Goal of the firm

Objective
• Identify the strategic financial objectives of a firm
• Appreciate why shareholder value maximization is the ultimate goal.
• Understand why profit maximization may not be prioritized.
• Understand the principal agency conflict between shareholders and
management.
• Appreciate the sources of conflict between Shareholders and Creditors.

Overview of Corporate Financial Strategy

➢ It looks at those aspects of finance that have a direct impact on the ultimate goal
of shareholders ie shareholder value maximization. These are mainly financing,
investment and dividend decisions.
➢ All financial decisions are guided by this main objective of shareholder value
maximization.
➢ The major questions becomes how is shareholder value maximized?.Is it possible
to maximize shareholder value in a perfectly competitive market?The development
of finance and its markets has also seen the function of liquidity management
playing a central role in creating value for shareholders
➢ Questions that decision makers constantly ask themselves include:
1. How should capital be raised? i.e debt or equity, How much of debt and how
much of equity?
2. How should it be invested? Or which investments should be undertaken?
3. How should profits be distributed? i.e pay them out as dividends, re-invest in
capital projects ? How much should be paid out and how much should be
retained without hurting shareholder value?
➢ The link between finance and strategy is a powerful tool in shaping a corporate
entity. Finance strategy has a bearing on the operations of all other functions of
an entity that include manufacturing, marketing, human resources management
and research and development. In most of the instances ,finance determines
 what and how it can be done in all these functions without the same functions
have the same bearing
➢ Value creation and value destruction processes are a function of the interaction
between managers, non-financial stakeholders, and corporate governance
activities.

Financial Strategy

➢ Defined as having two components:

a) The raising of funds/financial resources needed by the organization in the
most appropriate manner.

b) Managing the employment of those funds within the organization which

includes decision making on how to reinvest or distribute the final profits.

➢ Value can either relate to the underlying business or to value created for the
investors.
➢ Value may also relate to return generated over and above the required rate of
return.

Corporate Value vs Investor Value

➢ Financial strategy distinguishes corporate value and Investor value.

➢ Corporate value is about configuring the company to be a better business while
investor value reflects the required rates of return of capital markets and is mirrored
in the financial market place to the value of securities.
➢ The role of financial managers therefore, primarily pertains to ensuring that
Investor value/shareholder value properly reflects corporate value.
➢ For corporate value to be reflected in investor value, management should put in
place strategies that will allow the investors to generate higher rates of return in
the financial markets. This entails that the value of any company should be
transmitted into higher market returns through financial strategy.
➢ The most important aspect then becomes how is corporate value transmitted or
transformed into investor value in a competitive business environment.

Risk versus Return

It is a fundamental principle underlying financial theory that investors will demand a

return commensurate with the risk characteristics that they perceive in their
investment. Return is the reason why investors are prepared to part with their income.
However return can only be earned after taking a considerable risk unless the
investment is in a risk free security. This highlights the fact that risk is unavoidable but
 the most important aspect is to manage it to acceptable levels. The basic relationship
between risk and return is depicted by Fig 1 below:

Fig 1: Risk and returns relationship

Return

Risk
The vertical axis is strictly referred to as required return and horizontal axis as
perceived risk. There should be a return enough to compensate risk. Any financial
strategy that carries risk for the company should be able to generate a return
commensurate with the risk otherwise there will be shareholder value destruction. So
is it possible for a project or investment to generate a return which is not
commensurate with the risk taken???

Two –stage investment process

Shareholders invest in
company

Company invest in
portfolio of projects

If the portfolio of investments achieves a return exactly equal to the return demanded by
shareholders, then there is no value created. In strategic financial management, effort
should be put in the top box.
➢ More often than not, the efforts of most business people concentrate in the lower
box ie trying to make the projects portfolio better investments ie making them a
better business.
 ➢ Financial strategy should focus on making projects better investments for
shareholders.
➢ In perfectly competitive markets, no shareholder value is created ie market forces
would dictate that all investments receive only their risk adjusted required rates of
return.
➢ Shareholder value is therefore created /increased by exploiting market
imperfections.
➢ From a risk perspective, the overall risk of the portfolio of investments should not
exceed the total sum of its parts, there would value erosion.
➢ The idea therefore is to create an equivalent portfolio with an equal overall return
but without necessarily increasing the business risk.
➢ Projects with high risk do not destroy value since high risk goes with high returns
but is the overall portfolio of projects which determines whether there is value
creation or not.

Value Creating Alternatives

Return

Starting point

Risk

➢ One alternative is to reduce risk hence return. Is this acceptable to shareholders?

