Slide 1.1
Corporate Financial
Management, 3rd edition
Glen Arnold
Lecture 1
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.2
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.
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.3
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
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.4
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
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.5
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
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.6
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
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.7
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.
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.8
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.
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.9
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.
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.10
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.
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.11
Profit maximisation is not the same as
shareholder wealth maximisation
• Prospects
• Risk
• Accounting problems
• Communication
• Additional capital
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.12
Exhibit 1.8 Two firms with identical average profits but different risk levels
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.13
Ownership and control
• The problem
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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 work
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.14
Ownership and control
• Aligning the actions of senior management with the interests
of shareholders ‘goal congruence’
• Some solutions
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Linking rewards to shareholder wealth improvements
Sackings
Selling shares and the takeover threat
Corporate governance regulations
Information flow
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.15
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.
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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.
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005
Slide 1.16
Lecture review 2
• Profit maximisation: different from shareholder wealth maximisation
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Future prospects
Risk
Survival
Accounting problems
Communication
Additional capital
• Separation of ownership and control
• Managerialism
• Principal–agent problem:
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Some solutions:
Link managerial rewards to shareholder wealth improvement
Sackings
Selling shares and the takeover threat
Corporate governance regulation
Improve information flow
Arnold, Corporate Financial Management, 3rd edition © Pearson Education Limited 2005