Justify and criticize the usual assumption made in financial management literature that the objective of a company is to maximize the wealth of its shareholders. (Do not consider how this wealth is to be measured)

Advanced Financial Management Block Revision Mock Exams

Financial management is concerned with making decisions about the provisions and use of a firm‟s finances.
A rational approach to decision-making necessitates a fairly clear idea of what the objectives of the decision maker are or, more importantly, of what are the objectives of those on behalf of whom the decisions are being made.

There is little agreement in the literature as to what objectives of firms are or even what they ought to be. However, most financial management textbooks make the assumption that the objective of a limited company is to maximize the wealth of its shareholders. This assumption is normally justified in terms of classical economic theory. In a market economy firms that achieve the highest returns for their investors will be the firms that are providing customers with what they require. In turn these companies, because they provide high returns to investors, will also find it easiest to raise new finance. Hence the so called „invisible hand‟ theory will ensure optimal resource allocation and this should automatically maximize the overall economic welfare of the nation.

This argument can be criticized on several grounds. Firstly it ignores market imperfections. For example it might not be in the public interest to allow monopolies to maximize profits. Secondly it ignores social needs like health, police, defence etc.

From a more practical point of view directors have a legal duty to run the company on behalf of their shareholders. This however begs the question as to what do shareholders actually require from firms.

Another justification from the individual firm‟s point of view is to argue that it is in competition with other firms for further capital and it therefore needs to provide returns at least as good as the competition. If it does not it will lose the support of existing shareholders and will find it difficult to raise funds in the future, as well as being vulnerable to potential take-over bids.

Against the traditional and „legal‟ view that the firm is run in order to maximize the wealth of ordinary shareholders, there is an alternative view that the firm is a coalition of different groups: equity shareholders, preference shareholders and lenders, employees, customers and suppliers. Each of these groups must be paid a minimum „return‟ to encourage them to participate in the firm. Any excess wealth created the firm should be and is the subject of bargaining between these groups.

At first sight this seems an easy way out of the „objectives‟ problem. The directors of a company could say „Let‟s just make the profits first, then we‟ll argue about who gets them at a later stage‟. In other words, maximizing profits leads to the largest pool of benefits to be distributed among the participants in the bargaining process. However, it does imply that all such participants must value profits in the same way and that they are all willing to take the same risks.

In fact the real risk position and the attitude to risk of ordinary shareholders, loan creditors and employees are likely to be very different. For instance, a shareholder who has a diversified portfolio is likely not to be so worried the bankruptcy of one of his companies as will an employee of that company, or a supplier whose main customer is that company. The problem of risk is one major reason why there cannot be a single simple objective which is common to all companies.

Separate from the problem of which goal a company ought to pursue are the questions of which goals companies claim to pursue and which goals they actually pursue.

Many objectives are quoted large companies. Sometimes these are included in their annual accounts. Examples are:

• To produce an adequate return for shareholders;
• To grow and survive autonomously;
• To improve productivity;
• To give the highest quality service to customers;
• To maintain a contented workforce;
• To be technical leaders in their field;
• To be market leaders;
• To acknowledge their social responsibilities.

Some of these stated objectives are probably a form of public relations exercise. At any rate, it is possible to classify most of them into four categories which are related to profitability:

Pure profitability goals eg, adequate return for shareholders.

(ii) „Surrogate‟ goals of profitability eg, improving productivity, happy workforce.Constraints on profitability eg, acknowledging social responsibilities, no pollution, etc.
„Dysfunctional‟ goals.

The last category are goals which should not be followed because they do not benefit in the long run. Examples here include the pursuit of market leadership at any cost, even profitability. This may arise because management assumes that high sales equal high profits which is not necessarily so.

In practice the goals which a company actually pursues are affected to a large extent the management. As a last resort, the directors may always be removed the shareholders or the shareholders could vote for a take-over bid, but in large companies individual shareholders lack voting power and information. These companies can, therefore, be dominated the management.

There are two levels of argument here. Firstly, if the management do attempt to maximize profits, then they are in a much more powerful position to decide how the profits are „carved up‟ than are the shareholders.

Secondly, the management may actually be seeking „prestige‟ goals rather than profit maximization. Such goals might include growth for its own sake, including empire building or maximizing turnover for its sake, or becoming leaders in the technical field for no reason other than general prestige. Such goals are usually
„dysfunctional‟.

The dominance of management depends on individual shareholders having no real voting power, and in this respect institutions have usually preferred to sell their shares rather than interfere with the management of companies. There is some evidence, however, that they are now taking a more active role in major company decisions.

From all that has been said above, it appears that each company should have its own unique decision model. For example, it is possible to construct models where the objective is to maximize profit subject to first fulfilling the target levels of other goals. However, it is not possible to develop the general theory of financial management very far without making an initial simplifying assumptions about objectives. The objective of maximizing the wealth of equity shareholders seems the least objectionable.

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