Fm First Chapter Notes

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OVERVIEW OF FINANCIAL MANAGEMENT

1 | ANJUMAN PG CENTRE DHARWAD

INTRODUCTION

Business concern needs finance to meet their requirements in the economic

world. Any kind of business activity depends on the finance. Hence, it is called

as lifeblood of business organization. Whether the business concerns are bigor small, they need finance to fulfil their business activities.

In the modern world, all the activities are concerned with the economic

activities and very particular to earning profit through any venture or

activities. The entire business activities are directly related with making

profit. (According to the economics concept of factors of production, rent

given to landlord, wage given to labour, interest given to capital and profit

given to shareholders or proprietors), a business concern needs finance to

meet all the requirements. Hence finance may be called as capital, investment,fund etc., but each term is having different meanings and unique characters.

Increasing the profit is the main aim of any kind of economic activity.

MEANING OF FINANCE

Finance may be defined as the art and science of managing money. It includes

financial service and financial instruments. Finance also is referred as the

provision of money at the time when it is needed. Finance function is the

procurement of funds and their effective utilization in business concerns.

The concept of finance includes capital, funds, money, and amount. But each

word is having unique meaning. Studying and understanding the concept of

finance become an important part of the business concern.

DEFINITION OF FINANCE

According to Khan and Jain, Finance is the art and science of managing

money.

According to Oxford dictionary, the word finance connotes management of

money. Websters Ninth New Collegiate Dictionary defines finance as the

Science on study of the management of funds and the management of fund as

the system that includes the circulation of money, the granting of credit, the

making of investments, and the provision of banking facilities.

DEFINITION OF BUSINESS FINANCE

According to the Wheeler, Business finance is that business activity which

concerns with the acquisition and conversation of capital funds in meetingfinancial needs and overall objectives of a business enterprise.


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According to the Guthumann and Dougall,

Business finance can broadly be defined as the activity concerned with

planning, raising, controlling, administering of the funds used in the

business.

In the words of Parhter and Wert, Business finance deals primarily with

raising, administering and disbursing funds by privately owned business units

operating in non- financial fields of industry.

Corporate finance is concerned with budgeting, financial forecasting, cash

management, credit administration, investment analysis and fund

procurement of the business concern and the business concern needs to

adopt modern technology and application suitable to the global environment.

According to the Encyclopedia of Social Sciences, Corporation finance deals

with the financial problems of corporate enterprises. These problems include

the financial aspects of the promotion of new enterprises and their

administration during early development, the accounting problems connected

with the distinction between capital and income, the administrative questions

created by growth and expansion, and finally, the financial adjustments

required for the bolstering up or rehabilitation of a corporation which has

come into financial difficulties.

TYPES OF FINANCE

Finance is one of the important and integral part of business concerns, hence,

it plays a major role in every part of the business activities. It is used in all the

area of the activities under the different names.

Finance can be classified into two major parts:

Private Finance, which includes the Individual, Firms, Business or Corporate

Financial activities to meet the requirements.

Public Finance which concerns with revenue and disbursement of

Government such as Central Government, State Government and Semi-

Government Financial matters.

FINANCIAL MANAGEMENT

The present age is the age of industrialization. Large industries are being

established in every country. It is very necessary to arrange finance forbuilding, plant and working capital, etc. for the established of these industries.


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How much of capital will be required, from what sources this much of financewill be collected and how will it be invested, is the matter of financialmanagement.

Financial management is that managerial activity which is concerned

with the planning and controlling of the firms financial resources. It wasa branch of economics till 1890, and as a separate discipline, it is of recentorigin. Still, it has no unique body of knowledge of its own, and draws heavilyon economics for its theoretical concepts even today.

In general financial management is the effective & efficient utilization offinancial resources. It means creating balance among financial planning,procurement of funds, profit administration & sources of funds.

Definitions of Financial Management:

According to Solomon, Financial management is concerned with theefficient use of an important economic resource, namely, capital funds.

According to J. L. Massie, Financial management is the operationalactivity of a business that is responsible for obtaining and effectivelyutilizing the funds necessary for efficient operation.

According to Weston & Brigham, Financial management is an area offinancial decision making harmonizing individual motives & enterprisegoals.

