THE GOAL OF FINANCIAL MANAGEMENT

The financial manager in a corporation makes decisions for the stockholders of the firm. Given this, 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.

Given 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 thus be stated quite easily:

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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.

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 to only what is left after employees, suppliers, and creditors (and anyone else with a legitimate claim) are paid their 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 is winning also.

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 fact, we could have defined corporate finance as the study of the relationship between business decisions and the value of the stock in the business.

A MORE GENERAL GOAL

Given our goal as stated in the preceding section (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 given time.

As long as we are dealing with for-profit businesses, only a slight modification is needed. The total value of the stock in a corporation is simply equal to the value of the owners’ equity. Therefore, a more general way of stating our goal is as follows: Maximize the market value of the existing owners’ equity.

With this in mind, it doesn’t matter whether the business is a proprietorship, a partnership, or a corporation. For each of these, good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it. In fact, although we 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.

Finally, our goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. What we mean is that the financial manager best serves the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free marketplace.

SARBANES-OXLEY

In response to corporate scandals at companies such as Enron, WorldCom, Tyco, and Adelphia, Congress enacted the Sarbanes-Oxley Act in 2002. The act, better known as “Sarbox,” is intended to protect investors from corporate abuses. For example, one section of Sarbox prohibits personal loans from a company to its officers, such as the ones that were received by WorldCom CEO Bernie Ebbers.

One of the key sections of Sarbox took effect on November 15, 2004. Section 404 requires, among other things, that each company’s annual report must have an assessment of the company’s internal control structure and financial reporting. An independent auditor must then evaluate and attest to management’s assessment of these issues.

Page 10Sarbox contains other key requirements. For example, the officers of the corporation must review and sign the annual reports. They must explicitly declare that the annual report does not contain any false statements or material omissions; that the financial statements fairly represent the financial results; and that they are responsible for all internal controls. Finally, the annual report must list any deficiencies in internal controls. In essence, Sarbox makes company management responsible for the accuracy of the company’s financial statements.

Because of its extensive reporting requirements, compliance with Sarbox can be very costly, which has led to some unintended results. Since its implementation, hundreds of public firms have chosen to “go dark,” meaning that their shares are no longer traded on the major stock exchanges, in which case Sarbox does not apply. Most of these companies stated that their reason was to avoid the cost of compliance. Ironically, in such cases, the law had the effect of eliminating public disclosure instead of improving it.

 

For more about Sarbanes-Oxley, visit  www.soxlaw.com .

Concept Questions

1.3a   What is the goal of financial management?

1.3b   What are some shortcomings of the goal of profit maximization?

1.3c   Can you give a definition of corporate finance?

1.4 The Agency Problem and Control of the Corporation

We’ve seen that the financial manager acts in the best interests of the stockholders by taking actions that increase the value of the stock. However, we’ve also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders’ expense? In the following pages, we briefly consider some of the arguments relating to this question.

AGENCY RELATIONSHIPS

The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests. For example, you might hire someone (an agent) to sell a car you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problem.

agency problem The possibility of conflict of interest between the stockholders and management of a firm.

Suppose you hire someone to sell your car and agree to pay that person a flat fee when he or she sells the car. The agent’s incentive in this case is to make the sale, not necessarily to get you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way in which an agent is compensated is one factor that affects agency problems.

MANAGEMENT GOALS

To see how management and stockholder interests might differ, imagine that the firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to Page 11take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

More generally, the term agency costs refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity, such as the one we have just described.

Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control or, more generally, corporate power or wealth. This goal could lead to an overemphasis on corporate size or growth. For example, cases in which management is accused of overpaying to buy up another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefit the stockholders of the purchasing company.

Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals.

DO MANAGERS ACT IN THE STOCKHOLDERS’ INTERESTS?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates, at least in part, to the way managers are compensated. Second, can managers be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that even in the largest firms, management has a significant incentive to act in the interests of stockholders.

Managerial Compensation Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and often to share value in particular. For example, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth, the more valuable is this option. In fact, options are often used to motivate employees of all types, not just top managers. For example, in late 2014, Google’s more than 46,000 employees owned enough options to buy 6.1 million shares in the company. Many other corporations, large and small, have adopted similar policies.

