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Goals of financial management

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Shareholders wealth maximization

The goal of the firm, and therefore of all managers and employees, is to maximize the wealth of the owners for whom it is being operated. The wealth of corporate owners is measured by the share price of the stock, which in turn is based on the timing of returns (cash flows), their magnitude and their risk. When considering each financial decision, alternative or possible action in terms of its impact on the share price of the firm's stock, financial managers should accept only those actions that are expected to increase share price. Because share price represent the owner's wealth in the firm, share price maximization is consistent with owner-wealth maximization.

Although shareholder wealth maximization is the primary goal, in recent years many firms have broadened their focus to include the interests of stakeholders as well as shareholders. Stakeholders are groups such as employees, customers, suppliers, creditors, owners and others who have a direct economic link to the firm. Employees are paid for their labor, customers purchase the firm's products or services, suppliers are paid for the materials and services they provide, creditors provide debt financing that is to be repaid subject to specified terms and owners provide equity financing for which they expect to be compensated. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well being but to preserve it.

The stakeholder view does not alter the shareholder wealth maximization goal. Such a view is often considered part of the firm's social responsibility and is expected to provide maximum long-run benefit to shareholders by maintaining positive stakeholder relationships. Such relationships should minimize stakeholder turnover, conflicts and litigation. Clearly, the firm can better achieve its goal of shareholder wealth maximization with cooperation of (rather than conflict with) its stakeholders.

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Profit maximization
To achieve the goal of profit maximization, the financial manager takes only those actions that re expected to contribute to the firm's overall profits. For each alternative being considered, the financial manager would select the one that expected to result in the highest monetary return. Corporations normally measure profits in terms of EPS, which is calculated by dividing the period's total earnings available for the firm's common stockholders by the number of shares of common stock outstanding.

Profit maximization as a goal fails for a number of reasons. It ignores the following:

(i) Timing: Because the firm can earn a return on funds it receives, the receipt of funds sooner rather than later is preferred.

(ii) Cash flows: Profits do not necessary result in cash flows available to stockholders. Owners receive cash flow either in form of cash dividends or proceeds from selling their shares for a higher price than initially paid. A greater EPS does not necessarily mean that a firm's board of directors will vote for increased dividends. Also a higher EPS does not necessarily translate into a higher stock price. Firms sometimes experience earnings increases without any corresponding favorable change in stock price.

(iii) Risk. Profit maximization also disregards risk. A basic premise in financial management is that a trade-off exists between the return (cash flow) and risk. Cash flow and risk affect share prices differently. Higher cash flows are generally associated with higher share prices. Higher risk tends to result in a lower share price because the stockholder must be compensated for the greater risk. In general, stock holders are risk averse. i.e. they avoid risk. When risk is involved, stockholders expect to earn higher rates of return on investments of higher risk and lower rates on lower-risk investments. Thus, differences in risk can significantly affect the value of an investment.

Social responsibility

Another issue that deserves consideration is social responsibility: should businesses operate strictly in their stockholder's best interests, or are firms also partly responsible for the welfare of their employees, customers and communities in which they operate? Certainly, firms have an ethical responsibility to provide a safe-working environment, to engage in fair hiring practices, and produce products that are safe to consumers. However, social responsible actions such as these have costs to businesses, and it is questionable whether businesses would incur these costs voluntarily. It is clear, however, that if some firms act in a socially responsible manner while other firms do not, then the socially responsible firms will be at a disadvantage in attracting investors because of the extra costs involved.

Does this mean that firms should not exercise social responsibility? Not at all, but it does mean that most significant cost-increasing actions will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses. In spite of the fact that many socially responsible actions must be mandated by government, in recent years numerous firms have been voluntarily taking actions, especially in the area of environmental protection, because these actions help sales. For some firms, social responsible actions may not even be very costly, because the companies often heavily advertise such actions, and many consumers prefer to buy from socially responsible companies rather than from companies that shun social responsibility.

The role of ethics

Ethics are standards of conduct or moral behavior. Business ethics can be thought of as a company's attitude and conduct towards its employees, customers, community and stakeholders. Today, the business community in general and the financial community in particular are developing and enforcing ethical standards. The goal of these ethical standards is to motivate businesses and market participants to adhere to both the letter and the spirit of laws and regulations concerned with businesses and professional practice. A firm's commitment to business ethics can be measured by the tendency of the firm ...

Solution Summary

Shareholders wealth maximization

The goal of the firm, and therefore of all managers and employees, is to maximize the wealth of the owners for whom it is being operated. The wealth of corporate owners is measured by the share price of the stock, which in turn is based on the timing of returns (cash flows), their magnitude and their risk. When considering each financial decision, alternative or possible action in terms of its impact on the share price of the firm's stock, financial managers should accept only those actions that are expected to increase share price. Because share price represent the owner's wealth in the firm, share price maximization is consistent with owner-wealth maximization.

Although shareholder wealth maximization is the primary goal, in recent years many firms have broadened their focus to include the interests of stakeholders as well as shareholders. Stakeholders are groups such as employees, customers, suppliers, creditors, owners and others who have a direct economic link to the firm. Employees are paid for their labor, customers purchase the firm's products or services, suppliers are paid for the materials and services they provide, creditors provide debt financing that is to be repaid subject to specified terms and owners provide equity financing for which they expect to be compensated. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well being but to preserve it.

The stakeholder view does not alter the shareholder wealth maximization goal. Such a view is often considered part of the firm's social responsibility and is expected to provide maximum long-run benefit to shareholders by maintaining positive stakeholder relationships. Such relationships should minimize stakeholder turnover, conflicts and litigation. Clearly, the firm can better achieve its goal of shareholder wealth maximization with cooperation of (rather than conflict with) its stakeholders.

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