Corporate finance studies three decisions.
A fourth, day-to-day area is working capital management: cash, receivables, inventory and payables.
The standard goal is to maximize the long-run value of the firm to its owners. Value means the present value of all future cash flows, not this quarter's profit and not today's share price on its own. A manager who cuts research to hit an earnings target raises profit and lowers value.
A sole proprietorship and a partnership have unlimited personal liability and are taxed in the owners' hands. A corporation is a separate legal person: owners have limited liability, shares transfer easily, and the firm can raise large amounts of capital. The cost is that owners and managers are different people.
Shareholders (principals) hire managers (agents) who may pursue their own interests: empire building, excessive pay, avoiding risk to protect their jobs, or taking too much risk when paid in options. Agency costs are the value lost plus the cost of controlling the problem. Controls include an independent board, performance-linked pay, share ownership requirements, audits, activist shareholders, the threat of takeover and debt, which forces cash out of the firm.
A second conflict sits between shareholders and lenders. Shareholders of a highly indebted firm may prefer risky projects because lenders bear much of the downside. Lenders respond with covenants.
Employees, customers, suppliers and communities are affected by corporate decisions. In practice long-run value depends on treating them well enough that they keep dealing with the firm.
Two yardsticks are used most. Total shareholder return (TSR) adds the share price change and dividends over a period, usually compared with an index or peer group. Economic value added (Module 6) compares operating profit with the cost of the capital used to earn it. TSR captures what owners actually received; EVA captures whether the business itself earned its keep. Over short periods they can disagree, because share prices move on expectations.
A mature company has 500 of cash it does not need. Management can pay it out, or spend it on an acquisition that the board's own analysis values at 450. Paying out leaves shareholders with 500 of value. The acquisition turns 500 of cash into 450 of business, a loss of 50 to owners, while making the company bigger, which tends to raise management's pay and prestige. Michael Jensen called this the agency cost of free cash flow, and it is one reason investors welcome dividends, buybacks and moderate debt in mature firms.
A typical package for a large public company has three parts:
| Element | Typical basis | Problem it can create |
|---|---|---|
| Base salary | Fixed | None directly; the smallest part |
| Annual bonus | Revenue, EPS, cash flow or personal goals for one year | Short-termism; targets met by cutting investment |
| Long-term incentives | Performance share units vesting on three-year relative TSR or ROIC; options; restricted units | Options reward volatility; TSR targets can reward luck |
Good design ties a large share of pay to multi-year results the manager can influence, requires executives to hold shares, and includes clawback provisions if results are later restated.
US public companies must hold a non-binding shareholder vote on executive pay at least every three years, and most hold it annually. In Canada the vote is voluntary but most large issuers hold one. A low vote (below about 70% support) usually forces the board to engage with shareholders and change the plan.
Stock exchange rules in the US require a majority of independent directors and fully independent audit, compensation and nominating committees. Canadian rules require an independent audit committee and disclosure of governance practices against national guidelines. Separating the roles of chair and chief executive is common in Canada and increasingly so in the US. An independent board is only as good as its willingness to challenge management.
Activist investors buy a stake, often 5% to 10%, then push for change: a sale of the company, a spin-off, a bigger buyback, new directors. Their record is mixed but the threat alone disciplines some boards. They are one part of the 'market for corporate control', alongside hostile takeovers.
Maximizing long-run value does not mean squeezing employees, customers or suppliers. A firm that underpays staff, cuts product quality or delays suppliers may lift profit for a year and lose far more value when they leave. The disagreements are about real trade-offs, such as plant closures or lobbying, where shareholder and community interests diverge.
Dual-class share structures, where founders hold multiple-voting shares, are common on the TSX and among US technology firms; they weaken the takeover and voting controls. In Canada the Supreme Court has held that directors owe their duty to the corporation and may consider the interests of stakeholders, while Delaware law in the US is more shareholder-focused.
Open one company's management information circular or proxy statement. Record how the chief executive is paid (salary, bonus, shares, options), what performance measures drive the bonus, and whether the company has more than one share class.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.