Study on Financial Strategy and Financial Objectives Finance Essay

Check out more papers on Balance Sheet Economy Employment

This chapter consists of four sections, excluding this Preamble. The first section is concerned with corporate strategy and financial strategy. The second section considers objectives of organisations generally, whilst sections three and four are concerned with financial objectives and non-financial objectives, respectively.

Don't use plagiarized sources. Get your custom essay on

“Study on Financial Strategy and Financial Objectives Finance Essay”

Get custom essay

Learning Outcomes

On successful completion of this Chapter, students should normally be able to: discuss financial strategy and its relationship with overall corporate strategy, discuss the influence of the goals of different interest groups on corporate strategy, explain the objective of maximisation of shareholder wealth, explain the notion of satisficing and its relevance to the maximisation of shareholder wealth, identify and explain a range of typical financial and non-financial targets, discuss the relationship between financial targets and non-financial objectives.

CORPORATE STRATEGY AND FINANCIAL STRATEGY

Introduction

Chambers dictionary defines strategy in a number of ways, one of which is ‘any long-term plan’. The Chartered Institute of Management Accountants (CIMA) have defined strategy as ‘a course of action, including the specification of the resources required, to achieve a specific objective’ (CIMA, 1991). If we adopt the CIMA definition of strategy, it follows that corporate objectives precede strategy. The objectives of a company may be expressed in different ways, including expression as financial targets. Later, we shall consider some specific suggestions that have been made for possible financial targets. So, the definition introduces the idea of working towards an objective, and the first step in the study of financial strategy is therefore the identification and formulation of objectives. The area of corporate objectives has been the subject of much research. We note that, as a mere legal abstraction, a body corporate can no more have objectives than it can drive a car. The directors and senior managers of the company can have aims and objectives, but the company itself cannot. Nevertheless, many commentators use the term ‘corporate objectives’ to identify objectives that the directors of a company wish that company to achieve. We emphasise that a particular organisation will have a corporate strategy devised by its directors to achieve their objectives for the company. To consider the nature of strategic decisions, we note that Johnson & Scholes (2001) summarised the characteristics of strategic decisions for an organisation as follows: Strategic decisions will be concerned with the scope of the organisation’s activities, Strategy involves the matching of an organisation’s activities to the environment in which it operates, Strategy also involves the matching of an organisation’s activities to its resource capability, Strategic decisions therefore involve major decisions about the allocation or re-allocation of resources, Strategic decisions will affect operational decisions, because they will set off a chain of ‘lesser’ decisions and operational activities, involving the use of resources, Strategic decisions will be affected not just by environmental considerations and resources availability, but also by the values and expectations of the people in power within the organisation, Strategic decisions are likely to affect the long-term direction that the organisation takes, Strategic decisions have implications for change throughout the organisation, and so are likely to be complex in nature. Financial strategy includes, for example, decisions relating to the sources from which funds are obtained and the mix of corporate funding, the amount that should be paid out by way of dividends, and financial aspects of the acquisition and replacement of fixed assets. Although there is some overlap, the factors that influence objectives and hence strategies can be classified, in broad terms, as follows: General and environmental influences The power and influence of stakeholder groups, including internal coalitions Overriding economic imperatives Perceived social responsibilities of the organisation General and Environmental influences These influences include the following: (a) External influences, such as the values of society, the values of the sector in which the firm operates, and the influence of organised groups, such as government departments, consumer groups, environmental groups, animal welfare organisations, and so on, (b) The nature of the business itself, including the market conditions of the sector in which the firm operates (for example, whether the market is expanding, stagnating, or declining), the products the firms manufactures and sells, and the technology the firm uses (which will influence matters such as operating methods, the skills needed by its employees