Chapter 1 An Overview of Financial Management 9elected a board of directors, which then selected Smith to run the company. Smith
and the! rm’s other managers are working on behalf of the shareholders, and they
were hired to pursue policies that enhance shareholder value. At the same time,
the managers know that this does not mean maximize shareholder value “at all
costs.” Managers have an obligation to behave ethically, and they must follow the
laws and other society-imposed constraints that we discussed in the opening
vignette to this chapter. Throughout this book, we focus primarily on publicly
owned companies; hence, we operate on the assumption that management’s pri-
mary goal is shareholder wealth maximization. That translates into this rule:
A manager should try to maximize the price of the! rm’s stock, subject to the con-
straints discussed in the opening vignette.If a manager is to maximize shareholder wealth, he or she must know how that
wealth is determined. Essentially, shareholder wealth is the number of shares out-
standing times the market price per share. For example, if you own 100 shares of
GE’s stock and the price is $40 per share, your wealth in GE is $4,000. The wealth
of all of GE’s stockholders can be summed; and that is the value of the! rm’s stock,
the item that management should maximize. The number of shares outstanding is
a given, so what really determines shareholder wealth is the price of the stock.
Throughout this book, we will see that the value of any asset is the present
value of the stream of cash " ows the asset provides to its owners. We discuss stock
valuation in depth in Chapter 9, where we will see that a stock’s price at any given
time depends on the cash " ows a “marginal” investor expects to receive after buy-
ing the stock. To illustrate, suppose investors are aware that GE earned $2.20 per
share in 2007 and paid out 52% of that amount, or $1.15 per share, in dividends.
Suppose further that most investors expect earnings, dividends, and the stock price
to increase by about 6% per year. It might turn out that these expectations are met
exactly. However, management might make a prudent decision that causes pro! ts
to rise at a 12% rate, causing the stock price to jump from $40 to $60 per share. Of
course, management might make a big mistake, pro! ts might suffer, and the stock
price might decline to $20. Thus, investors are exposed to risk when they buy GE
stock or any other company’s stock. If, instead, the investor bought a U.S. Treasury
bond, he or she would receive a guaranteed interest payment every six months plus
the bond’s par value when it matures; so his or her risk would be minimal.
We see then that if GE’s management makes good decisions, its stock price
will increase; however, if its managers make bad decisions, the stock price will de-
crease. Management’s goal should be to make decisions designed to maximize the stock’s
price. Note, though, that factors beyond management’s control also affect stock
prices. Thus, after the 9/11 terrorist attacks on the World Trade Center, the price of
most stocks fell no matter how effective their management may have been.
Firms have a number of different departments, including marketing, account-
ing, production, human resources, and! nance. The! nance department’s princi-
pal task is to evaluate proposed decisions and judge how they will affect the stock
price and thus shareholder wealth. For example, suppose the production manager
wants to replace some old equipment with new automated machinery that will re-
duce labor costs. The! nance staff will evaluate that proposal and determine
whether the savings seem to be worth the cost. Similarly, if marketing wants to
sign a contract with Tiger Woods that will cost $10 million per year for 5 years, the
! nancial staff will evaluate the proposal, look at the probable increase in sales, and
reach a conclusion as to whether signing Tiger will lead to a higher stock price.
Most signi! cant decisions are evaluated in terms of their! nancial consequences.
Note too that stock prices change over time as conditions change and as inves-
tors obtain new information about a company’s prospects. For example, Apple
Computer’s stock ranged from $77 to $193 per share during a recent 12-month
period, rising and falling as good and bad news was released. Wal-Mart, which is in
Shareholder Wealth
Maximization
The primary goal for
managers of publicly
owned companies implies
that decisions should be
made to maximize the
long-run value of the
firm’s common stock.Shareholder Wealth
Maximization
The primary goal for
managers of publicly
owned companies implies
that decisions should be
made to maximize the
long-run value of the
firm’s common stock.