Essentials of Managerial Finance 14th Edition

Book Preface

When you invest in the common stock of a company, what do you hope (expect) to gain? Rational investors would answer this
question with a single word—wealth. As you will discover in this chapter, a corporation acts in the best interests of its stockholders when decisions are made that increase the value of the firm, which translates into an increase in the value of the company’s stock. The managers of large corporations generally are encouraged to ‘‘act in the best interests’’ of the firms’ stockholders through executive compensation packages that reward ‘‘appropriate behavior’’—that is, actions that interests and stockholders believe that value is not being maximized, these executives often are ousted from their very lucrative positions. Sounds likea good plan, doesn’t it?

Although it seems like a good idea to rewardmanagers who run firms with the best interests of the stockholders (owners) in mind, in recent years stockholders have complained that executive compensation plans in many large corporations provide excessive rewards to executives who are interested only in increasing their own wealth positions. Consider, for example, that the CEO of Pfizer was paid $79 million during the period 20012005 and the CEOs of Home Depot and Verizon Communications
paid $27million and$50 million, respectively, during the period from 20042005, even though at the same time these same firms produced negative returns for stockholders.1 According to Paul Hodgson, senior research associate at The Corporate Library, this is evidence ‘‘that the link between long-term value growth and long-term incentive awards is broken at too many companies— if it was ever forged properly in the first place.’’2 In recent years, investors have said, ‘‘Enough is enough.’’ Stockholders are now demanding, and more boards of directors are imposing, tougher rules with regard to compensation packages, making it more difficult for executives to earn excessive salaries. In 2006, for example, the shareholders of Pfizer, Merrill Lynch, Morgan Stanley, General Electric, Citigroup, and Raytheon, among others, became much more active in expressing their feelings about ‘‘excessive’’ executive pay plans A compensation plan that has received a great deal of attention recently is the policy of offering ‘‘golden parachute’’ packages that provide executives with excessive paymentswhen they are dismissed from their firms. In the past, a golden parachute, which gets its name from the fact that a significant severance pay permits an executive to easily ‘‘land on his or her financial feet’’ after dismissal from the company, often had to be honored no matter the reason for dismissal; one exception would be if a criminal offense was committed by the executive. More companies are now limiting the amount of the severance pay that executives can earn. In addition, large corporations, including ImClone Systems, NCR Corporation, and Walt Disney Company, are revising their policies sothat it is easier to fire executives without having to pay excessive severance pay. More boards of directors are redefining what it means to be fired for ‘‘just cause’’ to include a wider range of actions or nonactions for which executives can be dismissed without severance pay. Firms now are including poor firm performance as a justifiable reason for dismissing executives without severance. It seems that stockholders are ‘‘speaking their minds,’’ and the boards of directors of many companies are listening.4

As you read this chapter, think about the issues raised here: As a stockholder in a company, what goal(s) would you like to see pursued? To what extent should top managers let their own personal goals influence the decisions they make concerning how the firm is run? What factors should management consider when trying to ‘‘boost’’ the value of the firm’s stock?