Foundations of Financial Management: An Analysis (part 2)

In this world nothing can be said to be certain, except death and taxes.

Benjamin Franklin

Goals of Financial Management

by

Charles Lamson

 Let us look at several alternative goals for the financial manager as well as the other managers of the firm. One may suggest that the most important goal for financial management is to earn the highest possible profit for the firm. Under this criterion, each decision would be evaluated on the basis of its overall contribution to the firm's earnings. While this seems to be a desirable approach, there are some serious drawbacks to profit maximization as the primary goal of the firm.

First, a change in profit may also represent a change in risk. A conservative firm that earned $1.25 per share may be a less desirable investment if its earnings per share increase to $1.50, but the risk inherent in the operation increases even more.

A second possible drawback to the goal of maximizing profit is that it fails to consider the timing of the benefits. For example, if we could choose between the following two alternatives, we might be indifferent if our emphasis were solely on maximizing earnings.

Both Investments would provide $3.50 in total earnings, but Alternative B is clearly superior because the larger benefits occur earlier. We could reinvest the difference in earnings for Alternative B one period sooner.

Finally, the goal of maximizing profit suffers from the almost impossible task of accurately measuring the key variable in the case, namely, "profit." As you will observe throughout this analysis, there are many different economic and accounting definitions of profit, each open to its own set of interpretations. Furthermore, problems related to inflation and international currency transactions complicate the issue. Constantly improving methods of financial reporting offers some hope in this regard, but many problems remain.

Evaluation Approach

While there is no question that profits are important, the key issue is how to use them in setting a goal for the firm. The ultimate measure of performance is not with what the firm earns, but how the earnings are valued by the investor. In analyzing the firm, the investor will also consider the risk inherent in the firm's operation, the time patterns over which the firm's earnings increase or decrease, the quality and reliability of reported earnings, and many other factors. The financial manager, in turn, must be sensitive to all of these considerations. He or she must question the impact of each decision on the firm's overall valuation. If a decision maintains or increases the firm's overall value, it is acceptable from a financial viewpoint; otherwise, it should be rejected. This principle will be demonstrated throughout this analysis.

Maximizing Shareholder Wealth 

The broad goal of the firm can be brought into focus if we say the financial manager should attempt to maximize the wealth of the firm's shareholders through achieving the highest possible value for the firm. Shareholder wealth maximization is not a simple task, since the financial manager cannot directly control the firm's stock price, but can only act in a way that is consistent with the desires of the shareholders. Since stock prices are affected by expectations of the future as well as by the economic environment, much of what affects stock prices is beyond management's direct control. Even firms with good earnings and favorable financial trends do not always perform well in a declining stock market over the short-term.

The concern is not so much with daily fluctuations in stock value as with long-term wealth maximization. This can be difficult in light of changing investor expectations. In the 1950s and 1960s, the investor emphasis was on maintaining rapid rates of earnings growth. In the 1970s and 1980s, investors became more conservative, putting a premium on lower risk and, at times, high current dividend payments.

In the early and mid-1990s, investors emphasized lean, efficient, well-capitalized companies able to compete effectively in the global environment. But by the late 1990s, there were hundreds of high-tech internet companies raising capital through initial public offerings of their common stock. Many of these companies had dreams, but very little revenue and no earnings, yet their stock sold at extremely high prices. Some in the financial community said that the old valuation models were dead, didn't work, and were out of date; earnings and cash flow didn't matter anymore. Alan Greenspan, former chairman of the Federal Reserve board, made the now-famous remark that the high-priced stock market was suffering from "irrational exuberance." By late 2000, many of these companies turned out to be short-term wonders. By 2003, hundreds were out of business. 

Management and Stockholder Wealth

Does modern corporate management always follow the goal of maximizing shareholder wealth? Under certain circumstances, management may be more interested in maintaining its own tenure and protecting private spheres of influence than in maximizing stockholder wealth. For example, suppose the management of a corporation receives a tender offer to merge the corporation into a second firm; while this offer might be attractive to shareholders, it might be quite unpleasant to present management. Historically, management may have been willing to maintain the status quo rather than to maximize stockholder wealth.

As mentioned earlier, this is now changing. First, in most cases "enlightened management" is aware that the only way to maintain its position over the long run is to be sensitive to shareholder concerns. Poor stock price performance relative to other companies often leads to undesirable takeovers and proxy fights for control. Second, management often has sufficient stock option incentives that motivate it to achieve market value maximization for its own benefit. Third, powerful institutional investors are making management more responsive to shareholders. 

Social Responsibility and Ethical Behavior

Is our goal of shareholder wealth maximization consistent with the concern for social responsibility for the firm? In most instances the answer is yes. By adopting policies that maximize volumes in the market, the firm can attract capital, provide employment, and offer benefits to its community. This is the basic strength of the private enterprise system.

Nevertheless, certain socially desirable actions such as pollution control, equitable hiring practices, and fair pricing standards may at times be consistent with earning the highest possible profit or achieving maximum valuation in the market. For example, pollution control projects frequently offer a negative return. Does this mean firms should not exercise social responsibility in regard to pollution control? The answer is no---but certain cost increasing activities may have to be mandatory rather than voluntary, at least initially, to ensure that the burden falls equally over all business firms.

Unethical and illegal financial practices on Wall Street by corporate financial "dealmakers" often make news headlines. Insider trading is one of the most widely publicized issues. Insider trading occurs when someone has information that is not available to the public and then uses this information to profit from trading in a company's publicly traded securities. This practice is illegal and protected against by the Securities and Exchange Commission (SEC). Sometimes the insider is a company manager; other times it is the company's lawyer, investment banker, or even the printer of the company's financial statements. Anyone who has knowledge before public dissemination of that information stands to benefit from either good news or bad news.

Such activities as insider trading serve no beneficial economic or financial purpose, and it could be argued that they have a negative impact on shareholder interests. Illegal security trading destroys confidence in U.S. securities markets and makes it more difficult for managers to achieve shareholder wealth maximization. 

Next Post: "The Role of the Financial Markets."

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 11-13*

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