and so on), (c) The organisation’s culture, including its history and traditions, its organisational structure, and the style of management employed by senior managers. Stakeholder groups Prior to CA2006, case law imposed a duty on directors to act in good faith in the interests of the company, by which was meant the shareholders collectively. There was also a duty to act in the interests of creditors if insolvency was threatened, and the Act preserves that requirement. However, in ‘normal’ circumstances, the Act now requires directors to consider a number of factors in their decision-making, including, but not limited to, the following: the likely long term consequences of a decision; the interests of the company’s employees; relationships with the company’s trading partners; the effect of the company’s operations on the community and the environment; the desirability of maintaining the company’s reputation for high standards of business conduct; and the need to act fairly as between members. It seems that the inclusion of these factors is an attempt to capture the principle of ‘enlightened shareholder value’, the model for corporate endeavour [1] adopted by the Company Law Review. ‘Enlightened shareholder value’ shares some characteristics with the concept of ‘satisficing’. It is possible to identify a wide variety of different groups whose interests are directly affected by the activities of a firm. These groups or individuals are referred to as stakeholders in the firm. Sharplin (1983) identifies many such stakeholders, including the following: Ordinary (equity) shareholders Preference shareholders Trade creditors Holders of unsecured debt securities Holders of secured debt securities Intermediate (business) customers Final (consumer) customers Suppliers Employees Corporate managers Past employees Retired employees Competitors Neighbours The immediate community National society World society Organisational strategists The chief executive The board of directors Government Special interest groups Ordinary, or equity, shareholders are the providers of the risk capital of a company and it is usually assumed that their goal is to maximise the wealth that they have as a result of their ownership of shares in the company. Trade creditors have supplied goods or services to the firm on credit. They will usually have the objective of being paid in full by the due date. However, longer-term considerations mean that they will wish to ensure a continuing trading relationship with their customer and will therefore handle the account with tact, diplomacy, and realism. Long-term creditors, which will often be banks, will have the objective of receiving payments of interest and capital in full as they fall due. Where a loan is secured on assets of the company, the creditor will be able to appoint a receiver to dispose of the company’s assets if the company defaults on the repayments. However, to avoid the possibility that this may result in a loss to the lender (where the market value of the assets are insufficient to cover the loan amount), the lender will wish to minimise the risk of default and will therefore decline to lend more than is prudent. Employees will usually want to maximise the rewards paid to them in salaries and benefits, taking account of their particular skills and the rewards available in alternative employment. Many, perhaps most, employees will also prize security of employment. Managers, in common with other employees, will have the objective of maximising their own rewards. It is the duty of the directors to run the company for the benefit of shareholders. The objective of reward maximisation may conflict with the exercise of this duty, in ways that we examine later. Government has objectives that can be formulated in political terms. Government agencies interact with the firm in various ways including taxation of the firm’s profits, the collection of statistics, the provision of grants, enactment of health and safety legislation, and so on. Government policies will often be related to macroeconomic objectives such as sustained economic growth and high levels of employment. Sharplin does not differentiate between central and local government. Johnson & Scholes (2001) separate power groups into ‘external stakeholder groups’ and ‘internal coalitions’. Internal coalitions will include the finance department, sales and marketing, the manufacturing department, the board of directors, and so on. Each internal coalition or external stakeholder group will have different expectations about what it wants, and the expectations of the various groups may be in conflict. Each group, therefore, will influence strategic decision-making. Cyert & March (1964) are particularly associated with the notion of satisficing. This view sees the firm in a broad, societal context as an alliance of interests. No stakeholder is considered more important than any of the others. Consequently, the aim of the firm is considered to be the provision of a satisfactory ‘return’ to each of the stakeholders.