The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, according to The Wall Street Journal, the best-paid executive in 2013 was Lawrence Ellison, the CEO of Oracle. According to The Journal, he made about $76.9 million. By way of comparison, Ellison made only slightly more than LeBron James ($72.3 million) and Robert Downey Jr. ($75 million). Information about executive compensation, along with lots of other information, can be easily found on the Web for almost any public company. Our nearby Work the Web box shows you how to get started.

 

Business ethics are considered at  www.business-ethics.com .

Page 12Control of the Firm Control of the firm ultimately rests with stockholders. They elect the board of directors, who in turn hire and fire managers. The fact that stockholders control the corporation was made abundantly clear by Steve Jobs’s experience at Apple. Even though he was a founder of the corporation and was largely responsible for its most successful products, there came a time when shareholders, through their elected directors, decided that Apple would be better off without him, so out he went. Of course, he was later rehired and helped turn Apple around with great new products such as the iPod, iPhone, and iPad.

An important mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else’s stock. A proxy fight develops when a group solicits proxies in order to replace the existing board and thereby replace existing managers. For example, in 2013, hedge fund Elliott Management launched a proxy battle with oil company Hess Corporation. Elliott argued that Hess should divest its smaller divisions and focus solely on exploration and production and that CEO/chairman John Hess should be stripped of the position of chairman. In the end, Hess stepped down as chairman, three directors backed by Elliott were placed on the board of directors, and Hess announced plans to sell its retail gasoline, marketing, and trading businesses.

Another way that managers can be replaced is by takeover. Firms that are poorly managed are more attractive as acquisitions because a greater profit potential exists. Thus, avoiding a takeover gives management another incentive to act in the stockholders’ interests. For example, in the chapter opener, we discussed George Zimmer’s firing by the board of The Men’s Wearhouse. A few months later, rival Jos. A. Bank made a bid to buy the company, despite the fact that Bank was a significantly smaller firm. The offer was rejected. But, in an interesting turn of events, The Men’s Wearhouse offered to buy Jos. A. Bank! After months of back and forth, the two companies announced in March 2014 that a deal had been finalized, with The Men’s Wearhouse buying Jos. A. Bank for $65 per share. That price was about 38 percent higher than Bank’s stock price when talks began, so The Men’s Wearhouse made an excellent “suit-or.”

Conclusion The available theory and evidence are consistent with the view that stockholders control the firm and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will undoubtedly be times when management goals are pursued at the expense of the stockholders, at least temporarily.

STAKEHOLDERS

Our discussion thus far implies that management and stockholders are the only parties with an interest in the firm’s decisions. This is an oversimplification, of course. Employees, customers, suppliers, and even the government all have a financial interest in the firm.

Taken together, these various groups are called stakeholders in the firm. In general, a stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners.

stakeholder Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.

Concept Questions

1.4a   What is an agency relationship?

1.4b   What are agency problems and how do they come about? What are agency costs?

1.4c   What incentives do managers in large corporations have to maximize share value?

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WORK THE WEB

The Web is a great place to learn more about individual companies, and there are a slew of sites available to help you. Try pointing your Web browser to finance.yahoo.com. Once you get there, you should see something like this on the page:

 

To look up a company, you must know its “ticker symbol” (or just ticker for short), which is a unique one- to four-letter identifier. You can click on the “Symbol Lookup” link and type in the company’s name to find the ticker. For example, we typed in “PZZA”, which is the ticker for pizza maker Papa John’s. Here is a portion of what we got:

 

There’s a lot of information here and many links for you to explore, so have at it. By the end of the term, we hope it all makes sense to you!

Questions

1.  Go to finance.yahoo.com and find the current stock prices for Southwest Airlines (LUV), Harley-Davidson (HOG), and Starwood Hotels & Resorts (HOT).

2.  Get a quote for American Express (AXP) and follow the “Key Statistics” link. What information is available on this link? What domrq, ttm, yoy, and lfy mean?

1.5 Financial Markets and the Corporation

We’ve seen that the primary advantages of the corporate form of organization are that ownership can be transferred more quickly and easily than with other forms and that money can be raised more readily. Both of these advantages are significantly enhanced by the existence of financial markets, and financial markets play an extremely important role in corporate finance.