²The private investors who bought the bankrupt system concentrated on aviation, maritime, and defense markets rather than retail customers. In 2010 the company arranged $1.8 billion in new financing to replace and upgrade its satellite system. The first launches of a fleet of 66 new satellites took place in 2017.

³In the U.S., corporations are identified by the label “Corporation,” “Incorporated,” or “Inc.,” as in Iridium Communications Inc. The U.K. identifies public corporations by “plc” (short for “Public Limited Corporation”). French corporations have the suffix “SA” (“Société Anonyme”). The corresponding labels in Germany are “GmbH” (“Gesellschaft mit beschränkter Haftung”) or “AG” (“Aktiengesellschaft”).

⁴The corporation’s bylaws set out in more detail the duties of the board of directors and how the firm should conduct its business.

⁵Here we use “financial markets” as shorthand for the financial sector of the economy. Strictly speaking, we should say “access to well-functioning financial markets and institutions.” Many investors deal mostly with financial institutions, for example, banks, insurance companies, or mutual funds. The financial institutions in turn engage in financial markets, including the stock and bond markets. The institutions act as financial intermediaries on behalf of individual investors.

⁶See L. Guiso, P. Sapienza, and L. Zingales, “Trusting the Stock Market,” Journal of Finance 63 (December 2008), pp. 2557–2600. The authors show that an individual’s lack of trust is a significant impediment to participation in the stock market. “Lack of trust” means a subjective fear of being cheated.

⁷The quotation is from Warren Buffett’s annual letter to the shareholders of Berkshire Hathaway, March 2008.

⁸Ponzi schemes are named after Charles Ponzi who founded an investment company in 1920 that promised investors unbelievably high returns. He was soon deluged with funds from investors in New England, taking in $1 million during one three-hour period. Ponzi invested only about $30 of the money that he raised, but used part of the cash provided by later investors to pay generous dividends to the original investors. Within months, the scheme collapsed, and Ponzi started a five-year prison sentence.

⁹Ponzi schemes pop up frequently, but few have approached the scope and duration of Madoff’s.

¹⁰The idea that identical assets must have the same value is sometimes called the law of one price or the no-arbitrage condition.