CLASSIFYING ORGANISATIONAL OBJECTIVES

It is possible to classify organisational objectives at different ‘levels’. One such classification scheme is as follows: Mission statements Corporate objectives Operational objectives. A mission is a general objective, often visionary, sometimes unwritten, usually open-ended, and almost always without any time limit for achievement. There is a view that, to have practical value for planning, an objective must be expressed as a target, that is to say, be expressed in quantitative terms. This means that practical objectives are closed ones. For example, a practical corporate objective cannot be to earn a ‘satisfactory’ growth in profit, since what constitutes “satisfactory” growth is a subjective matter. A Board determined to be self-congratulatory could argue that any growth achieved was ‘satisfactory’, whatever its level. So, to be of practical use, the objective must be to achieve profit growth at or above some specified percentage level for a specified number of years. This view is not accepted by all commentators, for example, Johnson & Scholes (2001) argue that mission can have an important influence on strategic thinking (however, mission is very difficult to express in closed terms). Sometimes it may seem as if the formal expression of a company’s objectives in its Mission Statement owes much to the Public Relations Department. The following was the Mission Statement of ICI in 1991: The chemical industry is a major force for the improvement of the quality of life across the world. ICI aims to be the world’s leading chemical company, serving customers internationally through the innovative and responsible application of chemistry and related sciences. Through achievement of our aim, we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate. We will do this by: Seeking consistent profitable growth; Providing challenge and opportunity for our employees, releasing their skills and creativity; Achieving a standard of quality and service internationally which our customers recognise as being consistently better than any of our competitors; Operating safely and in harmony with the global environment. This statement raises more questions than it answers. For example, what criteria will be used to judge which company is the world’s ‘leading’ chemical company? Who will judge what is, and what is not, ‘responsible’ application of science? The second paragraph is a single sentence of mere futurity, a statement of something that will happen and not an aim or objective [2] . The third paragraph is also problematic. It is not clear whether ‘growth’ means increase in profit or turnover or both or some other measure, such as, say, earnings per share. We note the curious mixture of future and present tenses: ‘We will do thisA¢â‚¬A¦’ coupled with ‘A¢â‚¬A¦ customers recogniseA¢â‚¬A¦’. We also note that the criteria for judging global environmental harmony are left unspecified; indeed, ‘A¢â‚¬A¦in harmony with the global environment’ is so vague as to be meaningless. It is perhaps unsurprising that Mission Statements, by whatever title they have been given, have been used by Company Directors and their Public Relations advisers as vehicles for articulating lofty aspirations and affirming companies’ commitment to whatever the day’s fashionable cause happens to be. Corporate objectives are those that are concerned with the firm as a whole. It has often been said that objectives should be SMART, that is to say: Specific Measurable Achievable Relevant Time-based We have seen above [3] that there are counter arguments to the view that objectives should always be measurable in quantitative terms. Argenti (1989) (citing the creation of customers, serving society, providing employment, and maximising profits as examples of objectives) concludes that an objective must be expressed so as to specify: its beneficiaries the nature of the benefit the size of the benefit. Corporate objectives outline the expectations of the firm (and the strategic planning process is concerned with the means of achieving the objectives). Objectives usually relate to factors that are seen as crucial for business success, including the following: Profitability (return on investment) Market share Growth Cash flow Customer satisfaction The quality of the firm’s products Industrial relations Added value The De La Rue group discloses its Corporate Objectives as follows: Corporate Objectives To retain and build our position as the world’s leading security printing and payment systems group by consistently striving for the best possible performance in quality, innovation, value and service for our customers. Through continuing enhanced performance, to attain for our shareholders consistent growth in earnings and dividends per share and to communicate effectively to them our objectives and achievements. To train, motivate, support and reward our staff worldwide, focusing on their vital contribution to the success of the Company and also their involvement in the communities local to their business. Operational objectives are objectives that are specific to individual parts of an organisation. Examples are as follows: To increase the number of customers by some percentage (an objective of a sales department), To reduce the number of rejects by some percentage (an objective of a production department), To produce monthly management reports within, say, 5 working days of the end of each month (an objective of the management accounting department). Operational objectives are often referred to as targets or are formulated as part of a plan. Missions, objectives, and targets and plans are inter-related aspects of the strategic planning process. It is senseless to set a target that is unrealistic. For example, setting a target of collecting debts from customers within a week of issuing the invoice would be a welcome state of affairs, but it is not realistic and is unachievable. Unachievable targets are worse than a mere waste of time; they will demotivate employees and may detract from other, more realistic, aims. Following Argenti (1989), we state that quantification of primary objectives and secondary targets must emerge from a realistic appraisal of the organisation’s position and resources, and from the planning process. We note that it may be convenient to classify objectives as long-term or short-term. A company