The Role of Investors

The Role of Investors

Key Points

• Investors are vital to businesses.

  • They provide the capital needed to start up, grow, and maintain firms.

• Investors expect a return on their invested capital

  • Principal plus some return in excess that is commensurate with the risk inherent in the investment.

• There are many ways to invest, broadly classified into equity and debt.

• Investor returns depend on future performance and prospects of the firm, which are inherently risky.

• In publicly held companies with a large shareholder base, investors have limited information about the firm and have little direct control over the actions of managers.

• The separation of ownership (by investors) and control (by managers) leads to the principal-agent problem.

  • Arises when:

  • (a) Principals and agents have different incentives.

  • (b) Principals have imperfect information about optimal actions that agents could pursue.

• Investors act through their representatives:

  • Board of Directors (equity holders)

  • Covenants included as part of the investment contract (debt holders).

I. Introduction to Investors

• Previous weeks focused on how businesses create value through innovation and efficient delivery of products/services at lower prices than consumers are willing to pay.

• Successful firms earn profits by producing goods/services at costs lower than sale prices, demonstrating efficiency in meeting market demands.

• This week’s focus shifts to the distribution of value among various stakeholders, specifically investors, who provide essential capital for startup, expansion, innovation, and ongoing operations.

• Capital enables firms to conduct R&D, develop products, acquire equipment, and explore new markets ahead of revenue realization.

• Investors provide the necessary capital for risk-taking and sustaining operations through economic cycles.

• Investors primarily invest through:

  • Equity: Gain partial ownership and expect returns through dividends and/or stock price appreciation.

  • Debt: Provide loans and expect interest payments plus principal return.

• Firms must return remaining cash flows to shareholders (dividends) or reinvest if returns exceed those available elsewhere in financial markets.

II. Book Values and Market Values

• Book Value

  • Derived from the company's accounting records, based on historical costs and current financial information.

• Market Value

  • Reflects what investors are willing to pay for equity and debt, depending on anticipated future performance.

• Market value is determined by the firm’s ability to generate future cash flows, not merely by summing individual asset values.

• Considering the firm as a “going concern,” market value incorporates tangible and intangible assets to assess its overall worth.

  • Examples of assets:

  • Plant and equipment (physical resources for production).

  • Intellectual property and trade secrets (proprietary technologies and competitive advantages).

  • Workforce expertise (driving performance).

  • Strong customer and supplier relationships (ensuring loyalty and operational stability).

• Market power influences value, allowing firms to shape market prices and conditions.

• Example:

  • As of December 31, 2023, Tesla's assets were valued at $106 billion, and common stock equity at $62.6 billion, while its market capitalization was approximately $800 billion, indicating investors valued it at over 12 times its book value, reflecting growth and profitability expectations.

III. Debt vs Equity

• III.1. Debt Investors

  • Lend money to firms for interest payments and principal return.

  • Debt contracts detail repayment schedules and lender rights in default scenarios.

  • Debt investors have a higher preference claim on assets and income than equity investors.

  • Interest payments are prioritized before dividends distributed to equity shareholders.

  • Risk associated with investing in debt is lower, and returns are capped at the agreed interest rate.

  • Bond rating agencies (S&P, Fitch, Moody’s) assess firms' financial health and likelihood of distress, guiding debt investors on risk levels and required premiums.

• III.2. Equity Investors

  • Receive a portion of residual profits while being protected against losses beyond their initial investment (limited liability).

  • Up-side rewards are aligned with company performance, with returns depending on dividends and stock price appreciation.

  • Experienced higher risks, receiving less or no dividends during poor performance.

• III.3. Financing Privately vs. Publicly Held Firms

  • Private firms mostly raise equity through:

  • Private placements, venture capital, and private equity funds (often taking active management roles).

  • Rely on bank loans and private debts for financing, encountering higher interest and stricter terms.

  • Public firms can access broader capital markets through IPOs and corporate bonds, benefiting from lower costs due to higher transparency and credit ratings.

IV. Investor Expectations of Returns

• Investors seek a financial return that compensates for investment risks, typically through:

  • Capital appreciation, dividends, or interest payments.

• Risk-return tradeoff

  • Higher risk taken by investors expects higher returns.

• Investors analyze:

  • Financial statements, market conditions, industry trends, competitive positions.

  • There is an emphasis on forward-looking indicators (projected revenues, earnings growth, operational efficiency).

• Some investors care about more than financial returns (i.e., non-financial factors); this is part of the ESG (Environmental, Social, Governance) movement.

  • Investors prioritize sustainable and ethical practices, acknowledging that long-term value considers societal and environmental impact.

• Hart and Zingales (2017) argue traditional financial theories inadequately capture all investor preferences, emphasizing the necessity of considering ethical impacts in investment decisions.

V. Governance and the Principal-Agent Problem

• V.1. Overview of the Principal-Agent Problem

  • Central to corporate governance, featuring a relationship where investors (principals) entrust management (agents) with their capital.

  • Misalignment between incentives of management and investors arises from information asymmetry and differing goals.

• The principal-agent problem can manifest in various scenarios, as highlighted in the Freakonomics video on real estate agents.

• The challenges include:

  • Information asymmetry where agents have superior knowledge about optimal actions and benefits.

  • Differences in incentives, making it difficult for principals to attain perfect solutions.

• V.2. Corporate Governance and Incentives

  • Control rights and managerial incentives are essential in mitigating the principal-agent problem.

  • Equity investors influence corporate policies through voting to align company strategy with shareholder interests.

  • The board of directors oversees management, selecting leaders and ensuring alignment with shareholder goals.

  • Effective governance relies on diversity (independent and inside directors), transparency, and accountability, fostering trust.

  • Performance-based executive compensation can also align managerial incentives with long-term goals.

VI. Roles of Accounting and Finance in Organizations and Business School Curricula

• Accounting focuses on recording and reporting financial transactions and adherence to standards.

  • Key roles include:

  • CFO, Controller, Accounting Manager, Cost Accountant, Tax Manager.

  • Courses cover financial, managerial accounting, auditing, and taxation to equip students with compliance and reporting skills.

• Finance manages assets and liabilities, emphasizing strategic planning and value creation.

  • Key roles: CFO, Treasurer, Investment Manager, Corporate Development Manager, Risk Manager.

  • Courses include corporate finance, investment analysis, and risk management to prepare students for financial decision-making.

• Distinction: Accounting emphasizes historical accuracy/compliance, while finance focuses on future value optimization.

Exhibits

Exhibit 1: Advantages & Disadvantages of Debt (vs. Equity) Financing

Advantages of Debt Financing:

• Retains upside: Owner maintains full control.

• Predictability: Fixed payment amounts aid financial planning.

• Tax shield: Interest is tax-deductible, lowering costs.

Disadvantages of Debt Financing:

• Cash flow strain: Fixed repayments can burden cash flows in tough times.

• Covenants may limit operational flexibility.

• Adds risk: A higher debt-equity ratio increases overall investment risk.

Exhibit 2: Comparing Different Types of Business Organizations

• Corporations:

  • Separate legal entity raising capital via stock.

  • Shareholder objective: maximize returns through dividends/capital appreciation.

  • Governed by a board overseeing management operations.

• Limited Liability Companies (LLCs):

  • Combine liability protection of corporations and flexibility of partnerships.

• Partnerships:

  • Owned by multiple individuals sharing profits/losses.

  • Governed by a partnership agreement.

• Sole Proprietorships:

  • Owned and operated by an individual who bears all risks and liabilities without a formal governance structure.