You are on page 1of 12

Chapter 1: The Goal of the

Firm
Alternative goals of the firm:
1.
2.
3.
4.
5.
6.
7.

Maximization of profits
Maximization of sales
Survival of the firm
Achieving a satisfactory level of profit
Achieving a target market share
Minimization of employee turnover
Finally wealth maximization
1-1

Goal of a firm: Profit Maximization Vs.


Wealth Maximization

Vagueness in definition: There are many


definitions of Profit and so it is vaguely defined.
Wealth is the present value of all future
dividends which is readily observed in current
share price at the market.
Profit is an annual concept and so it is a short
term concept but wealth is a long term concept.
Profit can be manipulated by the management
(like window dressing) but wealth is beyond the
direct manipulation of management.
Risk consideration. The theory of risk says that
risk and return is proportional. Profit can not be
increased without increasing risk.
1-2

Why is Wealth Maximization?


For overcoming the following drawbacks of
profit maximization, wealth maximization
is considered as ultimate goal:
Vagueness in definition
No standard/measurement/base
Profit is an annual concept
Profit can be manipulated by the
management (like window dressing)
No risk consideration
1-3

Financial Goals of the


Corporation

The primary financial goal is


shareholder wealth maximization,
which translates to maximizing
stock price.

Do firms have any responsibilities to


society at large?
Is stock price maximization good or
bad for society?
Should firms behave ethically?
1-4

Is stock price maximization


the same as profit
maximization?
No, despite a generally high

correlation amongst stock price, EPS,


and cash flow.
Current stock price relies upon current
earnings, as well as future earnings
and cash flow.
Some actions may cause an increase
in earnings, yet cause the stock price
to decrease (and vice versa).
1-5

Agency relationships

An agency relationship exists


whenever a principal hires an
agent to act on their behalf.

Within a corporation, agency


relationships exist between:

Shareholders and managers

Shareholders and creditors


1-6

Shareholders versus
Managers

Managers are naturally inclined to


act in their own best interests.
But the following factors affect
managerial behavior:

Managerial compensation plans


Direct intervention by shareholders
The threat of firing
The threat of takeover
1-7

Shareholders versus
Creditors

Shareholders (through managers)


could take actions to maximize
stock price that are detrimental to
creditors.

In the long run, such actions will


raise the cost of debt and
ultimately lower stock price.
1-8

Factors that affect stock


price

Projected cash
flows to
shareholders

Timing of the
cash flow stream

Riskiness of the
cash flows

1-9

Multinational vs Domestic Capital


Budgeting

Different currency denominations


Economic and legal ramifications
Language differences
Cultural differences
Role of governments
Political risk
1-10

Agency
considerations:
motivating
The delegation
of decision making
authority from
management
owners to managers is termed as agency theory.
It deals with potential conflicts of interest between
Outside shareholder and management. Three
Major types of potential conflict have been
identified:
1 Management may utilize corporate resources to provide themselves
perquisites.
2. Management may have shorter time horizon than shareholders
about selection of projects.
3. Management and owners may differ as to the evaluation of risk.
1-11

Agency Relationship

Stockholders vs Managers

Stockholders vs Creditors

( managerial
compensation, threat of firing, shareholders
intervention and threat of takeover)
( not to make
investment in high risky assets, not to borrow
fund from others, not to give higher proportion of
dividend and not to sale existing assets)

1-12