operating in an industry that is in recession and making losses in the short-term might continue to have, in the long-term, the objective of achieving steady growth in earnings, but, in the short term, its primary objective might switch to survival. In practice, it is often the case that managers’ performance is usually judged by short-term achievements. The board of directors of a public company are expected by City analysts to achieve growth in profits and earnings per share each year. If they do not, the share price will be adversely affected, and the board members will attract criticism. In extreme circumstances, the company may be the target for a hostile takeover bid as a result of failing to meet realistic targets. Consequently, the board will expect other senior and middle managers to achieve targets they have been set, and pay and prospects may be adversely affected if they do not. Since performance is often judged by short-term achievements, it is a natural tendency for managers to sacrifice longer term aims in order to achieve short-term targets. Examples of decisions that would involve the sacrifice of longer-term objectives include the following: Postponing (or abandoning altogether) capital expenditure projects (that would eventually contribute to long-term growth and profits), to protect short term cash flow and profits Cutting research and development expenditure to save operating costs (and in so doing, reduce the prospects for developing future profitable products) Reducing the level of customer service, to save operating costs. Corporate Objectives: Research into Practice This area has attracted a great deal of interest, particularly since the 1960s. Many academics, taking a normative view, identify the principal corporate objective as the maximisation of shareholder wealth. For example, Damodaran (1999) asserts: ‘There is general agreement, at least among corporate finance theorists, that the objective of the firm is maximize value or wealth.’ [Emphasis present in original.] That this is the aim adopted by senior managers in business appears to be borne out by empirical research. In a review article, Petty & Scott (1981), identified the following goals as being those most frequently cited by managers as being important: maximisation of the percentage return on total asset investment achievement of growth in earnings per share maximisation of total earnings. Arguably, maximisation of shareholder wealth is an articulation of the combined effect of pursuing these three goals. Through a postal questionnaire, Pike & Ooi (1988) asked senior managers of 100 large UK companies to indicate on a five-point Likert scale the importance of a number of aims. The results of this showed that managers were pursuing a number of aims simultaneously – these aims taken together amounted to the goal of maximising shareholder wealth. Pike & Ooi’s survey showed some consistency with other evidence gathered both in the UK and USA. Dissent from the Maximisation of Shareholder Wealth View The aim of maximising net present value (the usual measure of wealth) has been criticised by Berle & Means (1932) on the grounds that it neither describes managers’ aims nor constitutes the decision criterion used in most firms. Grinyer (1986) argues that the shareholders do not have maximisation of their wealth as their sole objective – he emphasises the flexibility and the variety of objectives. This is based on a greater level of financial sophistication on the part of the members than is probably the case. A further view is that of Marris (1963), who suggests that managers will act in the interests of any stakeholders who offer them additional reward. Further Dissent, Goal Congruence and Divergence Returning to the work of Pike & Ooi (1988), there are (at least) three problems with that work that need to be confronted. They are: Will senior managers always pursue the maximisation of wealth for shareholders, even if this leads to repercussions that adversely affect the senior managers themselves? In other words, isn’t it likely that managers will be influenced in their decision-making by the effects on their own welfare? How representative of the 30% of managers who refused to answer the questionnaire are those who did respond [4] ? Aren’t there other methodological problems with questionnaire surveys such as this? For example, with any questionnaire survey, how can we be sure that the respondents understood the questions properly? In addition, is it possible that respondents to surveys such as Pike & Ooi’s will tell lies? The first question, which we shall consider in detail, introduces a note of realism. It seems plausible that managers’ goals will not always be congruent with those of shareholders. In particular, it seems likely that managers will attach a higher priority to their own job security than would shareholders. Their actions may well reflect this in, for example, seeking to diversify the firm’s activities to reduce the risk of the firm failing. Shareholders, if they wish to reduce risk through diversification, will already have achieved that diversification through investment in an appropriate portfolio of investments. From the shareholders’ point of view, further diversification is superfluous, and managers’ efforts would be better directed at other goals. Managers’ goals may also differ from those of the firm’s owners where, for example, the managers’ remuneration is partially linked to some performance indicator. In these circumstances, a director may prefer to sacrifice long-term benefits for the company to achieve some short-term goal (profit of a certain amount, say). Some commentators have claimed that where the managers are also shareholders, such divergence of interests will not arise. This is not necessarily the case. Suppose an individual director is reliant upon his or her managerial salary for, say, 90% of their income and owns shares in their employing company that yield dividends and capital gains making up the remainder of their income: then it is at least plausible that that individual will act primarily to safeguard their position as manager rather than as shareholder. The (misguided) notion that no goal divergence is possible when managers are also shareholders has led to the suggestion that goal congruence can be achieved by, for example, share option schemes for directors. Such schemes, it