The Most Important Concepts in Finance
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The Most Important Concepts in Finance

Edited by Benton E. Gup

Anyone trying to understand finance has to contend with the evolving and dynamic nature of the topic. Changes in economic conditions, regulations, technology, competition, globalization, and other factors regularly impact the development of the field, but certain essential concepts remain key to a good understanding. This book provides insights about the most important concepts in finance.
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Chapter 4: An overview of corporate governance

Melissa B. Frye

Extract

Every finance student learns the basic idea of shareholder primacy, where the goal of the firm is to maximize shareholder value. In general, the owners of the firm desire three things. First, they want to maximize their current wealth. Second, shareholders want the ability to transform their wealth into a time pattern of desired consumption. Third, they want to determine the risk characteristics of their consumption plan. Since the financial markets take care of the second and third priorities, companies are left with the objective of maximizing shareholder wealth. While there are significant critics of shareholder primacy theory, the idea that companies should strive to increase value is still widely accepted. However, in corporate America we have separation of ownership and control. The shareholders own the firm but the managers make the day-today decisions. Such a situation is defined as an agency relationship, where principals (shareholders) hire agents (managers) to make decisions on their behalf. While undoubtedly managers strive to increase shareholder wealth, it is not always easy to make decisions that increase firm value. Likewise, managers are often given incentives to focus on non-maximizing endeavors. For example, firm size is often linked to chief executive officer (CEO) compensation, providing a strong incentive for growth. While growth is generally viewed favorably by the market, firm growth is not always the way to maximize shareholder value. General Motors is now an excellent example of why sometimes getting smaller is actually better for shareholders. Chief executive officers are also motivated by other things such as power, independence, and perquisites that may not be aligned with shareholder interests.

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