Deliberately reduce profitability and yet still adding value. Example is that of a
company buying an insurance policy in order to reduce risk. Premiums reduce
profitability but the insurance policy also reduces risk, Investors will feel
comfortable, buy more of the share and hence value increases.
➢ The second alternative is to increase risk disproportionately to increase return i.e
value destruction as per diagram.
➢ Lastly, the best value creating alternative is to significantly increase return with as
little additional risk as possible.
 Shareholder Wealth Maximisation Objective
➢ The ultimate goal of companies is to maximise the wealthy of shareholders.
Management should work in the best interest of company owners with the ultimate
aim of maximising wealthy. Maximisation of shareholder value or company value
achieved through:
a) Maximising the company share price. Maximising the share price help
investors to benefit from capital gains. Capital gains are defined as the
difference between an assets’s buying price and selling price.
b) Maximisation of dividends. Dividends can serve as income to the
shareholders. Also they can be used to buy more of shares in the same
company hence increasing the stock of their wealth.

Agency Problem and Value of a firm

➢ Shareholders/owners of a firm appoint management (agencies) to run the day to

day affairs of a firm.
➢ Management start from the CEO, senior management etc.
➢ The firm (legal entity) generates profits to pay for the salaries of management
(agents) and also to pay dividends to the shareholders (principals).
➢ The principals aim and hope to achieve their goals through their agents.
➢ For achieving the goals of their principals, agents are rewarded through salaries
and other benefits.

Agency Problem

The problem arises when the goals of principals and agents are not compatible. Agents
can make decisions that are meant to further their interest at the expense of principals.
Since principals are not involved in the day to day running of the company, managers
often benefit from information asymmetry making controlling their actions a daunting
task. Appreciating the root cause of agency conflicts plays an important role in trying to
reduce their impact on corporate value. Despite measures and controls often put in
place by owners, human nature and behaviour has proved to be the one of the most
sophisticated and dynamic.

Goals of management may include:

1. Management of salaries / benefits (compensation)
2. Protection of their employment (job security)
3. Maximising profits
4. Empire building

➢ The goals of management may not necessarily result in achieving the shareholder
goals e.g building an empire is a management objective to better their CVs however
this could be undertaken by embarking in risky projects which affect the value of the
firm. Benefits could be increased at the expense of profitable projects etc

Managing the agency problem

Corporate financial strategy should therefore ensure that the agency problem is
managed to reasonable levels so that shareholder value is enhanced.
➢ The divergence of management and shareholder objectives can be managed
through;
1. Market forces
2. Agency costs
3. Organisational structuring

Market forces
Market forces are credited for ensuring an efficient allocation of resources as well as
putting in place controls on firm performance.

Business failure
➢ When management concentrate on their personal goals, the business usually
performs badly because most of these are short term, unsustainable objectives.
➢ The implications of business failure such as loss of jobs, humiliation, force
management to act in the best interest of shareholders.
➢ Shareholder goals, if adhered to usually result in the business performing well.

Corporate control

➢ More often than not, failure to maximise the value of the firm makes a company a
good candidate for hostile takeovers
➢ The firm becomes cheap that, for listed entities, potential investors will consider
undertaking hostile takeovers.
➢ Takeovers come with change of management; existing management is either
fired or lowered to junior positions.
➢ The fear of these consequences force management to work towards shareholder
goals which avoid takeovers.

Strategic Management of the Agency Problem

Action can be taken by the board of directors to try and control management’s activities
and decisions. These come with a cost to the entity hence the cost of reducing the
agency conflict should be outweighed by the benefits of reducing it.
Agency costs
➢ Shareholders may also have to spend in order to ensure that management work
towards their goals.
➢ These costs include :
1. Engaging auditors to police management.
2. Increase benefits/ salaries.
3. Management compensation linked to shareholder value maximisation.

Organisational Structuring
These methods of eradicating the agency problem include:
1. Share option schemes- gives management part ownership of the firm.
2. Committees that evaluate management actions.
3. Bonding managers ie insurance taken by firm to cover firm against actions of
dishonest managers.

Discouraging management to pursue their own goals is a very complex process. Some
measures put in place may not be effective or may not work at all. Some school of
thought is that management should be starved of financial resources hence
shareholders should demand significant dividends so as to leave little resources for
abuse. Information asymmetry however limits the actions of shareholders ie managers
usually have superior information than shareholders.

Shareholder value drivers-Case Study in Class

➢ There are four general sources of shareholder value creation as identified by
Porter:
1. Revenue enhancement
2. Operating costs reduction
3. Cost of capital reduction
4. Asset utilisation
There are more of these drivers and the most important aspect is whether they can
influence value significantly.

2.1.4 Agency Conflict II

Agency problems also exist between shareholders and creditors.
➢ Creditors become interested parties as providers of finance.
➢ Shareholders through managers may be in conflict with creditors when they do
any of the following :
1. Try to sell profitable assets which are key to generation of profits hence
repayment of debts.
2. Try to borrow extra funds from other providers of finance.
3. Take up risky projects which put repayments under uncertainty.
 2.1.5 Profit vs Shareholder Value Maximisation

