Module - FinMan

CHAPTER 2 - RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL

STRATEGY AND OBJECTIVES
LEARNING OBJECTIVES
After studying Chapter 2, you should be able to:
1. Discuss the importance of objective setting in a business enterprise.
2. Describe the primary financial objectives of a business firm.
3. Explain the responsibilities of a Finance Manager to achieve the firm's financial objectives.
4. Understand the nature of environmental ("green") policies and their implications for the
management of the economy and firm.

RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND

OTHER ORGANIZATIONAL OBJECTIVES

INTRODUCTION

Finance permeates the entire business organization by providing guidance for the firm's
strategic (long-term) and day-to-day decisions. For long range planning and management
control, a business firm establishes its overall objectives. Such objectives are developed by the
top management and they usually consist of general statement or a series of statements in
general terms stating what the company expects to achieve.

Objective setting is thus, an important phase in the business enterprise since upon correct
objectives setting will the entire structure of the strategies, policies and plans of a company rest.
Firms have numerous goals but not every goal can be -attained without causing conflict in
reaching other goals. Conflicts often 'arise because of the firm's many constituents who include
shareholders, managers, employees, labor unions, customers, creditors, and suppliers. There
are those who claim that the firm's goal is to maximize sales or market share; others believe the
role of business is to provide quality products and service; still others feel that the firm has a
responsibility for the welfare of society at large. For example, the objective may be stated in
such broad terms as:

 It is the goal of the company to be a leader in technology in the industry, or

 To achieve profits through a high level manufacturing efficiency, or
 To achieve a high degree of customer satisfaction

For the purpose though of measuring performance and degree of control, it is necessary to set
objectives or goal in more precise terms. The objectives are usually in quantitative terms and
are Set within a time frame. The setting of physical targets to be accomplished within n set time
period would provide the basis of conversation of the targets into financial objectives.
STRATEGIC FINANCIAL MANAGEMENT

Strategic planning is long-range in scope and has its focus on the organization as a "whole. The
concept is based on an objective and comprehensive assessment of the present situation of the
organization and the setting up of targets to be achieved in the context of an intelligent and
knowledgeable anticipation of changes in the environment. The strategic financial planning
involves financial planning, financial forecasting, provision of finance and formulation of finance
policies which should lead the firm's survival and success.

The responsibility of a finance manager is to provide a basis and information for strategic
positioning of the firm in the industry. The firm's strategic financial planning should be able to
meet the challenges and competition, and it would lead to firm's failure or success.

The strategic financial planning should enable the firm to judicious allocation of funds,
capitalization of relative strengths,. mitigation of weaknesses, early identification of shifts in
environment, counter possible actions of competitor, reduction in financing costs, effective use
of funds deployed, timely estimation of funds requirement, identification of business and
financial risk, and so forth.

The strategic financial planning is likewise needed to counter the uncertain and imperfect
market conditions and highly competitive business environment. While framing financial
strategy, shareholders should be considered as one of the constituents of a group of
stakeholders, debenture holders, banks, financial institutions, government, managers,
employees, suppliers and' customers. The strategic planning should concentrate on
multidimensional objectives like profitability, expansion growth, survival, positioning of the firm,
reaching global markets leadership, and brand business positioning. success,The financial
policy requires the deployment of firm's resources for achieving the corporate strategic
objectives. The financial policy should align with the company's strategic planning. It allows the
firm in overcoming its weaknesses, enables the firm to maximize the utilization of its
competencies and to direct the prospective business opportunities and threats to its advantage.
Therefore, the finance manager should take the investment and finance decisions in
consonance with the corporate strategy.

A company's strategic or business plan reflects how it plans to achieve its goals and objectives.
A plan's success depends on an effective analysis of market demand and supply. Specifically, n
company must assess demand for its products and services. and assess the supply of its inputs
(both labor and capital). The plan must also include competitive analyses, opportunity
assessments and consideration of business threats.

Historical financial statements provide insight into the success of a company's strategic plan
and are an important input of the planning process. These statements highlight' portions of the
strategic plan that proved profitable and, thus, warrant additional capital investment. They also
reveal areas that are less effective and provide information to help managers develop remedial
action.

Once strategic adjustments are planned and implemented, the resulting financial statements
provide input into the planning process for the following year, and this process begins again.
Understanding a company's strategic plan helps focus our analysis of the company's short-term
and long-term financial objectives by placing them in proper context.

