The Objectives in Corporate

Finance
Dr. Himanshu Joshi
FORE School of Management
New Delhi
The Objective in Corporate Finance
• Why do we need an objective at all?
The Objective in Corporate Finance
• At the level of individual firm:
• Every organization has to ask and answer the
question: what are we trying to accomplish?
Or how do we keep score? When all is said
and done, how do we measure better versus
worse?
The Objective in Corporate Finance
• At the level of Economy–wide or social level:
• If we could dictate the criterion or objective function
to be maximized by firms (and thus the performance
criterion by which executives choose among
alternative policy options) what would it be? Or more
simply:
• How do we want the firms in our economy to measure
their own performance?
• How do we want them to determine what is better
versus worse?
The Objective in Corporate Finance
• The Profit Maximization Criterion
• The Value (wealth) maximization Criterion
• The Stake holder’s theory and Balanced
Scorecard.
 Why Corporate Finance focuses on Stock
Price Maximization?
• Stock prices are the most observable of all
measures that can be used to judge the
performance of a publicly traded firm.
• unlike earnings or sales which are updated once
every quarter or year, stock price are updated
constantly to reflect new information coming out
about the firm.
• Thus managers receive instantaneous feedback on
every action they take from investors in markets.
 Why Corporate Finance focuses on Stock
Price Maximization?
• Stock prices in a market with rational
investors, reflect the long term effects of the
firm’s decisions.
• Even if market err in their estimates.
• Erroneous estimate of long term value is
better than a precise estimate of current
earnings because stock price reflects future
and is based on all available information.
 Why Corporate Finance focuses on Stock
Price Maximization?
• Stock price is the real measure of stock holder
wealth, since stock holders can sell their
stock and the receive the price now.
 When is stock price maximization the only
objective a firm needs?
• Although, this single mindedness sounds
extreme and may actually be damaging to
other claim holders in the firm (lenders,
employees, and society) it is appropriate if the
following assumptions hold:
 Hire and fire managers Maximize
Boards/Annual Meetings Stock holders
Stock Wealth
holders

Lend money
Bond No Social Cost
Holders Managers Society
Protect Costs can be
bondholder Traced to the firm
interest

Reveal
Markets are efficient
information
Financial Markets and assess effect
honestly and on
on value
time
 Assumptions:
1. The managers of the firm put aside their own
objectives and focus on maximizing
stockholder wealth measured by stock price.

They own enough stock in the

Managers are terrified of the
firm that maximizing stockholder
power of stockholders to replace
wealth becomes their primary
them.
objectives.
 Assumptions..
• The lenders to the firm feel secure that their
interests will be protected and the firm will
live up to its contractual obligations.

Stockholders might be The lenders might be able to

concerned about the damage to protect themselves fully when
the firm’s reputation if they take they lend by writing in
actions that hurt the lenders restrictions that proscribe the
and about the consequences of firm’s taking any actions that
that damage for future hurt the lenders.
borrowings.
 Assumptions..
3. The managers of the firm do not attempt to
mislead or lie to financial markets about their
future prospects.
and There is sufficient information for
markets to make judgments about the effects
of the firm’s actions on its value.
 Assumptions..
5. There are no burdens that are created for
society, in the form of health, pollution, or
infrastructure costs, in the process of
stockholder wealth maximization.
All costs created by the firm in its pursuits of
stockholders wealth maximization can be
traced to and charged to firm.
 Why stock price maximization works
• Stockholders hire managers to run their firms form them…
Because stockholders have absolute power to hire and fire
managers.

• Managers set aside their interests and maximize stock price…

Because markets are efficient.

• Stockholders wealth is maximized..

Because lenders are fully protected from stockholders actions

• Firm value is maximized…

Because there are no cost created for society

• Societal wealth is maximized…

 Agency Costs
• The core of the problem is that stockholders,
managers, bondholders, and society have
different interests and incentives.
• Consequently, conflicts of interests may arise
between these different groups.
• These conflicts create costs for the firm that
are called agency costs, and these costs can
result into stock price maximization going into
awry.
 Conflict Groups
• Stockholders and Managers
• Stockholders and Bondholders
• The firm and Financial Markets
• The firm and Society
Stock Price Maximization with Agency Costs

• Managers, given the limited powers of

stockholders have over them, may not make
decisions to maximize stockholder wealth but
may instead choose to further their own
interests.
• Stockholders, if not restricted contractually,
may increase stock price by transferring
wealth from those who lent them money.
Stock Price Maximization with Agency Costs..