According to Howard & Upton, Financial management is theapplication of the planning & control functions of the finance function. According to J. F. Bradley, Financial management is the area of

business management devoted to the judicious use of capital & carefulselection of sources of capital in order to enable a spending unit tomove in the direction of reaching its goals.

Thus, Financial Management is mainly concerned with the effective funds

management in the business. In simple words, Financial Management as

practiced by business firms can be called as Corporation Finance or

Business Finance.

Main features of financial management:

On the basis of the above definitions, the following are the maincharacteristics of the financial management-

Analytical Thinking-Under financial management financial problemsare analyzed and considered. Study of trend of actual figures is madeand ratio analysis is done.


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Continuous Process-previously financial management was requiredrarely but now the financial manager remains busy throughout theyear.

Basis of Managerial Decisions- All managerial decisions relating to

finance are taken after considering the report prepared by the financemanager.The financial management is the base of managerial decisions. Maintaining Balance between Risk and Profitability-Larger the risk

in the business larger is the expectation of profits. Financialmanagement maintains balance between the risk and profitability.

Coordination between Process- There is always a coordinationbetween various processes of the business.

Centralized Nature- Financial management is of a centralized nature.Other activities can be decentralized but there is only one departmentfor financial management.

Scope of financial management

Financing Decision

The Financing decision is the most important of the firms financingdecision. Here the financial manager is concerned with the makeup of the

right-hand side of the balance sheet. If you look at the mix of financing forfirms across industries, you will see marked differences. Some firms have

relatively large amounts of debt, whereas others are almost debt free. Does

the type of financing employed make a difference? If so, why? And, in somesense, can a certain mix of financing be thought of as best? In addition,dividend policy must be viewed as an integral part of the firms financing

decision. The dividend-pay-out ratio determines the amount of earningsthat can be retained in the firm. Retaining a greater amount of currentearnings in the firm means that fewer dollars will be available for currentdividend payments. The value of the dividends paid to stockholders musttherefore be balanced against the opportunity cost of retained earnings lostas a means of equity financing. Once the mix of financing has been decided,

the financial manager must still determine how best to physically acquire

the needed funds. The mechanics of getting a short-term loan, entering intoa long-term lease arrangement, or negotiating a sale of bonds or stock mustbe understood.

Investment Decision/

The second major decision of the firm is the investment decisions when itcomes to value creation. It begins with a determination of the total amountof assets needed to be held by the firm. Picture the firms balance sheet inyour mind for a moment. Imagine liabilities and owners equity being listed

on the right side of the balance sheet and its assets on the left. The financialmanager needs to determine the dollar amount that appears above the


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double lines on the left-hand side of the balance sheet that is, the size ofthe firm. Even when this number is known, the composition of the assets

must still be decided. For example, how much of the firms total assetsshould be devoted to cash or to inventory? Also, the flipside of investment

disinvestment must not be ignored. Assets that can no longer beeconomically justified may need to be reduced, eliminated, or replaced.

Asset Management Decision/ Capital Budgeting

The third important decision of the firm is the asset management decision.Once assets have been acquired and appropriate financing provided, these

assets must still be managed efficiently. The financial manager is chargedwith varying degrees of operating responsibility over existing assets. Theseresponsibilities require that the financial manager be more concerned with

the management of current assets than with that of fixed assets. A largeshare of the responsibility for the management of fixed assets would residewith the operating managers who employ these assets.

Efficient financial management requires the existence of some objective or

goal, because judgment as to whether or not a financial decision is efficientmust be made in light of some standard. Although various objectives arepossible, we assume in this book that the goal of the firm is to maximize the

wealth of the firms present owners.

OBJECTIVES OF FINANCIAL MANAGEMENT

Effective procurement and efficient use of finance lead to proper utilization ofthe finance by the business concern. It is the essential part of the financialmanager. Hence, the financial manager must determine the basic objectives ofthe financial management. Objectives of Financial Management may bebroadly divided into two parts such as:

1.

Profit maximization2.

Wealth maximization.3.

Economic value added

4.

