Corporations are complicated entities with many stakeholders, each with its own idea of how the firm should remain profitable. The need for a model that simultaneously takes into account multiple aspects of a firm is met by the investment-vehicle model. Although simple in form, this model provides a schematic upon which more complicated models are built. The Investment-Vehicle Model identifies four major entities:
The world in which the corporation is embedded includes such entities as markets, governments, investment opportunities, threats, and many other variables that affect a corporation’s decisions. Exchanges of money and real assets between the world and the corporation represent the investment decisions made by managers, the entrusted individuals who, theoretically, work in the best interest of the owners (investors). This represents a principal-agent situation where one person (agent) acts on behalf on another (principal). However, read the headlines in any financial newspaper and you will find examples where managers did not act in the best interest of investors. Embezzlement, insurance fraud, and insider trading all represent dilution of the owners’ claim to corporate profitability. In a perfect world, investment opportunity evaluations would not have to include the risk of unscrupulous or incompetent managers.
The firm represents the corporation itself including its products, managers, assets, debts, and financial structure. Just like people, corporations have unique characteristics that make up its ability to be profitable and to adapt when environmental conditions change. In a recession, some corporations fail where others thrive and still others just survive. The same is true for economic booms. Each corporation has its own set of strengths and weaknesses that determine whether its managers were correct in forecasting future environmental conditions. In fact, the word corporation comes from the Latin word corpus, literally meaning “body.”
Financial Markets and Intermediaries
Financial markets represent entities that connect investors’ money with the firm. The firm’s financial decisions are effectively carried out by these markets by providing an easy way for investors to buy securities that represent claims to the firm’s cash flows. The firm’s decision to raise capital through borrowing (e.g. by issuing bonds) or selling equity (e.g. by selling common stock) relies almost completely on the existence of these financial markets. Without them, the corporation would have to deal one-on-one with each investor. For corporations with millions of investors, this task would be too expensive to be profitable and ownership would reside with few and not many.
Investors represent either debt holders or owners of a corporation. Either way, they have a legal claim to a piece, but not a specific piece, of a corporation’s profitability. Corporations are legally liable to bond holders because bonds represent borrowing of an investor’s money. Bonds are typically a lower-risk investment than stocks because debt holders must be paid before any equity is shared with owners. Stock holders, in contrast, have legal claim to any remaining value after debts have been paid. However, as bond holders are paid a set amount for their investment, there is no limit to profitability for stock holders.
The Investment Vehicle Model includes the primary players that make up a corporation. However, several assumptions about the relationships among these players limit the model to perfect conditions that never exist in real life. For example, the principal-agent relationship represents just one aspect in evaluating an investment’s risk. Regardless of it faults, the investment vehicle view of a corporation provides a simple relationship-based model from which more sophisticated models can be derived.
This post is part of the series: Financial Models: Three Ways to View a Corporation
In a perfect world, investors, managers, employees, and other stakeholders are all focused on making a corporation as profitable as possible. Hence, only one view of a corporation would suffice. In an imperfect world, multiple models of a corporation help create a clearer picture.