• Firms may increase stock prices by feeding

misleading or fraudulent information to
markets that do not efficiently assimilate the
information in the first place.
• Finally, firms can create substantial costs for
society while they focus on maximizing stock
prices.
 Have little control over Managers put their own
managers Objectives above stockholders
Stock
holders

Significant
Lend money Social Cost
Bond
Holders Managers Society
Bondholders Some Costs can not
can be be traced to the
exploited firm

Delay bad news

Markets make mistake
or provide
Financial Markets and can overreact
misleading
information
Corporate Governance??
 Corporate Governance
• Corporate Governance is a buzz word now a days in
academic circles, among policy makers and corporate
executives.
• In some scholarly and business circles, the discussion
focuses mainly on questions of policies and procedures
designed to improve oversight of corporate managers by
board of directors.
• but at the heart of the current global corporate
governance debate is a remarkable division of the opinion
about the fundamental purpose of the corporation.
 The Solution??
• Stakeholder Theory and Balanced Scorecard.
• Stakeholder theory implies that managers
must pay attention to all constituencies that
can affect the value of the firm.
• Balance score card is quantified managerial
version of the stakeholder theory.
• And our value maximization principle is
completely consistent with these theories.
 Stakeholder Theory and B.S.Card
• But there is more to stakeholder story than this. Any theory of
corporate decision making must tell the decision makers- in this
case managers and BOD- how to choose among multiple
constituencies with competing and in some case conflicting
interests.
• Customers want low prices, high quality and full service.
• Employees want high wages and salaries, high quality working
conditions, and fringe benefits, including vacations, medical
benefits, and pensions.
• Suppliers of capital want low risk and high returns.
• Communities want high charitable contributions, increased local
employments and stable employment.
• Stakeholder theory must specify the core decision criterion- how
to make the tradeoffs between these demands.
Value Maximization Vs Stakeholder theory

• Value maximization providing the following

answer to the tradeoff question:
• Spend an additional dollar on any
constituency provided the long term value
added to the firm from such expenditure is a
dollar or more.
• Stakeholder theory by contrast provides no
such criterion.
Implications for Managers and Directors
• Because stakeholder theory leaves directors
and managers in firms with no principled
criterion for decision making, companies that
try to follow the dictates of stakeholder’s
theory will eventually fail if they are competing
with firm that are aiming to maximize value.
• If this is true, why do so many managers and
directors of corporations embrace stakeholder
theory??
Implications for Managers and Directors
• One answer lies in their personal short run interests. By
failing to provide a definition of better, stakeholder theory
often leave managers and directors unaccountable for
their stewardship of the firm’s resources.
• Without the criterion for performance, managers can not
be evaluated in any principled way.
• Therefore stakeholder’s theory plays into the hands of
managers by allowing them to pursue their own interests
at the expense of the firm’s financial claimants and
society at large.
 The Logical Structure of the Problem
• In discussing whether firms should maximize
value or not, we must separate two distinct
issues:
• Should the firm have a single-valued objective
or a scorecard?
• And, if so, should that objective be value
maximization or something else(for example,
maintaining employment or improving the
environment)?
Issue #1: purposeful behavior requires the
existence of a Single-Valued objective
Function
• Consider a firm that wishes to increase both
its current year profit and its market share.
 Maximum
Market Share

Current
Year
Profit

Market Share
Multiple Objectives is No Objective
• It is logically impossible to maximize in more than
one direction at the same time.
• Thus telling a manager to maximize current profits,
market share, future growth in profits, future
dividends will leave managers with no way to make
a reasoned decision.
• In effect it leaves manager with no objective.
• The result will be confusion and lack of purpose that
will handicap the firm in its competition for survival.
Issue#2: Total Firm Value Maximization Makes
Society better off
• If company that takes inputs out of economy
and puts its output of goods and services back
into the economy increases aggregate welfare
if the prices at which it sells the goods more
than cover its costs it incurs in purchasing the
incomes.
 Enlightened Value Maximization
• Enlightened value maximization recognizes that
communication with and motivation of an organization’s
managers, employees and partners is extremely difficult.
• What this means in practice is that if we simply tell all
participants in an organization that its sole purpose is to
maximize value, we will not get maximum value for the
organization.
• Value maximization is not a vision or a strategy or even a
purpose, it is scorecard for the organization.
• We must give people enough structure to understand what
maximizing value means so that they can be guided by it and
have a chance to actually achieve it.