Let us look at several alternative goals for the financial manager as well as the other managers of the firm. One may suggest that the most important goal for financial management is to earn the highest possible profit for the firm. Under this criterion, each decision would be evaluated on the basis of its overall contribution to the firms earnings. While this seems to be a desirable approach, there are some serious drawbacks to profit maximization as the primary goal of the firm.
First, a change in profit may also represent a change in risk. A conservative firm that earned $1.25 per share may be a less desirable investment if its earnings per share increase to $1.50, but the risk inherent in the operation increases even more.
A second possible drawback to the goal of maximizing profit is that it fails to consider the timing of the benefits. For example, if we could choose between the following two alternatives, we might be indifferent if our emphasis were solely on maximizing earnings.
Both investments would provide $3.50 in total earnings, but Alternative B is clearly superior because the larger benefits occur earlier. We could reinvest the difference in earnings for Alternative B one period sooner.
Finally, the goal of maximizing profit suffers from the almost impossible task of accurately measuring the key variable in this case, namely, profit. As you will observe throughout the text, there are many different economic and accounting definitions of profit, each open to its own set of interpretations. Furthermore, problems related to inflation and international currency transactions complicate the issue. Constantly improving methods of financial reporting offer some hope in this regard, but many problems remain.
A Valuation Approach
While there is no question that profits are important, the key issue is how to use them in setting a goal for the firm. The ultimate measure of performance is not what the firm earns, but how the earnings are valued by the investor. In analyzing the firm, the investor will also consider the risk inherent in the firms operation, the time pattern over which the firms earnings increase or decrease, the quality and reliability of reported earnings, and many other factors. The financial manager, in turn, must be sensitive to all of these considerations. He or she must question the impact of each decision on the firms overall valuation. If a decision maintains or increases the firms overall value, it is acceptable from a financial viewpoint; otherwise, it should be rejected. This principle is demonstrated throughout the text.
Maximizing Shareholder Wealth
The broad goal of the firm can be brought into focus if we say the financial manager should attempt to maximize the wealth of the firms shareholders through achieving the highest possible value for the firm. Shareholder wealth maximization is not a simple task, since the financial manager cannot directly control the firms stock price, but can only act in a way that is consistent with the desires of the shareholders. Since stock prices are affected by expectations of the future as well as by the economic environment, much of what affects stock prices is beyond managements direct control. Even firms with good earnings and favorable financial trends do not always perform well in a declining stock market over the short term.
The concern is not so much with daily fluctuations in stock value as with long-term wealth maximization. This can be difficult in light of changing investor expectations. In the 1950s and 1960s, the investor emphasis was on maintaining rapid rates of earnings growth. In the 1970s and 1980s, investors became more conservative, putting a premium on lower risk and, at times, high current dividend payments.
In the early and mid-1990s, investors emphasized lean, efficient, well-capitalized companies able to compete effectively in the global environment. But by the late 1990s, there were hundreds of high-tech Internet companies raising capital through initial public offerings of their common stock. Many of these companies had dreams, but very little revenue and no earnings, yet their stock sold at extremely high prices. Some in the financial community said that the old valuation models were dead, didnt work, and were out of date; earnings and cash flow didnt matter anymore. Alan Greenspan, chairman of the Federal Reserve Board, made the now famous remark that the high-priced stock market was suffering from irrational exuberance. By late 2000, many of these companies turned out to be short-term wonders. A few years later, hundreds were out of business.
Management and Stockholder Wealth
Does modern corporate management always follow the goal of maximizing shareholder wealth? Under certain circumstances, management may be more interested in maintaining its own tenure and protecting private spheres of influence than in maximizing stockholder wealth. For example, suppose the management of a corporation receives a tender offer to merge the corporation into a second firm; while this offer might be attractive to shareholders, it might be quite unpleasant to present management. Historically, management may have been willing to maintain the status quo rather than to maximize stockholder wealth.
As mentioned earlier, this is now changing. First, in most cases enlightened management is aware that the only way to maintain its position over the long run is to be sensitive to shareholder concerns. Poor stock price performance relative to other companies often leads to undesirable takeovers and proxy fights for control. Second, management often has sufficient stock option incentives that motivate it to achieve market value maximization for its own benefit. Third, powerful institutional investors are making management more responsive to shareholders.
Social Responsibility and Ethical Behavior
Is our goal of shareholder wealth maximization consistent with a concern for social responsibility for the firm? In most instances the answer is yes. By adopting policies that maximize values in the market, the firm can attract capital, provide employment, and offer benefits to its community. This is the basic strength of the private enterprise system.
