Learning outcomes:

By the end of this lecture you should be able to:

 Describe alternative views on the purpose of the

business.
 Explain the role of the financial manager.
In whose interests is the firm run?

A company has responsibilities to a number of interested parties

Arnold, Glen (2013), Corporate financial management, Financial Times & Prentice Hall, 5th Edition, p4.
Goals of corporation
• What is the correct financial
objective?
– Minimize costs?
– Minimize the risk?
– Maximize sales or market
share?
– Maximize profit?
– Maximize shareholder wealth?
The assumed objective for the Finance:
 The company should make investment and financing
decisions with the aim of maximising long – term
shareholder wealth.

WHY?
Theoretical reasons:

 Shareholders, on the other hand, are asked to put money

into the business at high risk.
 The deal hear is, you gave us your £ 10000 that you
need for your retirement,
 The directors of the firm, do not promise that you will
receive a dividend or even see your capital again.
 Because of this unfair balance of risk between the
different potential claimants,
 It seems reasonable that the owners should be entitled
to any surplus returns which result after all the other
parties have been satisfied.
Profit vs shareholder wealth
maximisation.
 Profit is a concept developed by accountants to aid
decision making.
 There are many reasons why accounting profit may not
be a good proxy for shareholder wealth:
• Risk:
Two firms have reported identical profit figures and
have the same future prospect, however one firm's
returns are more volatile, see the following diagram.
Profit vs shareholder wealth maximisation.

Arnold, Glen (2013), Corporate financial management, Financial Times & Prentice Hall, 5th Edition, p15.
Profit vs shareholder wealth
maximisation.
• Accounting problems:
Profits can vary significantly depending on
inventory costing system and / or depreciation
method.
• Additional capital:
Profits can be increased simply by making use of
more shareholders' money, however the return
on equity may fall.
What shareholders
desire?
• From shareholders’ point of view, generally
accepted objective is to
– Maximize shareholders’ wealth
• Maximising the wealth of shareholders is
equivalent to maximise the price per share
of existing stock.
MCQ

 In finance theory the objective of the firm is assumed to

be:
A) Profit maximisation.
B) Long-term shareholder wealth maximisation.
C) A maximisation of returns to all stakeholders.
D) A maximisation of returns to managers
and the labour force.
Role of financial managers
• To create value, the financial manager should:
– Make right investment/capital budgeting
decisions
 How much to invest and in what?
– Make a proper financial and dividend
decisions
 How should a project be financed?
 How much the earnings should be distributed
to investors?
 Cont.

Do managers maximize shareholder wealth?

Agency problems
• Agency relationship: Stockholders
(principals) hire managers (agents) to run
the company
• Managers, acting as agents for
stockholders, may act in their own interests
rather than maximizing value.
• Shareholders incur costs to monitor the
managers and constrain their actions – the
cost resulting from such conflict is
termed agency cost.
Managing managers
Ways to deal with agency problem, involving
• Managerial compensation
– Incentives can be used to align management
and stockholder interests
• Corporate control
– Management audits & reporting
requirements
• Takeovers
– The threat of a takeover may result in better
management
MCQ
The principal-agent problem is:
A) When stockbrokers fail to collect principal payments on a
financial security on behalf of the owner.
B) When the principals (e.g. shareholders) have to incur the
expense of ensuring that agents (e.g. managers) act in
the interest of the principals.
C) When agents (e.g. brokers) ask for additional payments
to carry out a transaction.
D) When there is a breakdown of communication between
principals (e.g. shareholders) and agents (e.g.
managers).