Market value added

Profit MaximizationMain aim of any kind of economic activity is earning profit. A businessconcern is also functioning mainly for the purpose of earning profit.Profit is the measuring techniques to understand the businessefficiency of the concern. Profit maximization is also the traditional andnarrow approach, which aims at, maximizes the profit of the concern.Profit maximization consists of the following important features.1. Profit maximization is also called as cashing per share maximization.

It leads to maximize the business operation for profit maximization.


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2. Ultimate aim of the business concern is earning profit, hence, itconsiders all the possible ways to increase the profitability of theconcern.Profit is the parameter of measuring the efficiency of the business

concern. So it shows the entire position of the business concern. 4.Profit maximization objectives help to reduce the risk of the business.Favourable Arguments for Profit Maximization The followingimportant points are in support of the profit maximization objectives ofthe business concern: (i) Main aim is earning profit. (ii) Profit is theparameter of the business operation. (iii) Profit reduces risk of thebusiness concern. (iv) Profit is the main source of finance. (v)Profitability meets the social needs also.Unfavourable Arguments for Profit Maximization the followingimportant points are against the objectives of profit maximization:

(i)

Profit maximization leads to exploiting workers and consumers.(ii)

Profit maximization creates immoral practices such as corruptpractice, unfair trade practice, etc.

(iii)

Profit maximization objectives leads to inequalities among thestake holders such as customers, suppliers, public shareholders,etc.

Profit maximization objective consists of certain drawback also:(i)

It is vague: In this objective, profit is not defined precisely orcorrectly. It creates some unnecessary opinion regarding earning habitsof the business concern.

(ii)

It ignores the time value of money: Profit maximization doesnot consider the time value of money or the net present value ofthe cash inflow. It leads certain differences between the actualcash inflow and net present cash flow during a particular period.

(iii)

It ignores risk: Profit maximization does not consider risk of thebusiness concern. Risks may be internal or external which willaffect the overall operation of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves

latest innovations and improvements in the field of the businessconcern. The term wealth means shareholder wealth or the wealth ofthe persons those who are involved in the business concern.Wealth maximization is also known as value maximization or netpresent worth maximization. This objective is an universally acceptedconcept in the field of business.

Favourable Arguments for Wealth Maximization


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(i)

Wealth maximization is superior to the profit maximizationbecause the main aim of the business concern under thisconcept is to improve the value or wealth of the shareholders.

(ii)

Wealth maximization considers the comparison of the value to

cost associated with the business concern. Total value detectedfrom the total cost incurred for the business operation. Itprovides extract value of the business concern.

(iii)

Wealth maximization considers both time and risk of thebusiness concern.

(iv)

Wealth maximization provides efficient allocation of resources.(v)

It ensures the economic interest of the society.Unfavourable Arguments for Wealth Maximization

(i)

Wealth maximization leads to prescriptive idea of the businessconcern but it may not be suitable to present day business

activities.(ii)

Wealth maximization is nothing, it is also profit maximization, itis the indirect name of the profit maximization.

(iii)

Wealth maximization creates ownership-managementcontroversy.

(iv)

Management alone enjoy certain benefits.(v)

The ultimate aim of the wealth maximization objectives is tomaximize the profit.

(vi)

Wealth maximization can be activated only with the help of theprofitable position of the business concern.

Economic value added

The goal of the financial management is to maximise the shareholdersvalue.The shareholders wealth is measured by the returns they receive o theirinvestments. Returns are in two parts, first are in the form of dividend and thesecond in the form of capital appreciation reflected in market value of theshares, of which market value is the dominant part. The market value of shareis influenced by number of factors, many of which may not be fully influencedby the management of firm, however, one factor, which influence on the

market value is the expectation of the shareholders regarding return on theirinvestment. The share prices influenced by the extent to which themanagement is able to meet the expectation of the shareholders. Variousmeasures like return on capital employed, return on equity, earnings pershare, etc.

The excess of returns over cost of capital simply termed as the EconomicValue Added (EVA). EVA measures whether operating profit is sufficientenough to cover cost of capital. Shareholders must earn sufficient return forthe risk they have taken in investing their money in companys capital. Thereturn generated by the company for the shareholders has to be more than


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the cost of capital to justify the risk taken by the shareholders. If thecompanys EVA is negative, the firm is destroying the wealth of shareholderseven though it may be reporting positive and growing EPS or return on capitalemployed. EVA is just a way of measuring an operation s real profitability.

