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Chapter 2 Financial Management by Cabrera

BS Accountancy (Universidad de Manila)

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CHAPTER .

-~~. 2·• .·
. '
~ELATIONSHIP 'OF•FINANCIAL.
·, ,_·'_'- . ·: : OBJECTIVES'· to · . · ·
' ORGANIZATIQNAt STlt.ATEGY
AWD'O~ECT~S
( I

' )
, ·.·~ec~etf.C~mi1i_J'l!ufcO!!Ji1 __. ,' \ I

I.. : '

After-studying Cha'pter.2! You shciutd be ,able to: --

, 1' 7 • • \ ' .

-
1. . Dis_cuss the importance ·of obje~tive setting in · r
.~--a · 6usiness enterprise.
.- ,
· 2. Describe
.
the 'prir:nary
I •
flhdndar
• . .
objectives
'
of a
· , business firm. -. · · ·. ·_· . ·

·3, .. -Expla_in .the/ responsibilities ·of 'c{ Finance

Manager to achieve,the firrn's financial
':' ·· objedives. --- : ·

4-. Understand the nature of environmental

· ("9reen") poli_
cies and their implications for
the· management the economy and .
firm. of. .

•-•·•·-•
. <
J·
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caAPTER 2

RELATIONSHIP OF
FINANCIAL .O BJECTIVES TO
ORGANIZATIONAL STRATEGY AN!)
'O THER ORGANIZATIONAL
, OBJECTIVES
,•

INTRODUCTION

At one time or another, most people have had°occasion to hire agents to take care
of a specific matter. In doing so, responsibility is delegated to another person.-For
example, when suing for damages, individuals may represent themselves or may ·
hire ·!l lawyer to plead their case 1n court. As an agent, the lawyer is given the
assignment to get the highest possible award. And so, it is with shareholders when
· they ,delegate the task ofrunning a firm to a _
financial manager who acts as an agent
1
.

of the company. Obviously, the goal is to achieve the highest value of an equity
share for the firm's owners. But there are no standard rules that indicate which '
course of·action should- be followed by managers to.achieve this. The ultimate
guideline is how investors perceive the' actions of managers. A· good_way' .to
motivate managers is to offer them lucrative sh.are options· linked to performance.

Finance permeates the entire business organization by providing guidance for th~
firm's strategic (long-term) and day-to-day decisions. For long range planning and
management con~rol, .a business firm establishes its ove111ll obj~ctives. Such ·
objectives are developed by the top . management and they usually. consist of
·general statement_or a series of statements _in ,general term_s stating wh_a t the
company expects to achieve.

Objective setting is thus: an imp9rtant phase in the business:e~terprise since upon

correct objectives setting will the entire structure of the strategies, polici~s 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 ofte~. arise
beca11se of the firm's many constituents who .include share~olders; managers,_
employees, labor unions, CU!itoiners,"creditors, and suppliers~The·~ are th~se who
· claim til,at the firm's goal is to maximize sales or market share; others believe the
role of business i~ to provide quali~ products and service; still others feel that the

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16 Chapter' ]

finn has a ·responsibili~ for the welfare .of,so~(ety at large. For example, the
objective m~y·be stated in such broad te'rms as:
• It is the _goal o(t?e co,111pany to b,e a le;ider in technology in the industry,
m .
• To acnieve pr~fiis through ihighi°level manufacturing efficiency, dr \ ·
• :fo·acfi'ieve a high degree of
. customer s;iiisfaction.
.
·
. i - . ! . ,.. - • • . . ' t

For· the purpose though of measuring performance .and degree <;>f control,' it js
necessary to set objectives or goal in more pr~cise terms. The objectives are usually
in quantitative terms and are set within a time frame. The setting of physi~_al ,targets
_to be a~complished within a set time period would provide the basis of conversion
of the targets into financial objective~.

STRATEGIC FINANCIAL MANAGEMENT

Strategic planning is long-range in scope and has its foctls bn the organization as
a' whole. The concept is based on an objective and comprehensive assessment of
the present situation of the organiz;ition and the setting up of targets to be achieved
in the context of an intelligent and knowledgeable an~cipation of changes _in the
environment. The strategic financial planning involves financial planning,.
_firymc-ial forecasting; provision of finance and forrnulatio~ of finance _policies.
which should lead the firm's survjval and succe·ss.
.'
The responsibility of a finance m'anager is to provide a basis and information for
strategic positioning of the firm in the industry. The firm's strategic ;financial
plann.ing should be·able to meet the challenges and 'competition, and it would lead
to firm's failu·re or success. - ·. . ' . - ' ·'
I

