Introduction
Financial administration plays a significant role in the success of any business. It involves making crucial decisions to effectively manage the company's finances and achieve its goals. One of the primary objectives of financial administration is to maximize shareholder wealth. In this article, we will explore why maximizing shareholder wealth is the goal of financial administration, discuss alternative measures, and understand how this goal helps limit excessive risk-taking.
The Objective of Financial Management
The ultimate objective of financial management is to maximize shareholder wealth. For public companies, this is reflected in the stock price, while for private companies, it is the market value of the owners' equity. By focusing on increasing shareholder wealth, financial managers aim to enhance the value of the company and provide a positive return to the shareholders.
Drawbacks of Other Potential Measures
While some might argue for alternative measures like maximizing cash flows or profit, these goals have certain downsides. The complexity of measuring cash flows is one of the main issues. Should the average cash flow over a specific period be considered? This ambiguity makes it difficult to establish a clear and objective measure.
On the other hand, maximizing shareholder wealth is not ambiguous. It is represented by the unique share price, which provides a clear indicator of the company's value in the market.
Balancing Risk and Reward
An important aspect of financial management is balancing risk with reward. In finance and investments, risk and reward go hand in hand. You cannot have one without the other. Therefore, it is essential to consider both the potential reward and the risk associated with achieving it.
The problem with measures like maximizing profit or cash flows is that they focus solely on the reward without considering the risk involved. This can lead to management decisions that prioritize short-term gains without adequately assessing the potential risks.
Excessive Risk and Its Consequences
When the goal of financial management is set as maximizing cash flow or profit, it can encourage management to take on excessive risks. Let's consider an example to illustrate this point.
Suppose a company has $100,000 to invest in houses. Each house costs $100,000, and their prices are expected to increase by 1% over the next year. The company can either invest the entire $100,000 in one house or distribute it equally among 100 houses.
If the goal is to maximize cash flow, the company would be inclined to invest in 100 houses. This decision carries a higher level of risk since it involves borrowing up to 100-to-1 leverage. While it may result in higher cash flows, it also exposes the company to significant risk.
The Value of a Stock
To understand the relationship between risk and reward, it is crucial to consider the value of a stock. The value of a stock is determined by discounting its expected future cash flows (dividends). The discount rate used reflects the risk associated with earning those cash flows.
Let's assume a company expects to pay $10 in dividends per share each year indefinitely. The value of the firm's stock can be calculated using the following formula:
In this equation, "k" represents the firm's cost of equity capital, which increases with the level of risk taken by the company. For example, if the cost of equity capital is assumed to be 8%, the value of the stock would be $125.
The stock's value reflects the balance between risk and reward. Increasing the risk to increase profits may initially lead to a higher stock value. However, there is a point where the increase in risk will outweigh the benefits of higher profits. At this point, the goal of financial management naturally limits excessive risk-taking.
Limiting Risk with Financial Management Goals
By setting the goal of maximizing shareholder wealth, financial management inherently limits excessive risk-taking. Let's consider a scenario to understand this concept further.
Suppose a firm can pay $12 in dividends annually. Increasing the dividends to $14 would require taking on additional risk, resulting in a higher cost of equity capital, let's say 11%. In this case, the value of the firm's stock would be $127.27. As the increase in the cost of equity capital outweighs the benefits of increased dividends, the firm should not take on the additional risk.
This example illustrates that there is a threshold beyond which the increased cost of equity will offset the benefits of higher dividends. Financial management, with the goal of maximizing shareholder wealth, provides a framework to evaluate and manage risks effectively.
Interactive App: Understanding the Impact of Risk
To gain a better understanding of how a stock's price reacts to increasing risk, an interactive application can be used. As risk increases, both expected cash flows and the required return on equity also increase. Initially, the effect of increasing expected cash flows dominates, resulting in an increase in the stock price. However, at some point, the increased required return on equity begins to dominate, causing the stock price to decline.
While the specific point where the impact on the required return may vary for each firm, this interactive app highlights the relationship between risk, expected cash flows, and stock prices.
The Objective of Financial Management in Different Countries
While the objective of financial management is to maximize shareholder wealth for U.S. firms, it may differ for firms based in other countries. For example, in some countries like Germany, it is common to have labor representatives on the Board of Directors of certain firms. In such cases, maximizing shareholder wealth may not be the sole objective of the financial manager. The objectives may include considering the interests of labor representatives and maintaining a balance between stakeholders.
Conclusion
Maximizing shareholder wealth is the primary objective of financial management. It provides a clear and objective measure of a company's value and aligns the interests of shareholders with the decision-making process. Alternative measures like maximizing cash flows or profit may not consider the balance between risk and reward, leading to excessive risk-taking. Financial management naturally limits excessive risk-taking and ensures a balanced approach to achieving long-term success by focusing on shareholder wealth.
"The ultimate goal of financial management is to maximize shareholder wealth by balancing risk and reward."