SHORT-TERM AND LONG-TERM FINANCIAL OBJECTIVES OF A BUSINESS

ORGANIZATION

Among are the primary financial objectives of a firm are the following:

SHORT AND MEDIUM-TERM

 Maximization of return on capital employed or return on investment

 Growth in earnings per share and price/earnings ratio through maximization of net
income or profit and adoption of optimum level of leverage
 Minimization of finance charges
 Efficient procurement and utilization of short-term, medium-term, and long-term funds

LONG-TERM

 Growth in the market value of the equity shares through maximization of the firm's market
share and sustained growth in dividend to shareholders

 Survival and sustained growth of the firm

There have been a number of different, well-developed viewpoints concerning what the primary
financial objectives of the business firm should be. The competing viewpoints are:

 The owner's perspective which hold that the only appropriate goal is to maximize
shareholder or owner 's wealth, and;

 The stakeholders' perspective which emphasizes social responsibility over profitability

(stakeholders include not only the owners and shareholders, but also include the business's
customers, employees and local commitments).

While strong arguments speak in favor of both perspectives, financial practitioners and
academics now tend to believe that the manager's primary responsibility should be to maximize
shareholder's wealth and give only secondary consideration to other stakeholders' welfare.

Adam Smith, an 1 8th century economist was one of the first and well known proponent of this
viewpoint. He argued that, in capitalism, an individual pursuing his own interest tends also to
promote the good of his community. He also pointed out that acting through competition and the
free price system, only those activities most efficient and beneficial to society as a whole would
survive in the long run. Thus, those same activities would alsö profit the individual most. Owners
of the firm hire managers to work on their behalf, so the manager is morally, ethically, and
legally required to act in the owners' best interests. Any relationships between the manager and
other firm stakeholders are necessarily secondary to the objective that shareholders give to their
hired managers.
The financial manager must have some goals or objectives io guide decision involving the
management of the firm's assets, liabilities and equity. Hence, priorities must be set to resolve
conflicting goals.

To reiterate, the primary financial goal of the firm is to maximize the wealth ofits existing
shareholders or owners. Therefore, the overriding premise of financial management is that the
firm should be managed to enhance owner well being. Shareholder's wealth depends on both
the dividends paid and the market price•of the equity shares. Wealth is maximized by providing
the shareholders with target attainable combination of dividends per share and share price
appreciation. While this may not be a perfect measure of shareholders' wealth, it is considered
one of the best available measures.

The wealth maximization goal is advocated on the following grounds:

 It considers the risk and time value of money

 It considers all future cash flow, dividends and earnings per share

 It suggests the regular and consistent dividend payments to the shareholders

 The financial decisions are taken with a view to improve the capital appreciation of the
share price

 Maximization of firm's value is reflected in the market price of share since it depends on
shareholder's expectations regarding profitability, long-run prospects, timing difference of
returns, risk distribution of returns of the firm

Critics of the wealth maximization objective however say that, this objective is narrow and
ignores the concept of wealth maximization of society since society's resources are used to the
advantage only of particular firm. The optimal allocation of the society's resources should result
in capital formation and growth of the economy which should ultimately lead to maximization of
economic welfare of the society.

RESPONSIBILITIES TO ACHIEVE THE FINANCIAL OBJECTIVES

1. INVESTING

The finance manager is responsible for determining how scarce resources or funds are
committed to projects. The investing function deals with managing the firm's assets. Because
the firm has numerous alternative uses of funds, the financial manager strives to allocate funds
wisely within the firm. This task requires both the mix and type of assets to hold. The asset mix
refers to the amount of pesos invested in current and fixed assets.

The investment decisions should aim at investments in assets only when they are expected to
earn a return greater than a minimum acceptable return which is also called as hurdle rate. This
minimum return should consider whether the money raised from debt or equity meets the
returns on investments made elsewhere on similar investments.

The following areas are examples of investing decisions of a finance manager:

A. Evaluation and selection of capital investment proposal

B. Determination of the total amount of funds that a firm can commit for investment

C. Prioritization of investment alternatives

D. Funds allocation and its rationing

E. Determination of the levels of • investments in working capital (i.e. inventory, receivables,

cash, marketable securities and its management)

F. Determination of fixed assets to be acquired

G. Asset replacement decisions

H. Purchase or lease decisions

I. Restructuring reorganization mergers and acquisition

J. Securities analysis and portfolio management

2. FINANCING

The finance manager is concerned with the ways in which the firm obtains and manages the
financing it needs to support its investments. The financing objective asserts that the mix of debt
and equity chosen to finance investments should maximize the value of investments made.
Financing decisions call for good knowledge of costs of raising funds, procedures in hedging
risk, different financial instruments and obligation attached to them. In fund raising decisions,
the finance manager should keep in view how and where to raise the money, determination of
the debt-equity mix, impact of interest, and inflation rates on the firm, and so forth.