EVA can be calculated as follows:Where,NOPAT=Net operating profit after taxTCE= Total Capital EmployedWACC= Weighted Average cost of capital

Market Value Added

A term closely related to EVA is Market Value Added (MVA). It is the market

value of capital employed in the firm less the book value of capital employed.MVA is calculated by summing up the paid value of equity and preferencecapital, retained earnings, long term and short term debt and subtracting thissum from market value of equity and debt. MVA is cumulative measure ofcorporate performance. It measures how a companys stock has added to ortaken out of investors pocket books over its life and compares it with thecapital those same investors put into the firm. EVA drives MVA. Continuousimprovements in EVA year after year will lead to increase in MVA.

Functions of Financial Management

Functions offinancial managementcan be broadly divided into two groups.

1. Executivefunctions of financial management, and

2.

Routinefunctions of financial management.

This division of functions of financial management is depicted below.

Executive Functions of Financial Management
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The executive functions of financial management are depicted & listed below.

Eight executive functions of financial management (FM) are:-

1.

Estimating capital requirements : The company must estimate its

capital requirements (needs) very carefully. This must be done at thepromotion stage. The company must estimate its fixed capital needsand working capital need. If not, the company will become over-capitalized or under-capitalized.

2. Determining capital structure: Capital structure is the ratio between

owned capital and borrowed capital. There must be a balance betweenowned capital and borrowed capital. If the company has too muchowned capital, then the shareholders will get fewer dividends.Whereas, if the company has too much of borrowed capital, it has topay a lot of interest. It also has to repay the borrowed capital after

some time. So the finance managers must prepare a balanced capitalstructure.

3. Estimating cash flow: Cash flow refers to the cash which comes in and

the cash which goes out of thebusiness.The cash comes in mostly fromsales. The cash goes out for business expenses. So, the finance managermust estimate the future sales of the business. This is called Salesforecasting.He also has to estimate the future business expenses.

4.

Investment Decisions : The business gets cash, mainly from sales. Italso gets cash from other sources. It gets long-term cash from equityshares, debentures, term loans from financial institutions, etc. It getsshort-term loans from banks, fixed deposits, dealer deposits, etc. The
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finance manager must invest the cash properly. Long-term cash mustbe used for purchasing fixed assets. Short-term cash must be used as aworking capital.

5. Allocation of surplus: Surplus means profits earned by the company.

When the company has a surplus, it has three options, viz.,1.

It can pay dividend to shareholders.2.

It can save the surplus. That is, it can have retained earnings.3.

It can give bonus to the employees.6.

Deciding Additional finance: Sometimes, a company needs additionalfinance for modernisation, expansion, diversification, etc. The financemanager has to decide on following questions.

1.

When the additional finance will be needed?2.

For how long will this finance be needed?3.

From which sources to collect this finance?

4.

How to repay this finance?

Additional finance can be collected from shares, debentures, loans fromfinancial institutions, fixed deposits from public, etc.

7. Negotiating for additional finance : The finance manager has to

negotiate for additional finance. That is, he has to speak to many bankmanagers. He has to persuade and convince them to give loans to hiscompany. There are two types of loans, viz., short-term loans and long-term loans. It is easy to get short-term loans from banks. However, it is

very difficult to get long-term loans.8.

Checking the financial performance : The finance manager has tocheck the financial performance of the company. This is a veryimportant finance function. It must be done regularly. This will improvethe financial performance of the company. Investors will invest theirmoney in the company only if the financial performance is good. Thefinance manager must compare the financial performance of thecompany with the established standards. He must find ways forimproving the financial performance of the company.

Routine Functions of Financial Management

The routine functions are also called as incidentalfunctions.

Routine functions are clerical functions. They help to perform the Executivefunctions of financial management.

The routine functions of financial management are briefly listed below.


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Six routine functions of financial management (FM) are:-

1.

Supervision of cash receipts and payments.2.

Safeguarding of cash balances.3.

Safeguarding of securities, insurance policies and other valuablepapers.

4.

Taking proper care of mechanical details of financing.5.

Record keeping and reporting.6.

Credit Management.

