Wealth Maximization

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Introduction to Finance

Finance is the study of the process, institutions, markets, and instruments used to transfer money and credit between individuals, businesses, and governments. Finance is applied economics. Economics is the study of the allocation of resources for the purpose of producing goods and services for various members of society. Therefore finance is the study of how the flow of money and credit facilitates that production and allocation. Finance has different focus and utilizes certain concepts more than the traditional study of economics in several ways; 1. Microeconomics focuses on the profit maximization assumption whereas in finance the focus is on value or wealth maximization 2. Finance considers the time value of money and the implications for interest rates on the time value of money decisions 3. Finance focuses on cash flows, not profits 4. Finance makes extensive use of the concept of risk. Risk is the possibility that the actual result will differ from the expected outcome. There are several sub-disciplines within finance including the following; 1. managerial or corporate finance 2. investment and securities analysis and portfolio theory 3. financial institutions and financial services 4. personal finance 5. insurance and risk management 6. real estate finance

The Finance Function


The finance managers main responsibilities are to plan for, obtain, and use funds to maximise the value of the Firm. Therefore the key finance functions are the investment, financing, and dividend decisions of an organisation. Therefore the finance functions are determined by the responsibilities of the finance manager. 1. In planning and forecasting, the finance manager (FM) must interact with the executives who are responsible for the general planning activities of the firm. 2. The FM is concerned with investment and financing decisions and their interactions. 3. The FM interacts with other managers in the business to help the firm operate as efficiently as possible. 1

4. The FM links his firm to the financial markets in which funds are raised and in which the firms securities are traded. Consider the place of finance in the organisation structure

Goal of the Firm -the goal of financial management is to maximise the value of the firm. If the company does very well, the value of its share will increase. It is important to recognise that value maximisation is broader than profit maximisation because: - maximisation of value takes into account time value of money - value maximisation considers the riskness of the income stream - Profit figures can vary widely depending upon the accounting rules and conventions used. Some possible objectives
A firm can choose from an infinitely long list of possible objectives. Some of these will appear noble and easily justified, others remain hidden, implicit, embarrassing, even subconscious. The following represent some of the most frequently encountered 1. Achieving a target market share; In some industrial sectors to achieve a high share of the market gives high rewards. These may be in the form of improved profitability, survival chances or status. Quite often the winning of a particular market share is set as an objective because it acts as a proxy for other, more profound objectives, such as generating the maximum returns to shareholders. On other occasions matters can get out of hand and there is an obsessive pursuit of market share with only a thin veneer of shareholder wealth espousement 2. Keeping employee agitation to a minimum; here, return to the organisation's owners is kept to a minimum necessary level. All surplus resources are directed to mollifying employees. Managers would be very reluctant to admit publicly that they place a high priority on reducing workplace tension, encouraging peace by appeasement and thereby, it is 2

hoped, reducing their own stress levels, but actions tend to speak louder than words. Survival; There are circumstances where the overriding objective becomes the survival of the firm. Severe economic or market shock may force managers to focus purely on short-term issues to ensure the continuance of the business. They end up paying little attention to longterm growth and return to owners. However this focus is clearly inadequate in the long run - there must be other goals. If survival were the only objective then putting all the firm's cash reserves into a bank savings account might be the best option. When managers say that their objective is survival what they generally mean is the avoidance of large risks which endanger the firm's future. This may lead to a greater aversion to risk, and a rejection of activities that shareholders might wish the firm to undertake. Shareholders are in a position to diversify their investments: if one firm goes bankrupt they may be disappointed but they have other companies' shares to fall back on. However the managers of that one firm may have the majority of their income, prestige and security linked to the continuing existence of that firm. These managers may deliberately avoid highrisk/high-return investments and therefore deprive the owners of the possibility of large gains. Creating an ever-expanding empire; This is an objective which is rarely openly discussed, but it seems reasonable to propose that some managers drive a firm forward, via organic growth or mergers, because of a desire to run an ever-larger enterprise. Often these motives become clearer with hindsight; when, for instance, a firm meets a calamitous end the post mortem often reveals that profit and efficiency were given second place to growth. The volume of sales, number of employees or overall stock market value of the firm have a much closer correlation with senior executive salaries, perks and status than do returns to shareholder funds. This may motivate some individuals to promote growth. Maximisation of profit ;This is a much more acceptable objective, although not everyone would agree that maximation of profit should be the firm's purpose. Maximisation of long-term shareholder wealth; While many commentators concentrate on profit maximisation, finance experts are aware of a number of drawbacks of profit. The maximisation of the returns to shareholders in the long term is considered to be a superior goal. This list of possible objectives can easily be extended but it is not possible within the scope of this book to examine each of them. Suffice it to say, there can be an enormous variety of objectives and a large potential for conflict and confusion. We have to introduce some sort of order.

