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If the financial markets are highly efficient, as they are in many countries, we would expect the former to be a wider avenue for value creation than the latter. Most Financial goal is to maximize shareholder wealth. Contrast this with diversification, where investors are able to diversify the securities they hold.
Therefore, diversification by a company is unlikely to create much, if any, value. Profit Maximization versus Valiie Creation Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder value. For one thing, total profits are not as important as earnings per share.
Even maximization of earnings per share, however, is not fully appropriate because it does not take account of the timing or duration of expected returns.
Moreover, earnings per share are based on accounting profits. Though these are certainly important, many feel that operating cash flows are what matter most. Another shortcoming of the objective of maximizing earnings per share is that it does not consider the risk or uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more uncertain if these projects were undertaken.
In addition, a company will be more or less risky depending on the amount of debt in relation to equity in its capital structure. This financial risk is another uncertainty in the minds of investors when they judge the firm in the marketplace. Finally, an earnings per share objective does not take into account any dividend the company might pay.
For the reasons given, an objective of maximizing earnings per share usually is not the same as maximizing market price per share. The market price of a firm's stock represents the value that market participants place on the company. Agency Problems Agency costs involve conflicts between stakeholders-equity holders, lenders, employees, suppliers, etc. The objectives of management may differ from those of the firm's stockholders.
In a large corporation, the stock may be so widely held that stockholders cannot even make known their objectives, much less control or influence management. Often ownership and control are separate, a situation that allows management to act in its own best interests rather than those of the stockholders.
We may think of management as agents of the owners. Stockholders, hoping that the agents will act in the stockholders' best interests, delegate decision-making authority to them. Jensen and Meckling were the first to develop a comprehensive agency theory of the firm. Incentives include stock options, bonuses, and perquisites, and they are directly related to how close management decisions come to the interests of stockholders.
Monitoring can be done by bonding the agent, systematically reviewing management perquisites, auditing financial statements, and explicitly limiting management decisions. These monitoring activities necessarily involve costs, an 'Michael C. Jensen and William H. The less the ownership percentage of the managers, the less the likelihood that they will behave in a manner consistent with maximizing shareholder wealth and the greater the need for outside stockholders to monitor their activities.
Agency problems also arise in creditors and equityholders having different objectives, thereby causing each party to want to monitor the others. Similarly, other stakeholders-employees, suppliers, customers, and communities-may have different agendas and may want to monitor the behavior of equityholders and management. Agency problems occur in investment, financing, and dividend decisions by a company, and we will discuss them throughout the book.
A Normative Goal Share price embraces risk and expected return. The purpose of capital markets is to allocate savings efficiently in an economy, from ultimate savers to ultimate users of funds who invest in real assets. If savings are to be channeled to the most promising investment opportunities, a rational economic criterion must govern their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk.
The market value of a company's stock, embodying both of these factors, therefore reflects the market's trade-off between risk and return. If decisions are made in keeping with the likely effect on the market value of its stock, a firm will attract capital only when its investment opportunities justify the use of that capital in the overall economy.
Any other objective is likely to result in the suboptimal allocation of funds and therefore lead to less than optimal capital formation and growth in the economy. Social Responsibility This is not to say that management should ignore social responsibility, such as protecting consumers, paying fair wages, maintaining fair hiring practices and safe working conditions, supporting education, and becoming actively involved in environmental issues l i e clean air and water.
Stakeholders other than stockholders can no longer be ignored. These stakeholders include creditors, employees, customers, suppliers, communities in which a company operates, and others. The impact of decisions on them must be recognized.
Many people feel that a company has no choice but to act in socially responsible ways; they argue that shareholder wealth and, perhaps, the corporation's very existence depend on its being socially responsible. Because criteria for social responsibility are not clearly defined, however, it is difficult to formulate a consistent objective. When society, acting through Congress and other representative bodies, establishes the rules governing the trade-off between social goals and economic efficiency, the task for the corporation is clearer.
The company can be viewed as producing both private and social goods, and the maximization of shareholder wealth remains a viable corporate objective. Each must be considered in relation to our objective; an optimal combination of the three will create value. The investment decision is the most important of the three decisions when it comes to the creation of value.
Capital investment is the allocation of capital to investment proposals whose benefits are to be realized in the future. Because the future benefits are not known with certainty, investment proposals necessarily involve risk. Consequently, they should be evaluated in relation to their expected return and risk, for these are the factors that affect the firm's valuation in the marketplace. Included also under the investment decision is the decision to reallocate capital when an asset no longer economically justifies the capital comrnitted to it.
The investment decision, then, determines the total amount of assets held by the firm, the composition of these assets, and the business-risk complexion of the firm as perceived by suppliers of capital.
The theoretical portion of this decision is taken up in Part Using an appropriate acceptance criterion, or required rate of return, is fundamental to the investment decision. Because of the paramount and integrative importance of this issue, we shall pay considerable attention to determining the appropriate required rate of return for an investment project, for a division of a company, for the company as a whole, and for a prospective acquisition.
In addition to selecting new investments, a company must manage existing assets efficiently. Financial managers have varying degrees of operating responsibility for existing assets; they are more concerned with the management of current assets than with fixed assets.
In Part V we explore ways in which to manage current assets efficiently to maximize profitability relative to the amount of funds tied up in an asset.