is claimed, will cause directors to take a long-term view in their decision-making, rather than pursuing short-run targets. However, this claim is based on a false premise (as we have seen) – the more so if directors’ performance is judged on short-run targets and their salaries are based (if only partially) on such targets. If such systems of reward are in place then again, notwithstanding the existence of separate share option schemes, it is at least plausible that the individual manager will act primarily to safeguard their position as manager rather than as shareholder. In considering the actions of directors and other senior managers in relation to the goals of investors we should be aware that in the case of listed companies there is concentration of share ownership – and hence power – in the hands of a comparatively small number of institutional investors. Collectively, the managers of these institutional funds can and do exert influence over Boards, through their ability to exercise the ultimate sanction of removal from the Board. Therefore, it may be true to say that the degree of goal divergence of the type we have been considering in the case of listed companies has decreased. Whether this trend continues or is reversed depends upon the power of institutional investors, which in turn stems largely from the statutes governing taxation. Agency Theory The discussion above relates to the position of directors as agents of the shareholders [5] . Whereas the motivation of the directors has been considered, so far we have not considered what practical actions shareholders may take to ensure that the directors act in their interests. This lacuna is now remedied by examining the application of agency theory to the directors-shareholder relationship, with the intention of shedding light on what shareholders may consider their interests – and hence proper corporate objectives – to be. Agency theory is an influential school of thought that has, up to a point, eclipsed earlier approaches. Agency theory has its foundations in the seminal work of the British Economics Nobel Laureate Coase. Coase (1937) suggested that microeconomic analysis could be focused on “the transaction” and its associated costs, rather than on “the market” (and “the enterprise”). Specifically, the suggestion was that the market mechanism is replaced by a set of hierarchical authority relationships where this would allow greater efficiency than would be the case with a range of individual contracting relationships. Williamson (1964) furthered Coase’s work contending that individuals within the firm act in their own self-interest. Now, the view that the directors can be expected to act primarily in their own interests rather than those of the shareholders, can be traced all the way back from Williamson (1964) through Simon (1959) and Berle & Means (1932) to the view of Smith (1776) that: ‘A¢â‚¬A¦being the Managers rather of other people’s money than of their own, it cannot well be expected that they should look over it with the same anxious vigilance with which the partners of a private copartnery frequently watch over their ownA¢â‚¬A¦. Negligence and profusion A¢â‚¬A¦ must always prevail, more or less, in the management of the affairs of such a company.’ This being so, the question arises as to what action the shareholders can take to cause the directors to act to maximise their (the shareholders’) utility. One line of reasoning is to be found stemming from Coase’s work. Besides the work of Williamson (1964), extension of Coase’s work also came in the form of work by Alchian & Demsetz (1972) who suggested that the specific system of reward in a given situation engenders a specific level of productivity. Further, that some form of monitoring will be required, which, in the case of a company where ownership is widely spread, is delegated to agents. Agency theory, then, is not based upon ‘the market’ – but neither is it based on ‘the transaction’: rather, it is based upon the legal relationships between the parties involved in agency contracts. This contribution to the principal-agent approach comes from Jensen & Meckling (1976) who suggested that the firm was best conceived as a nexus of contractual relationships between individuals, in particular as a mechanism that minimises the agency costs of the relationship between shareholders and directors. According to Jensen & Meckling (1976), the shareholders will introduce incentives to achieve this. Whatever financial incentives are introduced will have an associated cost. Furthermore, it is suggested that the principals will also introduce monitoring mechanisms that will produce reports on the efficacy of the incentives. These mechanisms will also have costs associated with them. It is suggested that there may be a third type of cost, a ‘bonding cost’, stemming from the agent’s desire to acquire a guarantee that s/he will act in the interests of the principals. Finally, there is the cost that is the difference between the effects of the monitoring mechanism together with the bonding and the maximisation of the principal’s interest. It seems then that there is a well-established body of thought that maintains that shareholders not only require their directors to act in their best interests, but also are prepared to meet the costs of ensuring that they do so. Corporate Financial Objectives: Theory Without considering specific aspects of specific businesses, we can say, in broad terms, that the employees of a business are engaged in: creating goods or supplying services (or both) for which there is a demand, and selling those goods or services (or both). The rationale of undertaking these activities is to secure the benefit for the shareholders of inflows of resources that exceed the resource costs of securing those inflows. This excess will be reflected in an increase in the resources owned by the business. The increased resources can be distributed to investors in the firm, or applied to existing or new “creating and selling” projects, or a combination of the two. Having established that the directors of a company have a duty to run the business for the benefit of the shareholders, the question arises at to how “benefit” should be defined and measured. Some suggestions as to the objectives which senior management of an organisation might aim to achieve are dealt with briefly below:

