The goal of the firm and the finance function

The second-year cohort of the weekend EMBA at the Lakeshore School of Business in Chicago meets its finance professor on a cold Saturday in January. Dr. Tomas Varga spent fifteen years as treasurer of an industrial company before moving to teaching, and he opens with a question rather than a formula. He asks each of the five managers in the front row what their organization is trying to achieve, and how they would know whether a decision moved it closer to that goal. Daniel Osei, who runs operations at Northfield Components, says profit. Grace Mwangi of Fairway Grocers says growth in same-store sales. Leo Brandt of Kestrel Analytics says annual recurring revenue, because that is what his investors ask about. Owen Tremblay, a manager at Prairie Ridge Energy, says the share price. Hana Kowalski of Lakeview Health says patient outcomes within a balanced budget. Dr. Varga writes all five answers on the board and says that the course will spend twelve weeks showing why they are related, when they conflict, and how a single idea, value, can reconcile most of them.

MBA-501 taught the cohort to read financial statements and to judge performance with ratios such as return on invested capital. This course takes the next step. It asks how much an asset, a project or a whole company is worth, how risk should affect that answer, and how a firm should pay for its investments and return cash to its owners. The tools are those of corporate finance, but the questions are managerial: should Northfield buy a new press line, should Kestrel raise equity or borrow, should Fairway buy back shares, and what is Cedarline Outdoor, the apparel company the cohort analyzed in MBA-501, really worth.

Three decisions

Dr. Varga sorts the work of corporate finance into three linked decisions. The investment decision asks which assets the firm should own: which projects to fund, which businesses to buy or sell, how much working capital to carry. The financing decision asks how to pay for those assets: with retained earnings, new shares, bank loans or bonds, and in what mix. The payout decision asks how much cash to return to owners and in what form, as dividends or as share repurchases. Each decision affects the others. A firm that invests heavily may need to raise outside money; a firm that borrows heavily may have to cut its dividend in a downturn; a firm that pays out all its cash cannot fund growth from within.

Behind all three sits a single yardstick. A decision is good if it increases the value of the firm, meaning the present value of the cash flows it will generate for the people who have provided its capital. That definition has three parts that will occupy most of the course: cash flows rather than accounting profit, the timing of those cash flows, and their risk.

Why value rather than profit

Daniel's answer, profit, is a natural one, and accounting profit is the number most managers are paid on. But profit is a poor guide to decisions for three reasons. First, profit ignores timing. A project that earns ten million dollars of profit spread over ten years is not as good as one that earns the same total in the first two years, because money received sooner can be reinvested. Second, profit ignores risk. A strategy that doubles expected profit while tripling the chance of insolvency may not be an improvement. Third, profit is not cash. As the cohort saw with Cedarline in MBA-501, net income stayed at about 21 million dollars a year while free cash flow fell from plus 16 million to minus 9 million, because inventory and receivables absorbed the cash. A firm can report profits all the way to a liquidity crisis.

Value addresses all three gaps. It measures what a decision does to expected future cash flows, discounts those cash flows for time and risk, and adds them up. Grace's same-store sales growth and Leo's recurring revenue are useful operating measures, but each can be bought: sales grow if prices are cut, and recurring revenue grows if sales commissions are generous enough. Growth creates value only if the return on the capital it uses exceeds the cost of that capital. That idea, first met in MBA-501 as the comparison between return on invested capital and the weighted average cost of capital, is the backbone of this course.

In this expression, the expected cash flow in each year is divided by one plus the discount rate raised to the number of years until it arrives. The discount rate reflects both the time value of money and the risk of the cash flows. Lessons 2 to 4 show how to apply the formula to cash flows of every shape, and lessons 7 and 8 show where the discount rate comes from.

Shareholders, stakeholders and the law

Owen's answer, the share price, is the one most finance textbooks give: the goal of the firm is to maximize the wealth of its shareholders, which for a listed company is reflected in its share price. The logic is that shareholders are the residual claimants. Employees, suppliers and lenders are paid under contracts before shareholders receive anything, so if a decision raises the value left for shareholders, it has usually made the whole pie larger. In the United States, most large public companies are incorporated in Delaware, whose courts have generally treated the long-term interests of stockholders as the end that directors serve, while giving boards wide discretion under the business judgment rule about how to pursue it. In 2019, the Business Roundtable, an association of chief executives of large companies, issued a statement on the purpose of a corporation that committed its signatories to deliver value to customers, employees, suppliers, communities and shareholders. The statement did not change the law, and studies since have found little change in governance practice, but it showed how contested the question has become.

