To study financial decision making, we first need to understand the goal of financial management. Such an understanding is important because it leads to an objective basis for making and evaluating financial decisions.
Profit maximization would probably be the most commonly cited business goal, but this is not a very precise objective. Do we mean profits this year? If so, then actions such as deferring maintenance, letting inventories run down, and other short-run, cost-cutting measures will tend to increase profits now, but these activities aren't necessarily desirable.
The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it's unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see, these numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we're all dead! More to the point, this goal doesn't tell us the appropriate trade-off between current and future profits.
The Goal of Financial Management in a Corporation
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 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 it.
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 in a corporation can thus be stated quite easily:
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 discussed above. 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. Of course, maximizing stock value is the same thing as maximizing the market price per share.
Large companies are sometimes guilty of unethical behavior. Often this unethical behavior takes the form of false or misleading financial statements. In one of the largest corporate fraud cases in history, energy giant Enron Corporation was forced to file for bankruptcy in December 2001 amid allegations that the company's financial statements were deliberately misleading and false. Enron's bankruptcy not only destroyed that company, but its auditor Arthur Andersen as well.
More recently, in late 2006, without admitting wrongdoing, Hewlett-Packard agreed to pay $14.5 million to California to settle the company's “pretexting” scandal. The scandal began when a board member complained that confidential information was being leaked to the public. In an effort to find the individuals responsible, HP used several methods including pretexting to obtain confidential phone records. Pretexting, which is obtaining records under false pretenses, has become an unfortunately common method of obtaining personal information. The scandal involved several high-ranking officials at HP, including Chairwoman Patricia Dunn and Chief Ethics Officer Kevin Hunsaker, both of whom resigned and subsequently faced criminal charges.
The difference between ethical and unethical behavior can sometimes be murky. For example, many U.S. companies have relocated to Bermuda for reasons beyond the beautiful pink beaches; namely, Bermuda has no corporate income taxes. With a population of less than 65,000, the island is home to more than 13,000 international companies. Stanley Works, the well-known maker of Stanley tools, was among the U.S. corporations that chose to move to the island paradise. By doing so, Stanley estimated that it would save $30 million per year in taxes. Since the goal of the corporation is to maximize shareholder wealth, this would seem like a good move, and the practice is entirely legal. But is it ethical? What are the issues?
Another corporate activity that has generated much controversy is the practice of outsourcing, or offshoring, jobs to other countries. U.S. corporations engage in this practice when labor costs in another country are substantially lower than they are domestically. Again, this is done to maximize shareholder wealth. But the ethical dilemma in this case is even trickier. Some U.S. workers do lose jobs when offshoring occurs. On the other hand, the Milken Institute estimated that every $1 spent on offshoring a service job to India generated a net value to the United States of $1.13, along with another $.33 to India. And it gets even more complicated: What about foreign companies such as BMW and Toyota who “insource” jobs by building plants in the United States? Is it unethical to outsource U.S. jobs while, at the same time, insourcing jobs from other countries?
A More General Financial Management Goal
Given our goal as stated above (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:
Maximize the market value of the existing owners' equity.
With this goal 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.
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. Our nearby Reality Bytes box discusses some recent ethical issues and problems faced by well-known corporations.
In response to corporate scandals involving companies such as Enron, WorldCom, Tyco, and Adelphia, Congress enacted the Sarbanes-Oxley Act in 2002. The Act, which is better known as “Sarbox,” is intended to strengthen protection against corporate accounting fraud and financial malpractice. Key elements of Sarbox took effect on November 15, 2004.
Sarbox contains a number of requirements designed to insure that companies tell the truth in their financial statements. For example, the officers of a public corporation must review and sign the annual report. They must attest that the annual report does not contain false statements or material omissions and also that the financial statements fairly represent the company's financial results. In essence, Sarbox makes management personally responsible for the accuracy of a company's financial statements.
Because of its extensive 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 would no longer be traded in the major stock markets, 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.
Sarbox has also probably affected the number of companies choosing to go public in the United States. For example, when Peach Holdings, based in Boynton Beach, Florida, decided to go public in 2006, it shunned the U.S. stock markets, instead choosing the London Stock Exchange's Alternative Investment Market (AIM). To go public in the United States, the firm would have paid a $100,000 fee, plus about $2 million to comply with Sarbox. Instead, the company spent only $500,000 on its AIM stock offering. The number of companies listing on the AIM is evidence of a flight from Sarbox rules: During 2005, 335 companies went public on the AIM, while only 126 went public on the NASDAQ.
|1.4a||What is the goal of financial management?|
|1.4b||What are some shortcomings of the goal of profit maximization?|