Corporate Finance 1 The objective of the firm In whose interests is the firm run Exhibit 11 A company has responsibilities to a number of interested parties A conflict between objectives ID: 745752
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Slide1
The Objective of the Firm
Corporate Finance 1Slide2
The objective of the firm
‘In whose interests is the firm run?’
Exhibit 1.1
A company has responsibilities to a number of interested partiesSlide3
A conflict between objectives
Which claimants are to have their objectives maximised, and which are merely to be satisficed?
Pro-capitalist economists
The rules of the game
Left-wing
Primacy of workers’ rights and rewards
Balanced stakeholder approach
Slide4
Some possible objectives
Achieving a target market share
Keeping employee agitation to a minimum
Survival
Creating an ever-expanding empire
Maximisation of profit
Maximisation of long-term shareholder wealth Slide5
The assumed objective for finance
The company should make investment and financing decisions with the aim of maximising long-term shareholder wealth.
The practical reason
The theoretical reasons
The ‘contractual theory’
Practicalities of operating in a free market system
Society is best served by businesses focusing on returns to the ownersSlide6
Adam Smith (1776)
“The businessman by directing . . . industry in such a manner as its produce may be of the greatest value, intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it…”
Source:
Adam Smith,
The Wealth of Nations
, 1776, p. 400.Slide7
Michael Jensen
Attacks the stakeholder approach (and its derivative, the Balanced Scorecard of Kaplan and Norton (1996)). Criticisms include:
Confusion resulting from a multiplicity of targets to aim for
Leaving managers unaccountable for their actions
Allowing managers to pursue their own interests at expense of the firm
However, Jensen argues that companies cannot create shareholder value if they ignore important constituencies.
They must have good relationships with customers, employees, suppliers, government etc.
Simply telling people to maximise shareholder value is not
enough to motivate them to deliver value.
They must be turned on by a vision or a strategy.Slide8
More thoughts on the key objectives
John Kay
Firms going directly for ‘shareholder value’ may do worse for shareholders than those that focus on vision and excellence first and find themselves shareholder wealth maximisers in an oblique way.
Milton Friedman
Businesses should pursue high returns for owners. This results in the best allocation of investment capital among competing industries and product lines.
Consumers end up with more of what they want because scarce investment money is directed to the best uses.
The self-interest of employees in retaining their jobs will often conflict with this overriding objective.
One powerful reason for advancing shareholders’ interests above all others is they own the firm and so deserve any surplus it produces.Slide9
What is shareholder wealth?
Maximising wealth can be defined as maximising purchasing power.
Maximising shareholder wealth means maximising the flow of dividends to shareholders
through time
.Slide10
Profit
maximisation
is not the same as shareholder wealth
maximisation
Prospects
Risk
Accounting problems
Communication
Additional capitalSlide11
Exhibit 1.8
Two firms with identical average profits but different risk levelsSlide12
Ownership and control
The problem
Diffuse and fragmented set of shareholders
Control often lies in the hands of directors
Separation, or a divorce, of ownership and control
The management team may pursue objectives attractive to them
‘Managerialism’ or ‘managementism’
An example of the principal–agent problem
Agency costs
(a) Monitor managers’ behaviour
(b) Create incentive schemes and controls for managers to encourage the pursuit of shareholders’ wealth maximisation
Agency cost of the loss of wealth caused by the extent to which prevention measures do not workSlide13
Ownership and control
Aligning the actions of senior management with the interests of shareholders ‘goal congruence’
Some solutions
Linking rewards to shareholder wealth improvements
Sackings
Selling shares and the takeover threat
Corporate governance regulations
Information flowSlide14
Lecture review 1
Firms should clearly define the objective of the enterprise to provide a focus for decision making.
Sound financial management is necessary for the achievement of all stakeholder goals.
Some stakeholders will have their returns satisficed, others
maximised.
Assumed objective of the firm for finance is to maximise shareholder wealth.
Practical
The contractual theory
Survival
Better for society
Counters the tendency of managers to pursue goals for their own benefit
They own the firm
Maximising shareholder wealth is maximising purchasing power or maximising the flow of discounted cash flow to shareholders over a long time horizon.Slide15
Lecture review 2
Profit maximisation: different from shareholder wealth maximisation
Future prospects
Risk
Survival
Accounting problems
Communication
Additional capital
Separation of ownership and control
Managerialism
Principal–agent problem:
Some solutions:
Link managerial rewards to shareholder wealth improvement
Sackings
Selling shares and the takeover threat
Corporate governance regulation
Improve information flow