Dr. Varga's view, which he invites the cohort to challenge, is that the conflict is smaller than it looks over long horizons. A firm that mistreats customers, cheats suppliers or burns out its employees rarely creates lasting value for shareholders, because the cash flows that value depends on come from those relationships. The conflicts are real at the margin: closing a plant, fighting a regulation, choosing how much to spend on safety beyond what the law requires. Finance does not resolve those choices, but it makes their costs and benefits visible. Hana's hospital has no shareholders at all, yet the same tools apply: a not-for-profit must still decide which investments create the most benefit per dollar of capital, and its lenders still care whether it can service its debt.

Agency problems

Shareholders of a large company do not run it. They elect a board, which hires managers, and managers make the decisions. This separation of ownership and control, described by Adolf Berle and Gardiner Means in the 1930s and formalized by Michael Jensen and William Meckling in 1976 as an agency relationship, creates agency costs. Managers may prefer growth and size, which bring prestige and pay, to returns. They may avoid risky but valuable projects that could cost them their jobs if they fail. They may hold more cash than the business needs because cash gives them independence from capital markets. And they may enjoy perquisites, from corporate jets to pet projects, that shareholders pay for.

Firms use several devices to align interests: boards with independent directors, pay tied to share price and to measures of return on capital, the threat of takeover if the share price falls too far, debt that commits managers to pay out cash, and disclosure rules that let investors monitor performance. None is perfect. Stock options can encourage short-term manipulation of the share price, and earnings targets can encourage managers to cut research or maintenance to hit a quarterly number. Lesson 9 returns to the idea that debt disciplines managers, and lesson 10 to the idea that dividends and buybacks keep cash out of their hands.

There is a second agency problem between shareholders and lenders. Because shareholders have limited liability, they gain from the upside of a risky bet but share the downside with creditors once the firm is near insolvency. A firm close to default may be tempted to gamble, or to pay a large dividend before creditors can stop it. Lenders protect themselves with covenants, such as the maximum ratio of debt to EBITDA of 3.5 times in Northfield's bank agreement, and they charge higher interest rates when they cannot monitor the borrower well.

The finance function inside a firm

In a mid-sized US company, the chief financial officer typically oversees two groups. The controller runs accounting, financial reporting, tax compliance and internal control. The treasurer manages cash, banking relationships, borrowing, foreign exchange and interest rate risk, and often the pension plan. A financial planning and analysis team builds budgets and forecasts and evaluates capital projects. In a company listed on the New York Stock Exchange or Nasdaq, the CFO also certifies the financial statements and internal controls under the Sarbanes-Oxley Act, works with the audit committee of the board, and speaks to investors and analysts. In a small business, all these roles may belong to one person and an outside accountant.

The cohort's companies show the range. Northfield is a private manufacturer owned by a founding family and financed by a bank loan. Kestrel is a venture-backed software firm whose finance team spends most of its time on fundraising and on tracking how many months of cash remain. Fairway is a regional grocer with thin margins and fast-turning inventory, for which working capital management is central. Prairie Ridge is a listed energy producer whose finance team must manage volatile commodity prices and a large, long-lived capital budget. Lakeview is a not-for-profit that borrows through bonds and must justify capital spending to a board and to government funders.

Markets and the role of prices

Corporate finance relies heavily on market prices. When investors buy and sell shares and bonds, they set the prices that tell a firm how much its capital costs. If capital markets are reasonably efficient, meaning that prices reflect available information quickly, a manager cannot expect to create value by timing the market or by financial engineering alone; value comes mainly from good real investments. The evidence on market efficiency is mixed. Prices react to news within minutes, and professional investors as a group do not beat low-cost index funds after fees, but there are well-documented anomalies, bubbles and crashes. Dr. Varga's working rule is to treat market prices as the best available estimate of value, while staying alert to the times when they are clearly out of line.

Prices also discipline decisions. When a company announces a large acquisition, its share price often falls, which is the market's judgment that the buyer is paying too much. Managers who dismiss such signals should have a good reason. In the cases that follow, the cohort will learn to estimate value independently and compare it with the market's estimate, and to ask what the market would have to believe for the current price to be right.

# Profit versus value: two projects with the same total profit
rate = 0.09                       # discount rate
fast = [6.0, 4.0, 0, 0, 0, 0, 0, 0, 0, 0]   # cash flows, millions, years 1-10
slow = [1.0] * 10
def pv(cfs, r):
    return sum(cf / (1 + r) ** t for t, cf in enumerate(cfs, start=1))
for name, cfs in [('fast', fast), ('slow', slow)]:
    print(f"{name}: total {sum(cfs):.1f}, present value {pv(cfs, rate):.2f}")

fast: total 10.0, present value 8.87
slow: total 10.0, present value 6.42

Both projects produce ten million dollars in total, but the project whose cash arrives early is worth more than two million dollars more today at a 9 percent discount rate. That difference is invisible in a profit total, and it is the first reason the course works with present values.