Maximisation of Profit

This popular suggestion is too broad an objective to be useful. The argument behind it is that the shareholders benefit from an increase in profit and that as the group that owns and controls the firm they will cause the managers of the company to strive to maximise profit. However, this ignores the vital question of risk. Risk and return are the twin sides of the same coin. The all-out pursuit of profit maximisation would result in investment in high-risk projects that would not suit risk-averse shareholders. Furthermore, there is the question of timing: profit maximisation alone will not enable us to discriminate between rival projects that deliver profits at different times. Finally, it may be possible to increase the absolute amount of profit by means of a scheme that causes the profit per share to fall. For example, consider the following data for 20×1 relating to Quirk plc – a company with 650,000 ordinary shares in issue: £000 Sales 7,000 Cost of Sales 4,900 Gross Profit (30%) 2,100 Other Costs 1,400 Net Profit (10%) A A 700 At the end of 20×1 the Board of Directors of Quirk plc decide to increase the scale of the company’s operations – the finance is obtained by issuing a further 260,000 ordinary shares. Following this decision, the following data is obtained relating to 20×2: £000 Sales 9,100 Cost of Sales 6,370 Gross Profit (30%) 2,730 Other Costs 1,820 Net Profit (10%) A A 910 In 20×1 the profit per share was £700,000/650,000 = 108p, approximately. In 20×2 the profit per share had fallen to £910,000/910,000 = 100p. In this example, the total profit had increased but the finance had not been used efficiently: a 40% increase in the number of shares issued led to an increase in profit of only 30%. Clearly, if increases in total profits are achieved at the expense of inefficiency, then the profit per share will decrease. From the above it is concluded that the maximisation of profit is an unsatisfactory objective. However, maximisation of profit per share appears to be more satisfactory provided that due consideration is given to risk. Profit per share is more usually referred to as earnings per share, or EPS. EPS is the earnings attributable to each equity [6] share. IAS 33 Earnings per Share governs how EPS is reported.

Maximisation of Return on Capital Employed (ROCE)

This objective has an advantage over maximisation of profit in that it takes into account the efficiency achieved in the application of resources to generate profit. However, it omits to take into account the relative riskiness of rival projects (or the related long-run stability of the company).

Survival and Long-Run Stability

These are clearly legitimate aims, but they are not sufficiently ambitious. Most investors would surely wish to see their company achieve more than mere survival and long-run stability.

Growth

Growth in profit or assets or both appears to reflect aims expressed by managers themselves – as revealed by Petty & Scott (1981) [7] and the Corporate Objectives of De La Rue. The use of the word ‘growth’ implies that long-run opportunities will not be sacrificed for short-term gains. However, caution is required since growth needs to be achieved efficiently as we saw from the example considered under maximisation of profit. Hence, ‘growth’ is too imprecise to serve as a satisfactory objective.