The strategic financial planri1ng should enable the firm to judicious a!location _of
funds, . ·capitalization of relative strengths, mitigation ' of- weaknesses, early
identification of shifts_in environm.ent, counter p·ossible 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 fot:h: ' ·,

The strategi~ financial planning is likewise needed io: counter the uncertain a?d
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, fina_nclal .
. institutions,. government, managers, employees, suppliers' ·and customers. ~he
strategic planning should concentrate on : multidimensional objectives Itke
.r

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Relatignshlp of Financial Ob~cti,,_es to Org_anizatiorfal Str~tegy and ... 17

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profitability;.expansion growth; survival, leadership, business success, positioning
of the firm, reaching global i:narkets and brand positioning. The .financial policy
requires the deployment of firm's resourc,es for achieviilg the corporate s!T3tegic
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 competendies 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 ·wlth thi,: corporate
strategy.

A company's strategic or business plan reflec,ts how it plans to achieve its goals
and objectives. A ·plan ' s success depends on an effective an~lysis ·of market
demand and supply. Specifically, a 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 importa!lt input of the ·planning process. These statements
highlight portions of the strntegic 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 st~tegic adjustments are planned and ·implemented, the resulting ,financial
statemerits provide input into the planniJ!g process for the·following year, and this-
pro<;ess begins again .. Understanding a company' s strategic plan helps focus our
2nalysis of the company's sht>rt-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 e~mings p~r- share and price/earnings tatio through
maximization of net income or profit and adoption of optimum level of
l~verage · ·
• 'Mirtimization offinrutce charges ·

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18 Chapter 2

• ' 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 ma~ket share and sustained growth in dividend to shareholdets
• ' Survival and sustained growth. of the firm I

There ~ave been a number_qf diffe~erit, well-developed viewpoints concemi~g

what tfie primary financial objectives of the business firm · should be. The
.competing viewpoints are: · · ·
-
• The owner's perspectiye which holds 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 ofbo.th perspectives, financial practiti"Oners

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 Smfth, .an 1gri, 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 h·is community. He als~ pointed
out thafactingthrough ·competition and the free price system, only those activities
most efficient and beneficial to society as a whole would survive in the lo~g run.
Thus, thqse· same activities.would also profit the individual 1nost1 ,O wners of the .
firm hire managers to work on their behalf, so .the manager is morally, ethically,
and-legally required to act in the own.ers' best interests . .Any relationship~ betwe~n-_
the manager and other firm stakeholders are necessarily secondary to the objective
that shareholders· give to' their hired managers: .. · .
.. I
The financial manager must have some go1,1ls or objectives to guide df;cision
in_volving the man11;gement ·of the firm's assets, liabilities and equity. Hence,
priorities must' be set to resolve conflicting ·goals .. I

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RelatloMhip of Financial Objectives to Organizational Strategy and ... l9

To reiterate, the primary financialgoal of the fi'nn is to ~;mize the wealth of its
existing ,hareholders or. owners. Therefore, the overriding premise of fin~cial
management is that the firm should be manag~ to, enhapce owner(s) well-being.
Shareholder's wealth depends on both the dividends paid aµd the market price_of .
the equity shares. Wealth is maximiz.ed by providing the shareholders with the
target attainable combination of dividends per share and share price appreciation.
While -this may not ,be a pei:fect measure of shareholders' wealth, it is considered
one of the best ava_ilable measures. · ·

The wealth maximiza~ion goal is advocated on the following grounds:

• It considers the risk and time value of money

• It considers an 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 di~bution of returns of the
firm

Critics of the wealth maximization objective however say that, this objective is
nan-ow -and ignores the co'ncept of wealth maximization of society since society' s
resources are used to the advantage only of a particular firm. The optimal
allocation of the society's resources should result in capitlll formation and growth .
. of the economy which should ultimatelyJead to-maximization of economic welfare
of the society'. ·

RESPONSIBI_LITIES TO ACHIEVE THE FINANCIAL OBJECTIVES

INVESTING

· The finance manager is responsible for determining how scarce resources or-funds
are committed to projects. Th_e iJvestihg 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 anrl' type of assets to hold. The asset mix refers to the af!lOUnt of pesos
invested in current and fixed· assets. .

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20 Cha:£;rp.:.:te::...r..=2_•- - - - - - - - - - - ' - - - - - -

The investment decisions should aim at ,nv'~~tments in assets only when· they
expected to earn a return greater than a minimum acceptable return -wlii~h is alsb
Jc
called as· hurdle rare: This minimum retorn should consider wfieth,er the money
raised fi-on't debt (or· equity meets the ret_ums on investmen~s made elsewhere ·on
·similar investments. · · · ·' . . · · 1, . · •
1'i .