Risk-return trade off

Financial decisions of the firm are guided by risk return trade off. These

decisions are interrelated and jointly affect the market value of its shares by

influencing return and the risk of the firm. The relationship between risk and

return can be simply expressed as below

Return = risk free rate+ risk premium
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Risk free rate is the rate obtainable from a default risk free government

security. An investor assuming risk from his/her investment requires a risk

premium above the risk free rate. Risk free rate is compensation for the time

and risk premium for the risk involved in the investment. Low levels of

uncertainty (low risk) are associated with low potential returns. High levels of

uncertainty (high risk) are associated with high potential returns. A proper

balance between return and the risk should be maintained to maximise the

market value of the firms shares. Such balance is called risk-return trade off.

The financial manager, in a bid to maximise shareholders wealth should strive

to maximise the return in relation to the given risk; He/She should seek

actions that avoid unnecessary risks. To ensure maximum return, fundsflowing in and out of the organisation should be constantly monitored to

assure that they are safeguarded and properly utilised. The financial

reportimg systems must be designed to provide timely and accurate picture of

the firms activities

FINANCIAL MANAGEMENT AND ITS RELATIONSHIP WITH OTHER

DISCIPLINES

Finance and EconomicsFinance is a branch of economics. Economics deals with supply and demand,

costs and profits, production and consumption and so on. The relevance of

economics to financial management can be described in two broad areas of

economics i.e., micro economics and macroeconomics.

Micro economics deals with the economic decisions of individuals and firms.

It concerns itself with the determination of optimal operating strategies of a

business firm. These strategies include profit maximization strategies,

product pricing strategies, strategies for valuation of firm and assets etc. Thebasic principle of micro economics that applies in financial management is


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marginal analysis. Most of the financial decisions should be made taken into

account the marginal revenue and marginal cost. So, every financial manager

must be familiar with the basic concepts of micro economics.

Macroeconomics deals with the aggregates of the economy in which the firm

operates. Macroeconomics is concerned with the institutional structure of thebanking system, money and capital markets, monetary, credit and fiscal

policies etc. So, the financial manager must be aware of the broad economic

environment and their impact on the decision making areas of the business

firm

Finance and Accounting

Accounting and finance are closely related. Accounting is an important input

in financial decision making process. Accounting is concerned with recordingof business transactions. It generates information relating to business

transactions and reporting them to the concerned parties. The end product of

accounting is financial statements namely profit and loss account, balance

sheet and the statements of changes in financial position. The information

contained in these statements assists the financial managers in evaluating the

past performance and future direction of the firm (decisions) in meeting

certain obligations like payment of taxes and so on. Thus, accounting and

finance are closely related.

Finance and Production

Finance and production are also functionally related. Any changes in

production process may necessitate additional funds which the financial

managers must evaluate and finance. Thus, the production processes, capacity

of the firm are closely related to finance.

Finance and Marketing

Marketing and finance are functionally related. New product development,sales promotion plans, new channels of distribution, advertising campaign

etc. in the area of marketing will require additional funds and have an impact

on the expected cash flows of the business firm. Thus, the financial manager

must be familiar with the basic concept of ideas of marketing.

Finance and Quantitative Methods

Financial management and Quantitative methods are closely related such as

linear programming, probability, discounting techniques, present value


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techniques etc. are useful in analyzing complex financial management

problems. Thus, the financial manager should be familiar with the tools of

quantitative methods. In other way, the quantitative methods are indirectly

related to the day-to-day decision making by financial managers.

Finance and Costing

Cost efficiency is a major strategic advantage to a firm, and will greatly

contribute towards its competitiveness, sustainability and profitability. A

finance manager has to understand, plan and manage cost, through

appropriate tools and techniques including Budgeting and Activity Based

Costing.

Finance and LawA sound knowledge of legal environment, corporate laws, business laws,

Import Export guidelines, international laws, trade and patent laws,

commercial contracts, etc. are again important for a finance executive in a

globalized business scenario. For example the guidelines of Securities and

Exchange Board of India [SEBI] for raising money from the capital markets.

Similarly, now many Indian corporate are sourcing from international capital

markets and get their shares listed in the international exchanges. This calls

for sound knowledge of Securities Exchange Commission guidelines, dealing

in the listing requirements of various international stock exchanges operatingin different countries.