Satisficing

The work of Cyert & March (1964) was discussed above. Here, we note that it is arguable that satisficing is a pre-requisite for maximising shareholder wealth, for if any of the stakeholder groups is dissatisfi(c)ed then the firm cannot operate effectively or efficiently. The effect of business activity on the wider community is under increasing scrutiny. Pressure groups have been formed to protect the environment and the consumer, and statutory protection has been given in some areas where there had been scope for adverse effects arising from business activity. Even where business activity is legal but meets with moral disapproval, that disapproval may well take a form that has a financial impact on the firm concerned. The rapid increase in the number of companies offering ethical investment supports this view. Indeed, Harte et al. (1991) observe: ‘The high profile of the ethical or socially responsible mutual funds/unit trusts, together with a growing sense … that their pioneering work in introducing an explicit social dimension into the investment decision-making function is attracting a wider institutional response … [and] has made them the subject of much media … attention.’ Further, Milne (1991, p. 83) cites Donaldson (1982), Tinker (1985), Gray et al. (1987), and Donaldson (1989) and “various research articles in Journal of Business Ethics and Advances in Public Interest Accounting” in support of the contention that: ‘The growing body of literature in business ethics generally supports the expansion of corporate responsibility.’ What constitutes socially irresponsible behaviour will change over time. For example, exploitative use of child labour was, but is no longer, legal in England whilst remaining widespread in the Indian sub-continent (New Internationalist, passim). The question becomes whether corporations should assume any social responsibilities over and above their statutory duties (such as the health and safety, employment, environmental and product safety legislation that already exists), and hence is a normative one. Gray (1990) and Malachowski (1990) both assert that it is legitimate to base rights and accountability on ‘barometers of public opinion’. Corporate Objectives: A Conclusion Although senior managers of companies may not be entirely clear about the objectives that they pursue, and although there may be occasions when senior managers act in their own interest rather than their company’s, it will be taken as axiomatic in these notes that there is a prime corporate objective and that this objective is the maximisation of shareholder wealth. The justification for this is threefold: it is plausible that maximisation of shareholder wealth is the objective that managers pursue in practice, it forms a logical and coherent theoretical framework, and its adoption is fruitful.