Determining a proper level of liquidity is very much a part of this management, and its determination should be in keeping with the company's overall valuation. Although financial managers have little or no operating responsibility for fixed assets and inventories, they are in- Chapter 1 Goals a n d Functions of Finance 7 strumental in allocating capital to these assets by virtue of their involvement in capital investment.
In Parts I1 and VII, we consider mergers and acquisitions from the standpoint of an investment decision.
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These external investment opportunities can be evaluated in the same general manner as an investment proposal that is generated internally. The market for corporate control is ever present in this regard, and this topic is taken up in Part VII.
Growth in a company can be internal, external, or both, domestic, and international. Therefore, Part VII also considers growth through international operations. With the globalization of finance in recent years, this book places substantial emphasis on international aspects of financial decision making. In the second major decision of the firm, the financing decision, the financial manager is concerned with determining the best financing mix or capital structure.
If a company can change its total valuation by varying its capital structure, an optimal financing mix would exist, in which market price per share could be maximized. In Chapters 9 and 10 of Part , we take up the financing decision in relation to the overall valuation of the company. OUTconcern is with exploring the implications of variation in capital structure on the valuation of the firm. In Chapter 16, we examine short- and intermediate-term financing.
This is followed in Part VI with an investigation of the various methods of long-term financing. The emphasis is on not only certain valuation underpinnings but also the managerial aspects of financing, as we analyze the features, concepts, and problems associated with alternative methods. Part VI also investigates the interface of the firm with the capital markets, the ever-changing environment in which financing decisions are made, and how a company can manage its financial risk through various hedging devices.
In Part VII, corporate and distress restructuring are explored. Although aspects of restructuring fall across all three major decisions of the firm, this topic invariably involves financing, either new sources or a rearrangement of existing sources. The third important decision of a company is the amount of cash to distribute to stockholders, which is examined in Chapter There are two methods of distribution: cash dividends and share redownload. Dividend policy includes the percentage of earnings paid to stockholders in cash dividends, the stability of absolute dividends about a trend, stock dividends, and stock splits.
Share redownload allows the distribution of a large amount of cash without tax consequence to those who choose to continue to hold their shares. The dividendpayout ratio and the number of shares redownloadd determine the amount of earnings retained in a company and must be evaluated in light of the objective of maximizing shareholder wealth.
The value, if any, of these actions to investors must be balanced against the opportunity cost of the retained earnings lost as a means of equity financing. Both dividends and share redownloads are important financial signals to the market, which continually tries to assess the future profitability and risk of a corporation with publicly traded stock.
Together, these decisions determine the value of a company to its shareholders. Moreover, they are interrelated. The decision to invest in a new capital project, for example, necessitates financing the investment. With a proper conceptual framework, joint decisions that tend to be optimal can be reached. The main thing is that the financial manager relate each decision to its effect on the valuation of the firm. Because valuation concepts are basic to understanding financial management, these concepts are investigated in depth in Chapters 2 through 5.
Thus, the first five chapters serve as the foundation for the subsequent development of the book. They introduce key concepts: the time value of money, market efficiency, risk-return trade-offs, valuation in a market portfolio context, and the valuation of relative financial claims using option pricing theory. These concepts will be applied in the remainder of the book.
In an endeavor to make optimal decisions, the financial manager makes use of certain analytical tools in the analysis, planning, and control activities of the firm. Financial analysis is a necessary condition, or prerequisite, for making sound financial decisions; we examine the tools of analysis in Part IV. One of the important roles of a chief financial officer is to provide accurate information on financial performance, and the tools taken up will be instrumental in this regard.
Why should a company concentrate primarily on wealth maximization instead of profit maximization? Beta-Max Corporation is considering two investment proposals. One involves the development of 10 discount record stores in Chicago. The other proposal involves a classical record of the month club. Here, the company will devote much effort to teaching the public to appreciate classical music. The life of the second project is 15 years. On the basis of this information, which project do you prefer?
What are the major functions of the financial manager?
What do these functions have in common? Should the managers of a company own sizable amounts of stock in the company? What are the pros and cons? In recent years, there have been a number of environmental, pollution, hiring, and othe; replations imposed on businesses. In view of these changes, is maximizationof shareholder wealth still a realistic objective?
As an investor, do you believe that some managers are paid too much? Do not their rewards come at your expense?
Financial Management and Policy (12th Edition)
How does the notion of risk and reward govern the behavior of financial managers? Jarrow, V.
Maksimovic, and W. Amsterdam: North Holland, , Chap. New York: Free Press, Oxford: Oxford University Press, Reading, Mass. Wachowicz Jr. It contains descriptions of and links to many finance Web sites and articles.
CHAPTER Concepts in Vdluation o make itself as valuable as possible to shareholders, a firm Common stocks are going to be important in this chapter and the must choose the best combination of decisions on invest- next two, as we study the valuation of financial market instruments. If any of these decisions are These are groundwork chapters on which we will later base our part of your job, you will have a hand in shaping your company's re- analyses of decisions on investment, financing, and dividends.
We turn-risk characterand your firm's value in the eyes of suppliers of shall consider the expected return from a security and the risk of capital. Riskcan be defined as the possibility that the actual return holding it. No need to wait for office hours or assignments to be graded to find out where you took a wrong turn.
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By and large, the allocation of savings in an economy occurs on the basis of expected return and risk. We have solutions for your book! The last chapter of the book, "International Financial Management," has a new section on economic exposure to unexpected currency movements and how to analyze the direction and magnitude of the effect.
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