Nevertheless, certain socially desirable actions such as pollution control, equitable hiring practices, and fair pricing standards may at times be inconsistent with earning the highest possible profit or achieving maximum valuation in the market. For example, pollution control projects frequently offer a negative return. Does this mean firms should not exercise social responsibility in regard to pollution control? The answer is nobut certain cost-increasing activities may have to be mandatory rather than voluntary, at least initially, to ensure that the burden falls equally over all business firms.
McDonalds CorporationGood Corporate Citizen
Given that stock market investors emphasize financial results and the maximization of shareholder value, one can wonder if it makes sense for a company to be socially responsible. Can companies be socially responsible and oriented toward shareholder wealth at the same time? The authors think so, and McDonalds also thinks the two can go together. For a company with thousands of restaurants throughout the world, being a good neighbor is important.
At a recent annual meeting, McDonalds stated, Community involvement sets McDonalds apart, builds brand loyalty, and promotes local pride and respect. It is the heart of our commitment to exceptional customer satisfaction. The people we serve at the front counter and the people we serve in the communitiesare one and the same. People do business with people they feel good about. Many customers visit McDonalds because we are a responsible corporate citizen.
McDonalds supports one of the worlds premier philanthropic organizations, Ronald McDonald House Charities (RMHC). RMHC provides comfort and care to children and their families by awarding grants to organizations through chapters in 31 countries and supporting more than 200 Ronald McDonald Houses in 19 countries. Recently, RMHC awarded nearly $4 million in grants to Interplast and Operation Smile to fund 40 medical missions in 28 countries throughout Latin America and Asia. In addition, it awarded $5 million to the United Nations Childrens Fund (UNICEF) to fund the immunization of one million African children and their mothers against neonatal tetanus, a disease that kills hundreds of infants a day in developing countries.
Beyond supporting RMHC, McDonalds provides assistance, including free food, water, and other help to disaster victims and volunteers. McDonalds has helped during earthquakes, hurricanes, floods, and other traumatic events. During the tragedy of September 11, 2001, McDonalds provided nearly 750,000 free meals to rescue workers and contributed more than $4 million to a relief fund with the help of RMHC and collections. The restaurant giant is an active promoter of diversity. Today over 30 percent of McDonalds franchise owners are women and minorities, and it purchases over $3 billion worth of goods and services from women and minority suppliers. Furthermore, McDonalds is an active pursuer of employment diversity and a supporter of educational scholarships, providing millions of dollars in educational assistance.
McDonalds emphasizes environmental programs and works with the Environmental Defense Fund to develop effective programs for reducing and recycling waste. It established McRecycle USA with the goal of using recycled materials for construction and remodeling of its restaurants.
Since the 1990s, McDonalds has purchased more than $4 billion worth of products made from recycled materials and it has eliminated approximately 200,000 tons of packaging by redesigning items including straws, napkins, cups, fry cartons, and other packaging items.
McDonalds actions speak louder than words. Other companies may say they are socially responsible, but McDonalds offers proof.
Unethical and illegal financial practices on Wall Street by corporate financial deal-makers have made news headlines from the late 1980s until the present. Insider trading has been one of the most widely publicized issues in recent years. Insider tradingThis occurs when someone has information that is not available to the public and then uses this information to profit from trading in a companys common stock. occurs when someone has information that is not available to the public and then uses this information to profit from trading in a companys publicly traded securities. This practice is illegal and protected against by the Securities and Exchange Commission (SEC). Sometimes the insider is a company manager; other times it is the companys lawyer, investment banker, or even the printer of the companys financial statements. Anyone who has knowledge before public dissemination of that information stands to benefit from either good news or bad news.
There has been a long history of Wall Street executives like Ivan Boesky, Dennis Levine, and Michael Milken who were sent to jail for insider trading activities. Such activities as insider trading serve no beneficial economic or financial purpose, and it could be argued that they have a negative impact on shareholder interests. Illegal security trading destroys confidence in U.S. securities markets and makes it more difficult for managers to achieve shareholder wealth maximization.
Ethics and social responsibility can take many different forms. Ethical behavior for a person or company should be important to everyone because it creates an invaluable reputation. However, once that reputation is lost because of unethical behavior, it is very difficult to get back. Some companies are more visible than others in their pursuit of these ethical goals and most companies that do a good job in this area are profitable, save money, and are good citizens in the communities where they operate.