1-2 The Financial Goal of the Corporation
💻 Managers for shareholders
Some corporations have hundreds of thousands of shareholders. All these people can not manage the corporation. Therefore professional managers are granted the authority to do so. All these managers and shareholders have a common objective -> maximize the current market value of shares. The increased wealth can then be put towards whatever the wish of the shareholders is.
Task of financial manager = increase market value
🎯 A Fundamental Result
Financial managers should act in the will of the shareholders
- Each stockholder wants three things :
- To be as rich as possible.
- To transform the wealth into the most desirable timing of usage. Either by borrowing more to spend now or invest to spend later.
- To manage the risk characteristics of that usage plan.
- Stockholders don't utilize the financial managers to obtain the best timing of usage of their wealth. They can also choose the amount of risk of their total investment by investing more- or less-risky securities.
- There is only one way for financial managers to help the firm's stockholders -> increasing their wealth. (by increasing the value of the firm and therefore the price of the shares).
A corporation may be able to increase current profits by not doing maintenance or staff training. This will most likely result in lower profits in the future, because machinery can not operate because it is unserviced. -> Shareholders will not prefer higher short-term profits if they disturb long-term profits.
A company can increase future profits by keeping the dividend low this year and investing the left over money to invest in the firm. This is good unless the company earns only a modest return on the money.
⚖ The Investment Trade-Off
The main objective is maximizing the market value. The difficult part is deciding whether to invest in a real asset or to pay out the cash to the shareholders. This decision will be made by looking at what the shareholders want. They have to outweigh what will make them more money:
- investing into the investment project (real asset) of the corporation and making more money in the future in return
- or take out the money as an additional dividend and invest it into other financial markets for themselves
When a corporation's proposed investments offer higher rates of return than it's shareholders can earn for themselves in other financial markets, its shareholders will approve the investments, the stock price will increase and the payouts in the future will be higher.
If the company does the investment project and earns a return lower than predicted, shareholders won't like it, stock prices will fall, and stockholders would want their money back so they can invest themselves in other financial markets.
example
Company bytehub inc. is planning on making a magnificent new project called project alpha...
if market return is 10% and the risk of project alpha is the same as the risk of the market then: the minimum acceptable rate of return on project alpha is 10%
if return of project alpha < 10% dividends should be paid, and project alpha abandoned. if return of project alpha > 10% dividends should not be paid to invest in project alpha.
cost of capital
Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile.
- minimum acceptable rate = hurdle rate = cost of capital
opportunity cost of capital
the amount of money foregone by investing in one asset compared to another. As an investor, this can simply be a choice of one asset over another. As a company, this choice can also involve the use of current assets in new investments.
opportunity cost of capital depends on risk because:
- shareholders are risk averse.
- shareholders have to trade off risk against return when they invest on their own.
the opportunity cost is the expected return that investors can achieve in financial markets at the same level of risk.
❓ Should Managers Look After the Interests of Their Shareholders?
It is not always the case that a financial manager strictly follows what the shareholders tell him/her to do. The relationship is also build upon looking at what is best for the company and making the shareholders trust you with their investment. So in some cases the financial manager needs to make decisions that would be the best for all the parties.
⚠️ Agency Problems and Corporate Governance
agency problems = conflicts between shareholders and managers objectives
Managers can go for their own profit instead of maximizing the wealth of the shareholders. For example, planning unnecessary meetings at exotic resorts. Or they work to maximize their own bonuses.
agency costs occur when
- managers do not attempt to maximize firm wealth
- shareholders have to pay to monitor the managers and constrain their actions
Agency problems these days occur often when managers do not pay attention to their spending.
It is important that shareholders pockets are close to the managers hearts.