ANZ Finance blog | Real World Ideas | McGraw Hill Australia New Zealand

How Universities Shape the Real World: The Case of Corporate Finance

Published 16 October 2020

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

Real World Ideas -- McGraw Hill ANZ Finance Blog -- Australia and New Zealand

It took me a long time to figure it out but if I had to tell a new university student, whatever they happen to be studying, just one thing it would be this: ideas come from universities. This is important because students come to universities to be trained for the real world, as though the university sits apart from that real world. On the contrary, universities are active shapers of the real world. On their first day of work, the most important question that a new graduate should be able to answer is, “What are the latest ideas in…?”

Corporate finance provides one of the best examples of how university ideas have very significant influence in practice.

I have been teaching corporate finance to undergrad students for about ten years. It’s very practical and very useful. Corporate finance is that part of finance that deals with decision-making within the firm. This can be a corner store or a multi-national corporation. What ideas should we pursue? Should we expand into this new market? Should we develop this new product? How are we going to finance our ideas? How can we manage our working capital better?

Despite its usefulness as a practical decision-making framework, corporate finance is not just something that is taught at university for students to later apply. It is much more than this. In fact, corporate finance theory, which was created in American universities, reshaped the way that corporate finance is practiced. It reshaped business.

The way that financial economists write their theories about financial decision-making requires them to identify a clear objective for the decision-makers to aim for. There was a problem standing in the way of an elegant theory. Shareholders have lots of different objectives. Some are saving for retirement. Some are in retirement. Some are charities trying to earn money for their cause. Some are superannuation funds earning money for their clients. Some are investing for their children’s education. Some are trying to make enough money to buy a Ferrari. If the firm’s owners have so many different objectives, which goal should the managers pursue?

The answer coming from universities and subsequently pursued by every major corporation, was that managers should aim to maximise the current market value of the firm (i.e. to maximise the current share price). Shareholder value creation should be the objective. That way, rather than worrying about all the different reasons why people want to earn a return on their investment, managers should just concentrate on pursuing ideas that will maximise the current market value. Problem solved.

This sounds like a nice idea but did it really have any far-reaching effects beyond making an elegant theory possible? It certainly did. For one thing, before ‘shareholder value’ became the rallying cause for corporate managers, many firms were not managed in the best interests of the shareholders (i.e. the owners). Some managers were more interested in building fiefdoms, including conglomerates of weird and wonderful businesses. Some CEOs were more interested in corporate dining rooms and corporate jets. Others had less selfish motives, including maximising the number of people employed in the company or facilitating enormous R&D expenditures. Once the shareholder value idea took hold, every decision was judged according to how much shareholder value it would create. This includes new products, new markets, investment in new information systems, new marketing campaigns, equipment purchases, land purchases and on it goes.

Even more than this, the pursuit of shareholder value led to firms selling off divisions. Conglomerates were broken up. Corporate raiders used the idea to drive a wedge between management and shareholders to gain control of the company, for better or worse. Workers were laid off. Corporate dining rooms were dismantled. On a positive note, in some cases, more people are employed now than when the layoffs occurred and, arguably, many businesses were saved by the pursuit of shareholder value, though many lives were disrupted. One thing is clear. The very nature of decision-making in corporate America was reshaped by this one idea, which came from university researchers pursuing a theory of corporate finance.

Maybe, an under-appreciated and not often asked question of new graduates should be, “What is the best idea you learned about in university?” It could be that it’s the idea that will transform business in the not too distant future.

Discussion Question

What is the latest idea in the area of finance in which you are most interested?

Further Reading

The underlying theme in the textbook is ‘information’. It is central to finance and is a topic that we will be discussing in this blog in future. New ideas can also be found in the academic literature. For example, one contribution to the latest in ‘information’ research applied in finance was published in October 2020 in the Journal of Finance. The paper is called Information Inertia. Take a look.

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