Finance and Taxation

A sound knowledge in taxation, both direct and indirect, is expected of a

finance manager, as all financial decisions are likely to have tax implications.

Tax planning is an important function of a finance manager. Some of the major

business decisions are based on the economics of taxation. A finance manager

should be able to assess the tax benefits before committing funds. Presentvalue of the tax shield is the yardstick always applied by a finance manager in

investment decisions.

Finance and Treasury Management

Treasury has become an important function and discipline, not only in banks,

but in every organization. Every finance manager should be well grounded in

treasury operations, which is considered as a profit center. It deals with

optimal management of cash flows, judiciously investing surplus cash in the

most appropriate investment avenues, anticipating and meeting emerging


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cash requirements and maximizing the overall returns, it helps in judicial

asset liability management. It also includes, wherever necessary, managing

the price and exchange rate risk through derivative instruments. In banks, it

includes design of new financial products from existing products.

Finance and Banking

Banking has completely undergone a change in todays context. The type of

financial assistance provided to corporate has become very customized and

innovative. During the early and late 80s, commercial banks mainly used to

provide working capital loans based on certain norms and development

financial institutions like ICICI, IDBI, and IFCI used to provide long term loans

for project finance. But, in todays context, these distinctions no longer exist.Moreover, the concept of development financial institutions also does not

exist any longer. The same bank provides both long term and short term

finance, besides a number of innovative corporate and retail banking

products, which enable corporate to choose between them and reduce their

cost of borrowings. It is imperative for every finance manager to be up-to date

on the changes in services & products offered by banking sector including

several foreign players in the field. Thanks to Governments liberalized

investment norms in this sector.

Finance and Insurance

Evaluating and determining the commercial insurance requirements, choice

of products and insurers, analyzing their applicability to the needs and cost

effectiveness, techniques, ensuring appropriate and optimum coverage,

claims handling, etc. fall within the ambit of a finance managers scope of

work & responsibilities.

International FinanceCapital markets have become globally integrated. Indian companies raise

equity and debt funds from international markets, in the form of Global

Depository Receipts (GDRs), American Depository Receipts (ADRs) or

External Commercial Borrowings (ECBs) and a number of hybrid instruments

like the convertible bonds, participatory notes etc., Access to international

markets, both debt and equity, has enabled Indian companies to lower the

cost of capital. For example, Tata Motors raised debt as less than 1% from the

international capital markets recently by issuing convertible bonds. Finance

managers are expected to have a thorough knowledge on international


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sources of finance, merger implications with foreign companies, Leveraged

Buy Outs (LBOs), acquisitions abroad and international transfer pricing. The

implications of exchange rate movements on new project viability have to be

factored in the project cost and projected profitability and cash flow

estimates. This is an essential aspect of finance managers expertise. Similarly,protecting the value of foreign exchange earned, through instruments like

derivatives, is vital for a finance manager as the volatility in exchange rate

movements can erode in no time, all the profits earned over a period of time.

Finance and Information Technology

Information technology is the order of the day and is now driving all

businesses. It is all pervading. A finance manager needs to know how tointegrate finance and costing with operations through software packages

including ERP. The finance manager takes an active part in assessment of

various available options, identifying the right one and in the implementation

of such packages to suit the requirement.

Agency Theory

Weve seen that the financial manager in a corporation acts in the bestinterests of the stockholders by taking actions that increase the value of the

firms stock. However, weve also seen that in large corporations ownership

can be spread over a huge number of stockholders. This dispersion of

ownership arguably means that management effectively controls the firm. In

this case, will management necessarily act in the best interests of the

stockholders? Put another way, might not management pursue its own goals

at the stockholders expense? We briefly consider some of the arguments

below.

Agency Relationships

The relationship between stockholders and management is called an agency

relationship. Such a relationship exists whenever someone (the principal)

hires another (the agent) to represent his or her interest. For example, you

might hire someone (an agent) to sell a car that you own while you are away

at school. In all such relationships, there is a possibility of conflict of interest

between the principal and the agent. Such a conflict is called an agency

problem. Suppose you hire someone to sell your car and you agree to pay hera flat fee when she sells the car. The agents incentive in this case is to make


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the sale, not necessarily to get you the best price. If you paid a commission of,

say, 10 percent of the sales price instead of a flat fee, then this problem might

not exist. This example illustrates that the way an agent is compensated is one

factor that affects agency problems.