FINANCIAL TARGETS

Financial management is the management of the finances of a business; that is, financial planning and financial control to achieve the financial objectives of the business. The theory of financial management is based on the assumption that the objective of management is to maximise the market value of the company’. Specifically, that the objective of a company is to maximise the wealth of its ordinary shareholders. A company is financed by ordinary shareholders, preference shareholders, debenture holders, and other long-term and short-term creditors. All surplus funds, however, belong to the legal owners of the company, its ordinary shareholders. Any retained profits are the undistributed wealth of these equity shareholders. Now, if the financial objective of a company is to maximise the value of the company, and in particular the value of its ordinary shares, we need to be able to put values on a company and its shares. There are (at least) three possible methods of valuation: A balance sheet valuation (assets valued on a going concern basis) It is true that investors will consider a company’s balance sheet. If retained profits rise every year, the company will clearly be profitable. However, balance sheet values do not measure of ‘market value’, although retained profits gives an indication of what the company could pay by way of dividend to shareholders. A balance sheet valuation (assets valued on a on a break-up basis) This method of valuing a business is of interest when the business is threatened with liquidation, or when its management is thinking about selling off individual assets (rather than a complete business) to raise cash. Market values The market value is the price at which buyers and sellers will trade stocks and shares in a company. This is a method of valuation that is more relevant to the financial objectives of a company. Now, when shares are traded on a recognised stock market, such as the London International Stock Exchange, the market value of a company can be measured by the price at which shares are currently being traded. However, when shares are in a private company, and are not traded on any stock market, there is no easy way to measure their market value. Even so, the financial objective of these companies should be to maximise the wealth of their ordinary shareholders. The wealth of the shareholders in a company stems from dividends received and the market value of the shares. The dividends received and capital gains from increases in the market value of his or her shares constitute a shareholder’s return on investment. Dividends are generally paid by UK public companies twice a year (an interim and a final dividend). A current market value is, for shares with a Stock Exchange listing, always known from the current listed share price. There is a theory, strongly supported by empirical evidence, that market prices are heavily influenced by expectations of what future dividends will be. Hence, we might conclude that the wealth of shareholders in listed companies can be captured by the market value of the shares. Prudent financial practice (and UK company law) requires that dividends are paid only out of profits earned. Consequently, the higher the profit earned the greater the dividend that can prudently, and legally, paid. It seems to follow that maximising profit would be a legitimate aim in business: however, we saw above that there are problems with the maximisation of profit and that increasing earnings per share (EPS) was preferable. Since a key reason for increasing earnings per share is to increase the dividend payable, it would make sense to specify both in articulating financial objectives, e.g. the board of a company might set the twin targets of increasing both EPS and dividends per share by 5% p.a. Other financial targets might include restrictions on the company’s level of gearing, or debt. For example, a company’s senior managers might decide that the ratio of long-term debt capital to equity capital should not exceed, say, 1:1, or that the cost of interest payments should not exceed, say, 20% of profit before interest and tax. We noted earlier that ROCE was unsatisfactory as a candidate for the primary financial objective of a company, but it can be used as a subsidiary financial target. Depending on the industry in which the company operates, the board could set a minimum ROCE of, say, 15%. Similarly, a target for the gross profit percentage could be set. As we have noted, one important reason for striving to increase earnings per share is to increase the dividend payable; the other reason is for reinvestment in the company. Hence, another possible area that could be the subject of a financial target is the level of profit retention, e.g. management might set a target that dividend cover [8] should not be less than, say, 3:1. We emphasise that these financial targets are short-term in nature and are secondary to the maximisation of shareholder wealth in the long term that is taken to be the corporate objective. The pursuit of short-term targets at the expense of the long-term is potentially dangerous, for example postponing the acquisition of capital goods, or limiting research and development expenditure, or cutting back on staff training.

NON-FINANCIAL OBJECTIVES

In the pursuit of the long-term maximisation of shareholder wealth, a board of directors that subscribed to the notion of satisficing might well regard as important some non-financial objectives, for example: The welfare of employees A company might aim to provide better than average wages and salaries, comfortable and safe working conditions, good training and career progression, and make better than average pension provision. Where redundancies are necessary, such companies will provide generous redundancy payments, or spend money trying to find alternative employment for redundant staff, or both. The welfare of society as a whole (‘Corporate Social Responsibility’) The managers of some companies may place emphasis on the rôle that their company can play in relation to society as a whole. Increasingly, companies are accepting responsibilities in relation to environmental concerns. The fulfilment of responsibilities towards customers and suppliers Responsibilities towards customers that a company might accept include providing a product or service of the quality that customers expect, and dealing honestly and fairly with customers. Responsibilities towards suppliers might include avoiding the abuse of power stemming from the company’s size. Concluding remark Given the primary objective of maximisation of shareholder wealth, it is nevertheless possible that non-financial objectives could clash with secondary financial targets. In this case, short-term financial targets may have to be sacrificed to satisfy the non-financial objectives essential for the long-term prosperity of the company’s owners.

Did you like this example?

Cite this page

Study On Financial Strategy And Financial Objectives Finance Essay. (2017, Jun 26). Retrieved September 25, 2022 , from
https://studydriver.com/study-on-financial-strategy-and-financial-objectives-finance-essay/

Save time with Studydriver!

Get in touch with our top writers for a non-plagiarized essays written to satisfy your needs

Get custom essay

Stuck on ideas? Struggling with a concept?

A professional writer will make a clear, mistake-free paper for you!

Get help with your assigment
Leave your email and we will send a sample to you.
Stop wasting your time searching for samples!
You can find a skilled professional who can write any paper for you.
Get unique paper

Hi!
I'm Chatbot Amy :)

I can help you save hours on your homework. Let's start by finding a writer.

Find Writer