Introduction to Corporate Finance

1: The Scope of Corporate Finance

In the sections that follow, we first evaluate profit maximisation, and then describe shareholder wealth

maximisation. Next, we discuss the agency costs arising from potential conflicts between shareholders,

managers and other stakeholders (such as bondholders). Finally, we consider the role of ethics in

corporate finance, including a brief look at how some recent legislation affects financial management.

1-4a WHAT SHOULd A FINANCIAL MANAGER TRY TO MAXIMISE?

Should a financial manager try to maximise corporate profits, shareholder wealth or something else?

Here, we hope to convince you that managers should seek to maximise shareholder wealth.

Maximise Profit?

Some people believe that the manager’s objective is to maximise profits, and it is common to see

compensation plans designed so that managers receive larger bonuses for increasing reported earnings. To

achieve profit maximisation, the financial manager takes those actions that make a positive contribution

to the company’s profits. Thus, for each alternative, the financial manager should select the one with the

highest expected profit. From a practical standpoint, this objective translates into maximising earnings

per share (EPS), the amount earned on behalf of each outstanding ordinary share. Although it seems a

plausible objective, profit maximisation suffers from several flaws:

■ EPS figures are inherently backward-looking, reflecting what has happened rather than what will

happen.

■ Some short-run decisions (such as forgoing maintenance) to boost EPS can actually destroy value in

the long run. Even if managers strive to maximise profits over time, they should not ignore the timing

of those profits. A large profit that arrives many years in the future may be less valuable than a smaller

profit earned today. As we will learn in Chapter 3, money has a time value; simply put, a dollar today

is worth more than a dollar in the future.

■ A manager cannot maximise profits without knowing how to measure them, and conventional

barometers of profit come from accrual-based accounting principles rather than from a focus on cash

flows. In finance, we place more emphasis on cash – the true currency of business – than on profits

or earnings.

Focusing solely on earnings ignores risk. When comparing two investment opportunities, managers

should not always choose the one they expect to generate the highest profits. They must consider the

risks of the investments as well. As we will learn in Part 2, a trade-off exists between risk and return,

the two key determinants of share prices. Higher cash flow generally leads to higher share prices, whereas

higher risk results in lower share prices. Therefore, an investment project with high profits and high risk

could be less valuable than one with lower profits and lower risk.

Maximise Shareholder Wealth?

Modern finance asserts that the proper goal of companies is to maximise the wealth of shareholders, where

wealth is measured by the company’s share price. This share price reflects the timing, magnitude and risk

of the cash flows that investors expect a company to generate over time. When considering alternative

strategies, financial managers should undertake only those actions that they expect will increase the

company’s share price.

Why does finance preach the wisdom of maximising share value as the primary corporate objective?

Why not focus instead on satisfying the desires of corporate stakeholders such as customers, employees,

LO1.4

stakeholders

Those with a justified interest

in, or claim on, a company,

such as customers, employees,

suppliers, creditors and

shareholders

What problems might be

encountered if a company

ties its employee bonuses to

earnings per share?

thinking cap

question