The foll~wing a~eas

, . are
.
a
exa~plei of investing·decisions of .. fintmce'manager:
~·
a. Evaluation and selection o(capital investment proposal · -"
b. Detellnination' of the·total amount of funds that a firm c:an pommit for
. investment
C. Prioritization 'o f investment alternative's 1'i

d. Fu.nds allocation and its rationi11g

e. Determin~tion of the ,levels of invesri,tents in working capital /i.e.
inventory, receiva/J/es, cash, marketable securities and its nwnagement) ·
f. Deter,mination of fixed assets to be acquired ' ·
g. A_sset re.placement-decisions ' '
··h. Purchase or lease decis-ions ·
i. Restructuring reorganization mergers and acquisition
j: Securities analysis-and portfoiio managetne~t ~.,

FINANCING

.The financ~ manag~r is concerned ~ith .the ways. in which the firm obtains and
· manages ihe 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 ~ade. Financing decisions call for good
knowledge of costs of raising funds, ·procedures i_n hedging risk, different financial
instruments -and obligation attached to them. In fund raising decisions, the finance
maoager ~hould.l~tep 'ip -yiey,, how and,where to raise the money, det~rmination of .
the debt-equity mix, impact of interest, and.inflation rates on the firm, and so forth .

The finance manager w!II be involved in th·e following finance decisions:

a. Dete~inati~n. 9f the fi~ancing' patte~n _of;shoit-term, m 1
ediuf te.~m _and
· long-~erm funds requirements · · .· ,
b. D~terinin_ation of.the best capital structure or mixture of d~bt and equity
financing · '· · '· · .' '
';.;.

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Relationship of_ Financial Obje_ctives to OrE!!ni!ational Strategy and ·... 21

c. Procurement 'of funds through the issuance of financial _instruments such

' as equity shares, preference shares, bonds, lo~g-term notes, and so forth
d. Arrdngement with bankers, suppliers, and creditors for its working' capital,
medium-term and other long-term funds requirement
e. Evaluation cif alternative-sources of funds
,I

OPERATING
f '
This thi~d 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, ats short-term
liabilities (i.e.; <Jccounts payable, short-term loans). Managing the firm'.s working
capital is , a day-to-day responsjbility that ensures that the firm -has sufficient
resources. to continue its operations and avoid costly interruptions. This also
involves a num~er 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 leyel of cash, securities and inventory that should be kept" on hand
b. The credit policy·(i .~., should the firm seli° o~ credit? .lfso, what terms
shou1ci be extehded?)
I(' ', " •., •.• • •

c. Soutce of short-term financing (I.e., if the firm would borrow in the short-
tem,i, how and where shoµld it borrow?) ·
d. ,Fin311cing purchases of goods (i.e., should ~he firm p_urchase its raw
material.s or "inerchandise on credit or should it borrow in the ·short-term
~nd,pay cash?)

ENVIRONMENTAL "GREEN" POUCIES AND THEIR IMPUCATIONS

FOR THE M~NAGEMENT 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 tlie environment sufficiently?·Jn
recent" years;: Jjeople have increasingly ·turned to the government to achieve
additional environmental improyerilerits. Sometimes; people.turned to government
because property rights°failed to hold pollute~ accouptable for the costs they were
imposing on others. In these "external ·cost cases", government may• be able to
improve·a.ccountability and protect rights more efficiently by regulation . In other··

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22 ChaE_ter 2
instances, people ~ith strong desires for various environmental amenities (for
-example, green spaces, hiking trails and.wilderness land~)want the govem'1tent to ·
force others to help pay for them.

Courts help owners protect their prc;,perty against invasions by others; including
polluters. ln 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 .etfectiveness of the property rights - market exchante approach.
For example, consider the air quality in a large city such~ Manila or Quezon City.
Millions of people are harmed when pollutants are put into the air. But millions of ·
peopl.e also contribute to the pollution as they <!rive 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

environmept, the regulatory approach also has a number of deficiencies; Fi'rst,
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 inforination
· 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 ov~rsee a ·small part of the economy, is ·not
properly constrained by-readiJy·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 issoe
illustrates all of ~hese problems and the unc.ertainties that they generate.

People tum 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 p~llution, or
production of · g~ods an~ ~ervices, as in the provision _o f national parks.
Government can .mdeed shift the cost of services from some citizens to others. and
can ~o the sam~ with b~i1efits from its programs. There is little reason, however,
to e~pect a t1et.mcrease m efficiency when the government steps in. That is true in
environmental matters, as well as in many other areas of citizen concern.
. .

