the question is : The role of the financial manager involved creating value and
ID: 2702813 • Letter: T
Question
the question is :
The role of the financial manager involved creating value and maximising the wealth of the shareholders. This is achieved in a number of different ways including revenue maximisation and or cost minimisation. Using an example to illustrate, explain how the pursuit of a single subsidiary motivation may compromise the achievement of shareholder wealth maximisation.
The role of the financial manager involved creating value and maximising the wealth of the shareholders. This is achieved in a number of different ways including revenue maximisation and or cost minimisation. Using an example to illustrate, explain how the pursuit of a single subsidiary motivation may compromise the achievement of shareholder wealth maximisation.Explanation / Answer
According to financial management theory, it's assumed that the fundamental objective for a firm is to maximise shareholders wealth (Watson & Head 2007). Analysing the suggestions and arguments towards fundamental objective, it can be seen that not only in theory but also in the real world it is essential to maximise the wealth of shareholder.
Analysing the objective of profit maximisation, overriding the classical economics views by Hayek (1960) and Friedman (1970), other authors, Solomon (1963) and Geoffrey (1970) argued about the criticisms associated with the objective of maximisation of profits. The conflict of short term goal of profit maximisation and long term objective of shareholder wealth maximisation can be identified as the main conflict. If a firm adapts to an objective of profit maximisation and the managers are rewarded incentives for achieving it, the agency problem could be arise. Therefore in such a situation managers may take decisions towards their own selfish interests, rather than on shareholders. Achieving their self interest managers may reduce costs by cutting research and development costs, reducing quality control measurements, reduce advertising, using lower quality materials. At the same time the NPV positive projects could also be postponed to reduce their costs to determine more profits in short term. Producing low quality products, losing market share, losing customer trust on their products and finally reducing financial performance could be resulted as a result of using low cost strategies. It may lead the business towards insecure stock prices in long run.
The other criticism is profit maximisation does not appraise the associated risks. Therefore managers may undertake higher NPV projects to determine higher returns. "However higher the required returns, higher the risk" (Peter Atrill; Financial Management for Decision Makers, 2008). Investing on risky projects will result future cash flow problems. However, shareholders are assumed as rational investors who provide finance for firms to invest in future projects. As rational investors they require a reasonable return for their investments. Therefore it can be suggested that objective of profit maximising is different from the wealth maximising.
Even though shareholder wealth maximisation is the fundamental, firms are not being able to reject the profit perspective goals, because there are stakeholder groups who is interesting about financial activities in a firm. In addition to shareholders, Managers, Employees, Customers, Suppliers, finance providers and the community at large are included in the typical stakeholder group. Therefore it's essential to take account of profit maximisation within the firm. As a result of these multiple objectives managers can easily pursue their own interest.
In real world, financial statements are used to assess firm's performance. However, profits are defined as profit before interest and tax, profit after interest and so on. Therefore the ratio of Earnings per Share is often used instead of profit which is calculated using the net profits and the number of shares issued. Investors usually use EPS as a measurement of valuing stock. EPS is mostly used as it contains of net income of the firm, and it is also used as an indicator measuring firm's future cash flows. Although the disadvantage is EPS does not determine shareholders wealth. However, firms value should be determined by the future cash flows and the risk also need to be considered which is associated to the cash flow. However as mentioned earlier, profits does not take account of risks. I:e:"Reported profit figures such as Biotechnological companies and other new economy ventures have insignificant relationship on its stock prices" (Financial Management -Kaplan Publishers, 2009). Therefore, in the short term there's an inconsistence between profit maximisation and increase in stock prices in a firm.
According to Smith (1937), Berle and Means (1932) and Geoffrey (1994) the separation of ownership is involved the corporate structure. The conflict was mostly seen during the recent past, following the corporate scandals.
According to Maria and William in the article of Privatisation and the Rise of Global Capital Markets (Financial Management; winter, 2000) "The past years there was significant growth in capital markets valuation, growth in security issuance as a result of the privatisation programmes". The impacts of share issue privatisation are increasing market liquidity, pattern of share ownership (i:e: Individual and institutional investors such as Pension funds and Insurance Companies), and increasing of number of shareholders in many countries. However, globalisation was also affected on firm's activities simultaneously. Therefore the firms (i:e: Enron & Maxwell), which had poor Corporate Governance had the possibility to involving in unethical activities such as creative accounting and off balance sheet finance(Financial Management, Kaplan Publishers; 2009). At the same time Directors involved in high level of corporate takeover activities, achieving their personal interest such as empire building, large remuneration packages (Financial Management, Kaplan publishers; 2009).
Further analysis of Stakeholder theory and Shareholder theory by different authors, Jenson "2005) and Daniel and Press (2006) argued the criticism of stakeholder theory, whilst Daniel, Heck and Shaffer (2008) and Freeman (1984) argued the importance of both shareholder and stakeholder theory. However, it can be suggested that the stakeholders play a significant role towards increasing shareholders value. As an example to motivate employees of the firm, they should be treated in a good manner by rewarding increments, bonuses and so on. Long term employee satisfaction could drive the firm towards higher performance and the development of the business by increasing higher productivity and better quality of products. Simultaneously, building up a trust among customers and acquire and maintain the industry leadership.
At the same time shareholders provide finance for firms for its working capital management and noncurrent assets for its future projects. Therefore it can be seen an inter relationship and importance of shareholders and the other stakeholders.
According to Peter Atrill, (Financial Management for Decision makers , 2008)"In the early years financial management theory was mainly developed as part of accounting and the suggestions and arguments were based on casual observations rather than theoretical frame work". But after the number of high profile firms collapsed, the requirement of corporate governance occurred. Number of committees met and discussed to improve the Corporate Governance and the main concern was the conflict between shareholders interest and managers. Enron was the seventh largest listed company in US when it's collapsed in 2001 as a result of manipulation of financial statements. It's affected to shareholders, more than 20000 employees worldwide, creditors and customers (Janis Sarra; St John's Law Review ; Enron's Repercussion in Canada). The 11 titled "Sarbanes Oxley Act 2002"
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