6 PART

I Introduction a greater extent, stay on the sidelines. For example, if GM raises the funds to build its auto plant by selling both stocks and bonds to the public, the more optimistic, or risk-tolerant, investors buy shares of stock in GM. The more conservative individuals can buy GM bonds, which promise to provide a fixed payment. The stockholders bear most of the busi- ness risk along with potentially higher rewards. Thus capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear that risk.

This allocation of risk also benefits the firms that need to raise capital to finance their investments. When investors can self-select into security types with risk-return character- istics that best suit their preferences, each security can be sold for the best possible price. This facilitates the process of building the economys stock of real assets.

Separation of Ownership and Management

Many businesses are owned and managed by the same individual. This simple organiza- tion, well-suited to small businesses, in fact was the most common form of business orga- nization before the Industrial Revolution. Today, however, with global markets and large-scale production, the size and capital requirements of firms have skyrocketed. For ex- ample, General Electric has property, plant, and equipment worth about $35 billion. Cor- porations of such size simply could not exist as owner-operated firms. General Electric actually has about one-half million stockholders, whose ownership stake in the firm is pro- portional to their holdings of shares.

Such a large group of individuals obviously cannot actively participate in the day-to-day management of the firm. Instead, they elect a board of directors, which in turn hires and su- pervises the management of the firm. This structure means that the owners and managers of the firm are different. This gives the firm a stability that the owner-managed firm cannot achieve. For example, if some stockholders decide they no longer wish to hold shares in the firm, they can sell their shares to other investors, with no impact on the management of the firm. Thus financial assets and the ability to buy and sell those assets in financial markets allow for easy separation of ownership and management.

How can all of the disparate owners of the firm, ranging from large pension funds hold- ing thousands of shares to small investors who may hold only a single share, agree on the objectives of the firm? Again, the financial markets provide some guidance. All may agree that the firms management should pursue strategies that enhance the value of their shares. Such policies will make all shareholders wealthier and allow them all to better pursue their personal goals, whatever those goals might be.

Do managers really attempt to maximize firm value? It is easy to see how they might be tempted to engage in activities not in the best interest of the shareholders. For example, they might engage in empire building, or avoid risky projects to protect their own jobs, or overconsume luxuries such as corporate