Corporate Financial

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Corporate Financial Management, 3rd edition Glen
Arnold Lecture 1
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The objective of the firm

• Describe alternative views on the purpose of
  the business and show the importance to any
  organisation of clarity on this point.
• Draw a distinction between profit maximisation
  and shareholder wealth maximisation.
• Describe the impact of the divorce of corporate
  ownership from day-to-day managerial control.

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The objective of the firm

• In whose interests is the firm run?

Exhibit 1.1 A company has responsibilities to a
number of interested parties
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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

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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

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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 owners

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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.
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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.

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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.

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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.

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Profit maximisation is not the same as
shareholder wealth maximisation

• Prospects
• Risk
• Accounting problems
• Communication
• Additional capital

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Exhibit 1.8 Two firms with identical average
profits but different risk levels
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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 principalagent 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 work

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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 flow

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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.

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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
• Principalagent problem
• Some solutions
• Link managerial rewards to shareholder wealth
  improvement
• Sackings
• Selling shares and the takeover threat
• Corporate governance regulation
• Improve information flow