The Goal of Financial Management
The goal of financial management is to maximize shareholder wealth.For public companies this is the stock price, and for private companies this is the market value of the owners' equity.
We'll discuss the drawbacks of other potential measures.
We'll also explain why this measure makes sense, and limits excessive risk-taking.
Alternative Measures
Some might offer goals such asmaximize cash flowsormaximize profit.
Relatively minor problems with these goals relate to how to measure the cash flows—should they be the average cash flow over some period (and what period)?
In other words these measures areambiguous.
Maximizing shoreholder wealthis not ambiguous. There is one unique share price.
Larger Problem
The larger problem with measures such asmaximizing profitorcash flowsis that the they lackbalance. In finance and investments risk is balanced with reward. You can't have one without the other, and so you can't consider the reward without also considering the risk youmusttake to earn that reward.
That is the problem with these possible measures. They consider reward (profit and cash flows) without considering the risk it takes to maximize them.
Thus, setting these as goals of management, may lead management to take excessive risks (because risk isn't even considered).
Excessive Risk
As an example, say the goal was to maximize cash flow. Assume the following scenario.
Your company has $100,000 to invest in houses. There are 100 houses, each house costs $100,000, and their prices will increase by 1% over the next year.
You are able to borrow up to a maximum of 100-to-1 leverage.
You will sell all investments at the end of the year.
Assume interest rates and taxes are 0% (this is only saves us from immaterial calculations).
Expected Cash Flow
Consider the two possible investments:
You can invest $100,000 in one house. In this case you expect to earn $1,000 cash flow (or profit) over the year.
You can invest $1,000 each in 100 houses. Now you expect $100,000 in cash flow.
In fact, you can seemaximizing cash floworprofitwill simply instruct management to borrow as much as possible and use it all to buy houses (take on as much risk as possible).
A Stock's Value
The value of a stock* (or any asset) is the sum of all the stock's discounted expected future cash flows (dividends), where the discount rate reflects the risk taken to earn those cash flows. So, for example, say a company expects to pay $10 in dividends per share every year forever. Then the value of the firm's stock is:
`Value = \$10 + \frac{\$10}{1+k} + \frac{\$10}{(1+k)^2} + \frac{\$10}{(1+k)^3} + \ldots`
wherekis the firm's cost of equity capital (which increases with the risk the firm takes). If we assume`k = 8\%`, then the value of the firm's stock is $125.
- See this presentation onstock valuationfor a more detailed treatment.
Limiting Risk
So how does this limit risk? A firm may increase risk to increase the value of the stock. Say the firm can pay $12 in dividends annually, but it will increase their cost of equity capital to 9%. Then the value of the stock is $133.33, and management of the firm should take the additional risk.
However, what if to increase dividends to $14, the firm's cost of equity becomes 11%. Then the firm's value is $127.27. The firm thus should not take on the additional risk. Generally, at a certain point, the increase in the cost of equity will always more than offset the increase in increased dividends.
In this way, the goal of financial management naturally limits risk.
Interactive App
The following interactive application gives you a general idea of how a stock's price reacts to increasing risk.
As you increase risk, both expected cash flows and the required return on equity increase, however the effect of increasing expected cash flows dominate, and the stock price increases.
However, as risk rises, at some point the effect of the increased required return dominates, and increasing risk will decrease the stock price.
Below is a general example. The exact point where the effect on the required return dominates would vary from firm to firm.
The Goal in Other Countries
This presentation has covered the goal of financial management for U.S. firms. The goal of financial management may differ for firms based in other countries.
- For example in other countries, such as Germany, it is a common requirement to have representative of labor on the Board of Directors of certain firms. In this casemaximizing shareholder wealthis not the sole goal of the financial manager.
Credits and Collaboration
Click the following links to see thecode,line-by-line contributions to this presentation, andall the collaborators who have contributed to 5-Minute Finance via GitHub.
Learn more about how to contributehere.
