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KR editions 131 to 133

KR-131 : (eco refresher-IX)

Hi everyone,

Many were quite interested in our management/ economic refreshers. But before continuing the story a recap of the story so far:

  • We learnt about the 3 general types of businesses: sole ownership, partnership and corporation. 

  • Our hero (the college whizkid), started solo, progressed to a partnership and finally a corporation. We also saw the pros and cons of each of the 3 businesses.

  • After a few years to expand the company he realizes that he needs to raise a lot of capital (i.e. to raise more funds for expanding the company). So he decides to collect funds from the general public.

  • But he has a problem? Why will some stranger spend money to develop our whizkid's company? What can the whizkid do to encourage a stranger to contribute money (no one will part with money unless they get something in return)?

  • Our whizkid decides on selling stocks (or shares).


  • When someone buys a stock he stands to gain in 2 ways: through dividends and through capital gain (capital gain depends on the current price of the stock. If the current price of the stock is greater than price for which the stock was initially bought then the person owning the stock can sell it off for a profit). Also owning a stock is like owning a part (a share) of the company. 

  • Then we came to the problem that if 1000s of people buy stocks in a company how can all of them run the company? Well, they can't and so they elect a CEO to head the company. The CEO in turn has to manage the company (it is as if the stockholders elect a CEO to manage the company on their behalf).

  • From this arises the problem of "agency conflicts". We saw how there is a chance that the people running the company (managers, employees etc.) might not really work for the goal of the stockholders (the stockholders' primary goal is to increase the market value of the stock). We also saw the cascading effect: if managers spend more on personal luxuries or hiring more people etc. then the profits would dip, expenses would rise, company performance would dip and the stock price would also dip! When that happens the stockholders might decide to sack the top management (or the CEO). Thus the CEO has to always keep a watch over people under him and those people have to keep a watch over their subordinates and so on.

Well, that's the story till now...we shall continue on this from the next edition...

KR-132 : Management X

Our college whizkid needs to think of ways of how he can get his top management to work for the maximization of stockholders wealth.

  • Stockholder's wealth maximization is nothing but maximizing the market price of the company stock. More the stock price increases, more the gain for the stockholders.

  • So what can be done to ensure that the management work towards this goal? There are 2 broad options: punishments and rewards.

  • The managers would perform better if they got rewards for their work. And one form of rewards is to issue stocks to the manager!

Executive Stock Options:

  • This is a popular form of reward given to the higher managerial employees (including CEO). And in fact CEOs can earn a lot more from this than their salaries.

How it works?

  • Let's consider the CEO. The company (when we refer to the company we refer to the body of stockholders- the owners of the company) will give the CEO a stock option saying, "You can buy 100 stocks of the company within the next 5 years for a rate of $10 per stock irrsepective of the market price of the stock". 

  • The current market price might be $12 per stock. So if the CEO wants he can buy the 100 stocks now for a total of $1000 (if he were to buy it in the market it would cost him $1200). So if he exercises his stock option immediately and then sells his stocks in the market he gets a gain of $200 instantly. 

  • But instead of that he can also do something else to increase his profits. If he can increase the market price of the stock to say $100 within the next 3 or 4 years, exercise his stock option right and then sell off his stocks in the market imagine how much gain he would get! (he would buy stocks for $1000 and sell them for $10000!).

  • But how can he increase the market price? 

  • Simple- run the company more effeciently, increase the profits etc. (so that demand for the company's stock rises).

KR-133 : Management XI

 We were discussing on how the stockholders can get the management to work for their benefit? Some options are listed below.

  • One method was the executive stock options which we saw in the earlier edition.

  • Another is the threat of firing- when the company doesn't perform well, the top management faces the possibility of getting fired.

  • On similar lines is the threat of hostile takeovers: a hostile takeover is the acquisition of a company over the opposition of its management. 

  • Stockholders will generally feel that the management isn't doing well if the stock value is below its potential value. In this case, some other organization (or group) might believe that they can turnover the company's fortunes. But when some company (say company A) acquires another company (say B) in this scenario (i.e. company B stock's are lower than their potential) the acquirer will either dismiss the top management or demote the top management of company B.Thus company B management will be against such an acquisition and hence it is termed "hostile takeover".

Note: There are other types of takeovers where a company might acquire a smaller company which has been performing well (in this case the acquirer will have respect for the management of the smaller company and both managements will be on friendly terms unlike a hostile takeover).

  • Nowadays a major percentage of stocks are held by financial institutions (insurance companies, banks etc). If these institutions feels that the company isn't doing properly they might directly intervene in the way the company is run. Since they own a major part of the company, the management has to consider their views or else face the threat of firing or hostile takeovers.

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