Agency Theory
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-also referred to as agency problem or contractual theory It reflects on the roles of the various participants in the organisation i.e. workers, managers, owners, lenders and define their rights, obligations, and payoffs under various conditions. Most participants bargain for limited risks and maximum returns or benefits, whereas the firms owners are liable for any residual risk and thus hold a residual claim on any assets and earnings of the firm which remain after covering costs. To deal with agency problems, additional expenditures would be required. These include: Auditing systems Bonding assurances by managers that abuses will not be practised Organisation systems to limit the ability of managers to engage in undesirable practices.

OWNERSHIP AND CONTROL


The problem In theory the shareholders, being the owners of the firm, control its activities. In practice, the large modern corporation has a very diffuse and fragmented set of shareholders and control often lies in the hands of directors. It is extremely difficult to marshal thousands of shareholders, each with a small stake in the business, to push for change. Thus in many firms we have what is called a separation, or a divorce, of ownership and control. In times past the directors would usually be the same individuals as the owners. Today, however, only a small proportion of shares of most quoted firms are owned by the directors. The separation of ownership and control raises worries that the management team may pursue objectives attractive to them, but which are not necessarily beneficial to the shareholders - this is termed 'managerialism'. This conflict is an example of the principal-agent problem. The principals (the shareholders) have to find ways of ensuring that their agents (the managers) act in their interests. This means incurring costs, 'agency costs', to (a) monitor managers' behaviour, and (b) create incentive schemes and controls for managers to encourage the pursuit of shareholders' wealth maximisation. These costs arise in addition to the agency cost of the loss of wealth caused by the extent to which prevention measures do not work and managers continue to pursue non-shareholder wealth goals.

Some solutions
Various methods have been used to try to align the actions of senior management with the interests of shareholders, that is, to achieve 'goal congruence'. 1. Linking rewards to shareholder wealth improvements A technique widely employed to grant directors and other senior managers share options. These permit managers to purchase shares at some date in the future at a price which is fixed now. If the share price rises significantly between the date when the option was granted and the date when the shares can be bought the manager can make a fortune by buying at the pre-arranged price and then selling in the market-place. The managers under such a scheme have a clear interest in achieving a rise in share price and thus congruence comes about to some extent. An alternative method is to allot shares to managers if they achieve certain performance targets, for example, growth in earnings per share or return on assets. 2. Sackings The threat of being sacked with the accompanying humiliation and financial loss may encourage managers not to diverge too far from the shareholders' wealth path. However this method is employed in extreme circumstances only. It is sometimes difficult to implement because of difficulties of making a co-ordinated shareholder effort. 3. Selling shares and the takeover threat many companies quoted on the stock market are owned by financial institutions such as pension and insurance funds. These organisations generally are not prepared to put large resources into monitoring and controlling all the hundreds of firms of which they own part. Quite often their first response if they observe that management is not acting in what they regard as their best interest, is to sell the share rather than intervene. This will result in a lower share price, making the raising of funds more difficult. If this process continues the firm may become vulnerable to a merger bid by another group of managers, resulting in a loss of top management posts. Fear of being taken over can establish some sort of backstop position to prevent shareholder wealth considerations being totally ignored. 4. Corporate governance regulations There is a considerable range of legislation and other regulatory pressures designed to encourage directors to act in shareholders' interests. The Companies Acts require certain minimum standards of behaviour, as does the Stock Exchange. Following a number of financial scandals, reports on corporate governance have attempted to improve the accountability of powerful directors. Under these non-statutory proposals, the board of directors should no longer be dominated by a single individual acting as both the chairman and chief executive. Also the nonexecutive directors should have more power to represent shareholder interests; in particular, at least three independently minded non-executives should be on the board of a large company and they should predominate in decisions connected with directors' remuneration and auditing of the firm's accounts. 5. Information flow The accounting profession, the stock exchange and the investing institutions have conducted a continuous battle to encourage or force firms to release more accurate, timely and detailed information concerning their operations. The quality of corporate accounts and annual reports has generally improved, as has the availability of other forms of information flowing to investors and analysts, such as company briefings and 5

press announcements. This all helps to monitor firms, and identify any wealthdestroying actions by wayward managers early, but as a number of recent scandals have shown, matters are still far from perfect.

Social Responsibility -Sustainability reporting involves measuring, accounting and disclosing an organisations economic, environmental and social performance to advance sustainable Development -The Global Compact is a framework for businesses that are committed to aligning their operations and strategies with ten universally accepted principles in the areas of human rights, labour, the environment and anti-corruption . As the world's largest, global corporate citizenship initiative, the Global Compact is first and foremost concerned with exhibiting and building the social legitimacy of business and markets

Assignment A basic rationale for the objective of maximizing the wealth position of the stockholder as a primary business goal is that such an objective may reflect the most efficient use of societys economic resources and thus lead to a maximization of societys economic wealth Briefly evaluate this observation.

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