Management Goals

To see how management and stockholder interests might differ, imagine that

a corporation is considering a new investment. The new investment is

expected to favourably impact the stock price, but it is also a relatively risky

venture. The owners of the firm will wish to take the investment (because the

share value will rise), but management may not because there is the

possibility that things will turn out badly and management jobs will be lost. If

management does not take the investment, then the stockholders may lose avaluable opportunity. This is one example of an agency cost. It is sometimes

argued that, left to themselves, managers would tend to maximize the amount

of resources over which they have control, or, more generally, business power

or

wealth.Thisgoalcouldleadtoanoveremphasisonbusinesssizeorgrowth.Forexam

ple,cases where management is accused of overpaying to buy another

company just to increase the size of the business or to demonstrate corporate

power are not uncommon. Obviously, if overpayment does take place, such a

purchase does not benefitthe owners of the purchasing company.

Our discussion indicates that management may tend to overemphasize

organizational survival to protect job security. Also, management may dislike

outside interference, so independence and corporate self-sufficiency may be

important goals.

Do Managers Act in the Stockholders Interests?

Whether managers will, in fact, act in the best interests of stockholders

depends on two factors. First, how closely are management goals aligned with

stockholder goals? This question relates to the way managers are

compensated. Second, can management be replaced if they do not pursue

stockholder goals? This issue relates to control of the firm. There are a

number of reasons to think that, even in the largest firms, management has a

significant incentive to act in the interests of stockholders.

Managerial Compensation Management will frequently have a significant

economic incentive to increase share value for two reasons. First, managerialcompensation, particularly at the top, is usually tied to financial performance


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in general and oftentimes to share value in particular. For example, managers

are frequently given the option to buy stock at a fixed price. The more the

stock is worth, the more valuable is this option. The second incentive

managers have relates to job prospects. Better performers within the firm will

tend to get promoted. More generally, those managers who are successful inpursuing stockholder goals will be in greater demand in the labour market

and thus command higher salaries. In fact, managers who are successful in

pursuing Stockholder goals can reap enormous rewards. For example, Rueben

Mark, CEO of consumer products maker Colgate-Palmolive,

receivedabout$148millionin2004alone, which is less than

MelGibson($210million),but way more than Beyonc Knowles ($21 million).

For the five-year period ending 2004, Larry Ellison of software giant Oracle

was one of the top earners, receiving over $835 million.

Control of the Firm Control of the firm ultimately rests with stockholders.

They elect the board of directors, who, in turn, hires and fires management.

The mechanism by which unhappy stockholders can act to replace existing

management is called a proxy fight. A proxy is the authority to vote someone

elses stock. A proxy fight develops when a group solicits proxies in order to

replace the existing board, and thereby replace existing management. Another

way that management can be replaced is by takeover. Those firms that are

poorly managed are more attractive as acquisitions than well-managed firmsbecause a greater profit potential exists. Thus, avoiding a takeover by another

firm gives management another incentive to act in the stockholders interests.

Information on executive compensation, along with a ton of other

information, can be easily found on the Web for almost any public company.

Our nearby Work the Web box shows you how to get started. Sometimes its

hard to tell if a companys management is really acting in the shareholders

best interests. Consider the 2005 merger of software giants Oracle and

PeopleSoft. PeopleSoft repeatedly rejected offers by Oracle to purchase the

company. In November 2004, the board rejected a best and final offer, even

after 61 per cent of PeopleSofts shareholders voted in favour of it. So was the

board really acting in shareholders best interests? At first, it may not have

looked like it, but Oracle then increased its offer price by $2 per share, which

the board accepted. So, by holding out, PeopleSofts management got a much

better price for its shareholders.

Conclusion The available theory and evidence are consistent with the view

that stockholders control the firm and that stockholder wealth maximization

is the relevant goal of the corporation. Even so, there will undoubtedly be


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times when management goals are pursued at the expense of the

stockholders, at least temporarily.

Documents

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