The Objective of the Firm Corporate Finance 1

The objective of the firm ‘In whose interests is the firm run?’ Exhibit 1.1 A company has responsibilities to a number of interested parties

A conflict between objectives Which claimants are to have their objectives maximised, and which are merely to be satisficed? Pro-capitalist economists The rules of the game Left-wing Primacy of workers’ rights and rewards Balanced stakeholder approach

Some possible objectives Achieving a target market share Keeping employee agitation to a minimum Survival Creating an ever-expanding empire Maximisation of profit Maximisation of long-term shareholder wealth

The assumed objective for finance The company should make investment and financing decisions with the aim of maximising long-term shareholder wealth. The practical reason The theoretical reasons The ‘contractual theory’ Practicalities of operating in a free market system Society is best served by businesses focusing on returns to the owners

Adam Smith (1776) “The businessman by directing . . . industry in such a manner as its produce may be of the greatest value, intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it…” Source: Adam Smith, The Wealth of Nations, 1776, p. 400.

Michael Jensen Attacks the stakeholder approach (and its derivative, the Balanced Scorecard of Kaplan and Norton (1996)). Criticisms include: Confusion resulting from a multiplicity of targets to aim for Leaving managers unaccountable for their actions Allowing managers to pursue their own interests at expense of the firm However, Jensen argues that companies cannot create shareholder value if they ignore important constituencies. They must have good relationships with customers, employees, suppliers, government etc. Simply telling people to maximise shareholder value is not enough to motivate them to deliver value. They must be turned on by a vision or a strategy.

More thoughts on the key objectives John Kay Firms going directly for ‘shareholder value’ may do worse for shareholders than those that focus on vision and excellence first and find themselves shareholder wealth maximisers in an oblique way. Milton Friedman Businesses should pursue high returns for owners. This results in the best allocation of investment capital among competing industries and product lines. Consumers end up with more of what they want because scarce investment money is directed to the best uses. The self-interest of employees in retaining their jobs will often conflict with this overriding objective. One powerful reason for advancing shareholders’ interests above all others is they own the firm and so deserve any surplus it produces.

What is shareholder wealth? Maximising wealth can be defined as maximising purchasing power. Maximising shareholder wealth means maximising the flow of dividends to shareholders through time.

Profit maximisation is not the same as shareholder wealth maximisation Prospects Risk Accounting problems Communication Additional capital

Exhibit 1.8 Two firms with identical average profits but different risk levels

Ownership and control The problem Agency costs Diffuse and fragmented set of shareholders Control often lies in the hands of directors Separation, or a divorce, of ownership and control The management team may pursue objectives attractive to them ‘Managerialism’ or ‘managementism’ An example of the principal–agent problem Agency costs (a) Monitor managers’ behaviour (b) Create incentive schemes and controls for managers to encourage the pursuit of shareholders’ wealth maximisation Agency cost of the loss of wealth caused by the extent to which prevention measures do not work

Ownership and control Aligning the actions of senior management with the interests of shareholders ‘goal congruence’ Some solutions Linking rewards to shareholder wealth improvements Sackings Selling shares and the takeover threat Corporate governance regulations Information flow

Lecture review 1 Firms should clearly define the objective of the enterprise to provide a focus for decision making. Sound financial management is necessary for the achievement of all stakeholder goals. Some stakeholders will have their returns satisficed, others maximised. Assumed objective of the firm for finance is to maximise shareholder wealth. Practical The contractual theory Survival Better for society Counters the tendency of managers to pursue goals for their own benefit They own the firm Maximising shareholder wealth is maximising purchasing power or maximising the flow of discounted cash flow to shareholders over a long time horizon.

Lecture review 2 Profit maximisation: different from shareholder wealth maximisation Future prospects Risk Survival Accounting problems Communication Additional capital Separation of ownership and control Managerialism Principal–agent problem: Some solutions: Link managerial rewards to shareholder wealth improvement Sackings Selling shares and the takeover threat Corporate governance regulation Improve information flow