Slide 1.1 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 Corporate Financial Management, 3rd edition Glen Arnold Lecture 1

Slide 1.2 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 The objective of the firm Describe alternative views on the purpose of the business and show the importance to any organisation of clarity on this point. Draw a distinction between profit maximisation and shareholder wealth maximisation. Describe the impact of the divorce of corporate ownership from day-to-day managerial control.

Slide 1.3 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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

Slide 1.4 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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

Slide 1.5 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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

Slide 1.6 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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

Slide 1.7 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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.

Slide 1.8 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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.

Slide 1.9 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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.

Slide 1.10 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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.

Slide 1.11 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 Profit maximisation is not the same as shareholder wealth maximisation Prospects Risk Accounting problems Communication Additional capital

Slide 1.12 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 Exhibit 1.8 Two firms with identical average profits but different risk levels

Slide 1.13 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 Ownership and control The problem –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

Slide 1.14 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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

Slide 1.15 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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.

Slide 1.16 Arnold, Corporate Financial Management, 3 rd edition © Pearson Education Limited 2005 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