Financial Management Primary Objective

Read Chapter 1 and explain the primary objective of financial management and how acting to achieve that objective benefits society as a whole.

Intro to Corporate Finance

1.4The Goal of Financial Management Assuming that we restrict our discussion to for-profit businesses, the goal of financial management is to make money or add value for the owners. This goal is a little vague, of course, so we examine some different ways of formulating it to come up with a more precise definition. Such a definition is important because it leads to an objective basis for making and evaluating financial decisions. POSSIBLE GOALS If we were to consider possible financial goals, we might come up with some ideas like the following: •Survive. •Avoid financial distress and bankruptcy. •Beat the competition. •Maximize sales or market share. 11 •Minimize costs. •Maximize profits. •Maintain steady earnings growth. These are only a few of the goals we could list. Furthermore, each of these possibilities presents problems as a goal for the financial manager. For example, it’s easy to increase market share or unit sales: All we have to do is lower our prices or relax our credit terms. Similarly, we can always cut costs by doing away with things such as research and development. We can avoid bankruptcy by never borrowing any money or never taking any risks, and so on. It’s unclear whether any of these actions are in the stockholders’ best interests. Profit maximization would probably be the most commonly cited goal, but even this is not a precise objective. Do we mean profits this year? If so, then we should note that actions such as deferring maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to increase profits now, but these activities aren’t necessarily desirable. The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s still unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see in more detail in the next chapter, these accounting numbers may have little to do with what is good or bad for the firm. We are actually more interested in cash flows. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us what the appropriate trade-off is between current and future profits. The goals we’ve listed here are all different, but they tend to fall into two classes. The first of these relates to profitability. The goals involving sales, market share, and cost control all relate, at least potentially, to different ways of earning or increasing profits. The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory. The pursuit of profit normally involves some element of risk, so it isn’t really possible to maximize both safety and profit. What we need is a goal that encompasses both factors. THE GOAL OF THE FINANCIAL MANAGER The financial manager in a corporation makes decisions for the stockholders of the firm. So, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders’ point of view, what is a good financial management decision? If we assume that stockholders buy stock because they seek to gain financially, then the answer is obvious: Good decisions increase the value of the stock, and poor decisions decrease the value of the stock. From our observations, it follows that the financial manager acts in the shareholders’ best interests by making decisions that increase the value of the stock. The appropriate goal for the financial manager can be stated quite easily: The goal of financial management is to maximize the current value per share of the existing stock. The goal of maximizing the value of the stock avoids the problems associated with the different goals we listed earlier. There is no ambiguity in the criterion, and there is no short-run versus long-run issue. We explicitly mean that our goal is to maximize the current stock value. 12 If this goal seems a little strong or one-dimensional to you, keep in mind that the stockholders in a firm are residual owners. By this we mean that they are entitled only to what is left after employees, suppliers, and creditors (and everyone else with legitimate claims) are paid what they are due. If any of these groups go unpaid, the stockholders get nothing. So if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else also is winning. In other words, managers should make decisions that they believe will achieve the highest firm value because, by doing so, shareholders will benefit the most. Because the goal of financial management is to maximize the value of the stock, we need to learn how to identify investments and financing arrangements that favorably impact the value of the stock. This is precisely what we will be studying. In the previous section, we emphasized the importance of cash flows in value creation. In fact, we could have defined corporate finance as the study of the relationship between business decisions, cash flows, and the value of the stock in the business. A MORE GENERAL GOAL If our goal is as stated in the preceding section (to maximize the value of the stock), an obvious question comes up: What is the appropriate goal when the firm has no traded stock? Corporations are certainly not the only type of business; and the stock in many corporations rarely changes hands, so it’s difficult to say what the value per share is at any particular time. As long as we are considering for-profit businesses, only a slight modification is needed. The total value of the stock in a corporation is equal to the value of the owners’ equity. Therefore, a more general way of stating our goal is as follows: Maximize the value of the existing owners’ equity. With this in mind, we don’t care whether the business is a sole proprietorship, a partnership, or a corporation. For each of these structures, good financial decisions increase the value of the owners’ equity, and poor financial decisions decrease it. In fact, although we choose to focus on corporations in the chapters ahead, the principles we develop apply to all forms of business. Many of them even apply to the not-for-profit sector.