Managers more often than not aim at profit maximisation than maximising shareholder
value. The debate surrounding profit maximization and wealth maximisation is still going
on. The major aspect becomes, is maximising profits a sinister objective or rather
concentrating on maximising profit is the problem. Factually speaking companies need
to make profits for them to survive and grow, so how then does profit maximising
becomes an inferior objective. Profit maximisation is an inferior objective because of the
following reasons:
1. Timing.
➢ Profits are sometimes made when they are least desired.
➢ Profits add much value when generated at a point when the firm has capital
projects especially for expansion to undertake.
➢ In the youthful stage, profits are needed mostly to invest in expansion
➢ Profits are however generated at maturity stage when the firm has already
borrowed at penal rates to finance projects.
2. Risk
➢ When profit is made the ultimate goal, managers are tempted to take up risky
projects as they hunt for profits.
➢ Risky projects increase the overall risk of the firm and hence affect the value of
the firm negatively.
3. Cash flows
➢ Profits do not always imply a cash flow to shareholders in the form of
dividends.
➢ Dividends may not always be declared despite good profits.
4. Short term Profits.
-In pursuit of high profits, management may cut down on critical expenditures such
R&D.
-This affects the long term operations of the firm despite making the short term
profits.
 -this explains why EPS growth may not be an appropriate measure of good
performance by management.

Corporate Governance and Share Holder Value Maximizing

Corporate governance seeks to ensure a fair return on the investment and it also
establishes incentives and procedures that meet the interests of shareholders while
respecting other stakeholders’ interests in the organization.
➢ The recent economic crisis, financial scandals and collapse of many companies in
the developed and developing markets have attracted the attentions of
researchers and business people to improve the corporate governance

➢ Corporate governance is the ways in which providers of finance ensure

themselves a return on their investment.

➢ Reed (2002) states that corporate governance establishes incentives and

procedures that meets the interests of shareholders while respecting other
stakeholders’ interests in the organization.

➢ Ananchotikul and Eichengreen (2009) suggest corporate governance plays three

critical roles namely:

a) Corporate governance facilitates and enhances corporations’ performance

by providing incentives that act as motivation factors to the corporations’
managers and employees so as to improve efficiency of operation, return
on investment as well as achieve sustained growth and development.
b) Effective corporate governance prevents embezzlement of corporate
resources by the managers as well as limits them from abusing their
powers.
c) Moreover, they suggest that corporate governance gives a means of
monitoring the behaviors of managers so as to enhance corporation
accountability as well as provision of a cost effective way of protecting the
interests of the shareholders and the society at large against those of the
corporate insiders.

➢ Agency theory has been extensively used in explaining the conflict of interest
between investors as the principles and the managers as agents. This theory
implies that agents will be driven by self interest rather than willingness to
maximize the profit for shareholders.
➢ In order to solve this problem an independent board of director is expected to solve
this problem (Shleifer & Vishny, 1996).
➢ Agency theory suggests mechanism that rewards managers for maximizing
shareholders profit. Such schemes typically include plans whereby executive
managers obtain reduced share prices to align the interest of managers with those
of shareholders.

➢ Various scholars worked on different aspects of corporate governance and they

have examined corporate governance from different country perspectives.
➢ Li & Harrison (2007) focus on the different source of finance across country and
examine the difference between financing from banks and financing from capital
market and its impact on the structure of corporate governance.
➢ Class discussion: With regards to the source of finance, countries have been
classified into bank centred (banks are the provider of finance to the companies
such as Germany and Japan) and capital market (capital market is the source of
the finance for the companies like United Kingdom and United states).Examine the
difference between the two systems in term of practices of corporate governance

➢ The increasing attention is due to questionable practices and scandals of

companies.
➢ In addition, as Reed (2002) suggests that poor economic performance of
developing countries which is blamed on weak corporate governance may trigger
financial crisis in certain regions.
➢ As a result, international financial organizations such as IMF and the World Bank
are closely examining the corporate governance systems in developing countries.
➢ The pressure of globalization and the fact that more investors turns to equity
investment internationally, have led companies of emerging markets towards a
comprehensive reform to adopt corporate governance practices.
➢ The quality of corporate governance is more important to emerging market, as
these countries need to attract foreign direct investment (FDI) to further develop
their economies.
➢ In addition, companies operating in developing countries need to improve their
corporate governance systems, in order to decrease their cost of capital. According
to Cadbury (1999) increasingly, institutional investors, banks, mutual funds, base
their decision on the reputation and corporate governance quality. He points out
that sound systems of corporate governance attracts more domestic as well as
international investors.

➢ Poker (2011) suggest that managers are interested to disclose information if the
company is performing well to receive bonuses and incentives.

➢ The Agency problem and the need for an independent board is more significant in
emerging market as majority shareholders of corporations are family and boards
can become redundant when activist shareholders are family or
government(Turnbull, 1997).
➢ Adequate regulatory systems need to be put in place to promote corporate
governance.

➢ Zimbabwe is a good example of the impact poor corporate governance can have
on the public sector. Government spearheading efforts to craft a public and private
sector corporate governance framework.

➢ Board Independence is very pivotal in promoting corporate governance especially

when it comes to the selection of members. More often than not, board members
are either chosen by members of the management and fellow board members,
effectively compromising independence.

➢ In summary corporate governance play a crucial role in creating value for

shareholders. Managers should appreciate the impact of their actions on the
entity’s value.