Companies A and B
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If you buy a share of stock, what will you expect to receive, when will you expect to receive it, and will you be certain that your expectations will be met? When you purchase a stock, you expect to receive dividends plus capital gains. Not all stocks pay dividends immediately, but these corporations that do, typically pay dividends quarterly. Capital gains(losses) are received when the stock is sold. Stocks are risky, so you would not be certain that your expectations would be met – as you would if you had purchased a U.S Treasury security which offers a guaranteed payment every 6 months plus repayment of the purchase price when the security matures.
If most investors expect the same cash flows from Companies A and B but are more confident that A’s cash flows will be closer to their expected value, which company should have the higher stock price?
If investors are more confident that Company A’s cash flows will be closer to their expected value than Company B’s cash flows, then investors will drive the stock price up for Company A. Consequently, Company A will have a higher stock price than Company B
What are some actions that stockholders can take to ensure that management’s and stockholders’ interests are aligned?
Useful motivational tools that will aid in aligning stockholders’ and management’s interests include: (1) reasonable compensation packages, (2) direct intervention by shareholders, including firing managers who don’t perform well, and (3) the threat of takeover.The compensation package should be sufficient to attract and retain able managers but not go beyond what is needed. Also, compensation packages should be structured so that managers are rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date.
Stockholders can intervene directly with managers. Today, the majority of stock is owned by institutional investors and these institutional money managers have the clout to exercise considerable influence over firms’ operations. First, they can talk with managers and make suggestions about how the business should be run. In effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who has owned $2,000 of a company’s stock for one year can sponsor a proposal that must be voted on at the annual stockholders’ meeting, even if management opposes the proposal. Although shareholder-sponsored proposals are non-binding, the results of such votes are clearly heard by top management.