The finance manager will be involved in the following finance decisions:

a. Determination of the financing pattern of short-term, medium-term and long-term funds

requirements

b. Determination of the best capital structure or mixture of debt and equity financing

C. Procurement of funds through the issuance of financial instruments such as equity shares,
preference shares, bonds, long-term notes, and so forth
D. Arrangement with bankers, suppliers, and creditors for its working capital, medium-term and
other long-term funds requirement

E. Evaluation of alternative sources of funds

3. OPERATING

This third responsibility area of the finance manager concerns working capital management.
The term working capital refers to a firm short-term asset (i.e., inventory, receivables, cash, and
short-term investments) and its short-term liabilities (i.e., accounts payable, short-term loans).
Managing the firm's working capital is a day-to-day responsibility that ensures that the firm has
sufficient resources to continue its operations and avoid costly interruptions. This also involves a
number of activities ,related to the firm's receipts and disbursements of cash.

Some issues that may have to be resolved in relation to managing a firm's working capital are:

A. The level of cash, securities and inventory that should be kept on hand

B. The credit policy (i.e., should the firm sell on credit? If so, what terms should be extended?)

C. Source of short-term financing (i.e., if the firm would borrow in the short-term, how and where
should it borrow?)

D. Financing purchases of goods (i.e.,e should the firm purchase its raw materials or
merchandise on credit or Should it borrow in the short-term and pay cash?)

ENVIRONMENTAL "GREEN" POLICIES AND THEIR IMPLICATIONS FOR THE

MANAGEMENT OF THE ECONOMY AND FIRM
Private property rights can promote prosperity and cooperation and at the same time protect the
environment, but do they protect the environment sufficiently? In recent years, people have
increasingly turned to the government to achieve additional environmental improvements.
Sometimes, people turned to government because property rights failed to hold polluters
accountable for the costs they were •imposing on others. In these "external cost cases",
government may be able to improve accountability and protect rights more efficiently by
regulation. In other instances, people with strong desires for various environmental amenities
(for example, green spaces, hiking trails and wilderness Elands) want the government to force
others to help pay for them.
Courts help owners protect their property against invasions by others, including polluters. In
some cases however, it is difficult — if not impossible to define, establish and fully protect
property rights. This is particularly true when there is either a large number of polluters or a
large number of people harmed by the emissions, or both. In these large numbers of cases,
high transaction costs undermine the effectiveness of the property rights — market exchange
approach. For example, consider the air quality in a large city such as Manila or Quezon City.
Millions of people are harmed when pollutants are put into the air. But millions of people also
contribute to the pollution as they drive their cars. Property rights alone will be unable to handle
large-number cases like this efficiently. More direct regulations may generate a better outcome.
Although government regulation is an alternative method of protecting the environment, the
regulatory approach also has a \number of deficiencies. First, government regulation is often
sought precisely because the harms are uncertain and the source of the problem cannot be
demonstrated, so relief from the courts is difficult to obtain. But -when the harms are uncertain,
so are the benefits of reducing them. Second, by its very nature, regulation overrides or ignores
the information and incentives provided by market signals. Accountability of regulators for the
costs they impose is lacking, just as accountability for polluters is missing in the market sector
when secure and tradable property rights are not in place. The tunnel vision of regulators, each
assigned to oversee a small part of the economy, is not properly constrained by readily
observable costs. Third, regulation allows special interests to use political power to achieve
objectives that may be quite different from the environmental goals originally announced. The
global warming issue illustrates all of these problems and the uncertainties that they generate.

People turn to government to get what they cannot get in markets. In many cases, they are
seeking to get what they want with a subsidy from others. Government can provide protection
from harms, as in regulation that reduces pollution, or production of goods and services, as in
the provision of national parks. Government can indeed shift the cost of services from some
citizens to others,

and can do the same with benefits froni its programs. There is little reason, however, to expect a
net increase in efficiency when the government steps in. That is true in environmental matters,
as well as in many other areas of citizen concern.

When it is difficult to assign and enforce private property rights, markets often result in
outcomes that are inefficient. This is often the case when large numbers of people engage in
actions that impose harm on others. Government regulation has some premise but also poses
some problems of its own.

Global warming could exert a sizeable, adverse impact on human welfare, but there is
considerable uncertainty about both its cause and the potential gains that might be derived from
regulations such as those of the Kyoto treaty. Global temperature changes have been observed
previously. We do not know that the current warming is the result of human activity. We do not
even know whether on balance, a warming would exert an, adverse impact. These uncertainties
increase the attractiveness of adaptation as an option to regulation.

