Alternative Goals of a Firm
It is agued that even though entrepreneurs are directed with certain goals and have superior ideas in some areas of the value chain, their yield is bounded by available cash ( 2005). A shoe factory owner may aim to obtain maximum profit based on the industry leader but expanding firm size requires capital. In the same manner, a fish vendor may aim to sell in other populated areas to prevent the merchandise from perishing but transportation costs may as well equivalent to the costs of unsold fish. A significant point is that they have specific goals and strategic and entrepreneurial plans but are limited by absolute costs (of expansion) and transaction costs (of transportation).
In this respect, it becomes important to managers and entrepreneurs to rationalize their goals for their respective firms against their financial structure. Being conservative decision-makers will lead them to prioritize the latter to determine the former while being daring will result to a reversed approached. For the purpose of this discussion, they are initially daring but retain prudence to monitor performance and act when necessary. Given this, we will explain alternative goals of a firm, how can they be measured and the role of financial managers to aid decision-makers towards these goals.
Perhaps the most famous goal of a firm, profit maximization is a core concern of economic theory (2001). However easy and lucrative as it may sound, arriving at numerical benchmark alone requires the following methods. For example, a firm can calculate its marginal revenues and marginal costs curves, in which case, MR=MC is the maximum profit benchmark. Other alternatives are to graph total revenue and total cost curves and identify the farthest point between them or trial and error in price adjustments. These methods, in the contrary, are tarnished by lack of information and the use of very short-run demand curves on top of costs and time spent of firm audit and market research. Applied by counter economic theories of opportunity and transaction costs, profit maximization may not only be suited to be called “unrealistic” ( 2001) but also impractical. Due to this, financial managers have disregarded this theory since its objective is limited, if not, unbounded.
An alternative goal that directly resolves the deficiencies of profit maximization is when a firm exemplifies profit satisfying behavior. By using this, it places boundaries around the goal by making its own benchmark or target level of profit depending on preferred time frame and stake holder’s priority. For US corporations, the most important stakeholders are shareholders ( 2003 ). As a result, goals are framed to maximize shareholder’s value. The challenge for the firm is how to provide both short- and long-term values for shareholder’s investment. This involves crucial decisions such as the level of diversification of firm’s products or markets, R&D plans, dividend issuance and the level of retained earnings. Of course, this shareholder’s goal also determines the span and quality of operations of the firm particularly for publicly listed ones.
A goal of a firm, particularly a publicly traded one, is to maximize shareholders wealth (2006). As debt financing is a risky alternative for a firm since it has to pay its obligation even though operational performance is bad ( 1999), the funding through equity is crucial to a firm’s future prospects, if not, existence. As a result, managers are bound to satisfy their owners. The difficulty in accomplishing the task is that there are trade-offs between short- and long-term decisions, that even if managers are acting in good faith, their shares remain unattractive for investors.
To be able to cope with shareholder’s demand on value, earnings per share (EPS) can serve as barometer ( 1999). In simple terms, this is the profit of one unit of ordinary share of a certain business period. Another is computing for the return on investment (ROI). This shows the returns as percentage of investment being employed. EPS and ROI are both profitability measures that shareholders will base their future investment decisions. The higher the cash amount of EPS or percentage of ROI, it is most likely that shareholders will retain their investments and support the future strategies of managers. In the contrary, a low EPS or ROI will result to shareholder selling their shares.
The same concept is true for the return on equity (ROE). This is net income as percentage of equity capital. This excludes other financing, like debt or non-equity, other than issuance of shares. In formula, this can be illustrated as: Shareholder Value = Corporate Value – Debt (1999). The problem of these measurement models is that opportunity costs of shareholders from investing to other firms are not taken into consideration. As a result, the value becomes relative rather absolute and managers should use alternative measurements such as economic value added (EVA).
Like EPS, EVA is computed in dollar terms (1999). The opportunity costs are taken into account since the percentage of weighted average cost of capital is multiplied to the cost of invested assets before getting the difference with respect to profit. The higher the opportunity cost being forgone from a shareholder, the firm is ought to compensate for this with higher profits. Otherwise, EVA will be negative and will mean that the firm is not maximizing the value of shareholders in terms of the value of money being forgone due to exclusive investment to the firm. To maximize shareholder’s value, EVA should not only be positive but also increasing over a period of time.
The Role of Financial Managers
Financial managers can aid a firm in achieving shareholder’s value through funds management. The function involves three key activities: acquisition, allocation and utilization of investment (1999). The first involves the determination of acquiring investments from the right source. In effect, the firm does not only have to rely on shareholders but also through banks and other creditors to raise capital. In effect, the problem of satisfying them is eased in favor of spreading the risk of the firm particularly the risk of too much equity. This can become a problem when a firm undermines its positive credit rating or increasing the risk of hostile takeover. At this point, the firm is not just automatically shouldering the responsibility of maximizing shareholder’s value rather being selective to prevent post-investment disappointment from them which can be otherwise resolved through other forms of financing.
Second, allocation involves putting the investments in which a determined level of profit can be achieved. This task necessitates scrutiny and benefit-cost analysis of a given list investment opportunities which can be shown numerically by financial managers. They can suggest comparison to past performance, industry competitors and other benchmarks. The plan will determine the outcome unless the management has enough flexibility in its operations to change investment allocations without affecting the pre-computed gains from them. In most cases, however, financial flexibility is very difficult to obtain without enough liquidity or solvency. In addition, business units who have already receive their budget may lead to under performance due to budget cut or lesser motivation feeling that the firm has so much room for loss due to budget raise.
Upon implementation, financial managers can also give operational and tactical advice to the management when currency exchange fluctuations or interest rates affected their pre-implementation strategies. This is part of its utilization activities. They can always rely on his computations to shield the firm in untoward changes in its earlier allocation.
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