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Relationship of FLnancia/ Objectives to Organizational Strategy anii... 23

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 erigage in actions that impose harm on others. Gov~rnment regulation
has some premise but also poses some problems of its.own.

Glob~I warming c_ould exert a si:zeable adverse impact on human welfai;e, but there
1 s,eonsiderable uncertainty about both its caµse and the potential gains that might
be derived from regulations such as those of the Kyoto treaty. Global temperature
changes h~ve been observed previously. We do not know that the current warm'ing
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 OP.tion 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 la"ds, has brought
troublesome results along with benefit~, 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 sbareholder value, one can wonder if it makes sense· for a
c.ompany to be socially responsible. Can companies be socially responsible and
oriented tow~rd shareholder wealth at the same time? Many businessmen think so .
and so do most big business. est!lblishments that they have adopted well-laid
environme.ntal-savfog 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 pe sure they will add up. If an investor WaIJts wealth
maximization, management that minim_izes wastes might do the .other little things
right that make a company well-run and profitable.

Ii I,

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24 Chapter 2

REVIEW QUESTIONS

Questions .

I: . Suppose you were the financial manag~r of a not-for-profi_t busine~s (a

not-for-profit hospital): What kinds ·of goals do you thin!<. would . be
appropriate? .,
\

. 2. What ki nds of conflicts con.front the financial managers as an ~gerit ·of

the firm? How can a firm attract the best managers?

3. Does knowledge of financial theory and statistical ·approaches give a

manager all the ans~ers in solving financial problems? Explain. .

4. Evaluate the following statement: Managers ·shou Id 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. . ..

5. If a company ' s board of director~ wants m'a nagement to maximize -.:.- '
shareholders ' wealth, should the CEO ' s compensation be set as a fixed
amount,' er should the compensation depend on ~ow well the firm ,
performs? If it i_s to be based on performa1ice, how should performant e be _
measured? Wou Id' it be easier to measure performance by the growth 'rate •
in reported profits or the growth rate in the stock' s in.trinsic value? Which ·,
woulq_ be the better performance -measure? Why? . · ·' .,

6. · 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 bf It 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 corpo~ate actions that have these general tendencies. .
· 7. What are some actions that stockholders · can take to ensure_ that
management's .a nd stockholders'· interests are aligned?

,.

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Relatio_nship of Financial Objectives to Organizational Strategy and. .. 25

8. 'The president of Southern Tagalog <;orporation (STC) made this statement

iq the company's annual report: " STC's primary goal is to increase the
vafue of our common stockholder's equity". Later in the report, the
following announcements were made:

a.· The company contributed Pl .5 million to the symphony orchestra.

b. T.he company is spending PS00 million to open a 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 liad the decision been made not to expand.
c. The company holds about half of its assets in the form of government
treasury bonds, and it keeps these funds available for us'e in
emergencies. In the future, though, STC plans to shift its emergency
funds from treasury bonds to common stocks.

Discus; how STC '.s stockholders might view each of these actions and
.how the actions might affect the stock price.

9. Miguel Enterprises re~ently made a large investment to upgrade its

technology. While these improvements won 't have .much effect on
perfollllance in the short nm, they are expected to reduce future costs
significantly. Whafeffect will this investment have on Miguel Enterprises'
earnings per share this year? What effect might this investment have on
the compl\ny's intrinsic value _and s~ock price?

Multiple Choice Questions, ·

1. Which of the following statements is true?

a. The higher th_e profit of a firm, the higher the value of the firm is
assure~ of. receiving in the market.
b. , Social responsi_bility and profit maximization !1Te syrronymous.
· c. · Maximizing the earnings of the ·firm is the primary goal of
financial management. ·
d-. There are · some serious problems with the financial goal of ·
· maximizing th~ earnings of the finn .

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26 Chapter 2

2. Corporate _social responsibility _is , ·

a. . effectively enforced through the_controls envisioned by classfoat
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 involve~ent in socially

responsible behavior is that. ·
a. It encourages government intrusion in decisi91\ 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 af 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 securi_ties 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 emphasis 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..
....
6. Integrity is an ethical requirement for all financial managers. One _aspect
of integrity requires · · · · . _
a. Performance · of professional duties in accordance with apphcable
laws.
b. Avoidable of conflict of interest.
c. Refraining from-improper use of inside information.
d. Maintenance of 3!1 'appropriate level of professional competence.

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