Market-like schemes can reduce the costs of reaching a chosen environment goal, but the
programs provide little help in choosing the right goal.

Government ownership of national parks, as with other lands, has brought troublesome results
along with benefits, but there seems to be progress in moving closer to market solutions that
provide better information and incentives for government managers.

Given .that stock market investors emphasize financial results and .the maximization of
shareholder value, one can wonder if it makes sense for a company to be socially responsible.
Can companies be socially responsible and oriented toward shareholder wealth at the same
time? Many businessmen think so and so most big business establishments that they have
adopted well-laid environmental-saving strategies that can observe such as recycling programs,
pollution control, tree-planting activities •and so forth. The benefits come a little at a time but one
can be sure they will add up. If an investor wants wealth maximization, management that
minimizes wastes might do the other little things right that make a company well-run and
profitable.

REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital).
What kinds of goals do you think would be appropriate?

2. Evaluate the following statement: Managers should not focus on the current stock value
because doing so will lead to an overemphasis on short-term profits at the expense of long-term
profits.

3. If a company's board of directors wants management to maximize shareholders' wealth,

should the CEO's compensation be set as a fixed amount, or should the compensation depend
on how well the firm performs? If it is to be based on performance, how should performance be
measured? Would it be easier to measure performance by the growth rate in reported profits or
the growth rate in the stock's intrinsic value? Which would be the better performance measure?
Why?

4. Should stockholder wealth maximization be thought of as a long-term or short-term goal? For

example, if one action increases a firm's stock price from a current level of P 1,000 to P2,000 in
6 months and then to P3,000 in 5 years but another action keeps the stock at PI 000 for several
years but then increases it to P4,000 in 5 years, which action would be better? Think of some
specific corporate actions that have these general tendencies.

5. What are some actions that stockholders can take to ensure that management's and
stockholders' interests are aligned?

6. The president of Southern Tagalog Corporation (STC) made this statement in the company's
annual report: "STC's primary goal is to increase the value of our common stockholder's equity".
Later s in the report, the following announcements were made:

a. The company contributed PI .5 million to the symphony orchestra.

B. company is spending P500 million to open n new plant and expand operations. No profits will
be produced by the operation for 4 years. so earnings will be depressed during this period
versus what they would have been had the decision been made not to expand.

C. The company holds About half of its assets in the form of government treasury bonde and it
keeps these funds available for use in emergencies. In the future, though. STC plans to shift its
emergency funds from treasury bonds to common stocks,
Discuss how SVC's stockholders might view each of these actions and how the actions might
affect the stock price.

7. Miguel Enterprises recently made a large investment to upgrade its technology. While these
improvements won't have much effect on performance in the short run, they are expected to
reduce future costs significantly.' What effect will this investment have on Miguel Enterprises'
earnings per share this year? What effect might this investment have on the company's intrinsic
value and stock price?

II Multiple Choice Questions

1. Which of the following statements is -true?

a. The higher thé profit of a firm, the higher the value of the firm is assured of receiving' in the
market.
b. Social responsibility and profit maximization are synonymous..
c. Maximizing the earnings of the firm is the primary goal oi financial management.
d. There are some serious problems with the financial goal of maximizing the earnings of the
firm.

2. Corporate social responsibility is

A. effectively enforced through the controls envisioned by classical economics.
B. the obligation to shareholders to earn a profit.
C. the duty to embrace service to the public interest.
D. the obligation to serve long-term organizational interests.

3. A •common argument against corporate involvement in socially responsible behavior is that

A. It encourages government intrusion in decision making.
B. as a legal person,• a corporation is accountable for,its conduct.
C. It creates goodwill.
d. in a competitive market, such behavior incurs 'costs that place the company at a
disadvantage.

4. Which of the following statements is false?

A. Because socially desirable goals can impede profitability in many instances, managers
should not try to operate under the assumption of wealth maximization.
B. As finance emerged as a new field, much emphasis was placed on mergers and acquisitions.
C. Timing is a particularly important consideration in financial decisions.
D. During the 1930s, the government assumed a much greater role in regulating the securities
industry.

5. Which of the following statements is false?

A. In the mid 1950s, finance began to change to a more analytical, decision oriented approach:
B. Recently, the émphasis 'Of financial management has been on the relationships between risk
and returns.
C. Inflation has led to phantom profits and undervalued assets.
D. For as long as satisfactory level of profit is earned, the financial manager need not be
concerned with unethical behavior.