GOAL OF FINANCIAL MANAGEMENT.doc

GOAL OF FINANCIAL MANAGEMENT FOR A PUBLICLY TRADED CORPORATION, THE GOAL SHOULD BE TO MAXIMIZE SHAREHOLDER WEALTH BY MAXIMIZING SHARE PRICE.WHY? BECAUSE THE SHAREHOLDERS, AS RESIDUAL OWNERS, TAKE THE GREATEST AMOUNT OF RISK AMONG ALL THE STAKEHOLDERS. THEIR DIVIDENDS ARE PAID FROM AFTER-TAX EARNINGS, AFTER ALL OTHER EXPENSES HAVE BEEN ACCOUNTED FOR. ALSO, IN THE EVENT OF BANKRUPTCY AND LIQUIDATION, THE SHAREHOLDERS ARE THE LAST TO BE PAID AFTER ALL OTHER CLAIMS HAVE BEEN MET. IS THIS GOAL INCONSISTENT WITH THE WELFARE OF OTHER STAKEHOLDERS SUCH AS CREDITORS? NO. IF THE FIRM MISCHANNELS THE BORROWED FUNDS AND/OR FAILS TO GENERATE THE CASH FLOWS TO PAY INTEREST AND PRINCIPAL, LENDERS WILL RAISE INTEREST RATES FOR FUTURE BORROWINGS OR TAKE OTHER APPROPRIATE ACTIONS NOT EXCLUDING FORCING THE FIRM TO BANKRUPTCYEMPLOYEES? NO. IF THE FIRM FAILS TO TAKE CARE OF ITS EMPLOYEES BY PAYING COMPETITIVE WAGES AND BENEFITS, PROVIDING APPROPRIATE TRAINING AND CREATING A SAFE AND HARASSMENT-FREE WORKING ENVIRONMENT, EMPLOYEE- PRODUCTIVITY MAY DECLINE AND TURN-OVER WILL BE HIGH, AFFECTING REVENUES, PROFITS AND SHAREHOLDERS WELFARECUSTOMERS? NO. IF THE FIRM FAILS TO TAKE CARE OF ITS CUSTOMERS BY PROVIDING QUALITY PRODUCTS AND SERVICES AT COMPETITIVE PRICES OR FAILS TO FULFILL WARRANTIES, THEY WILL GO TO COMPETITITION, THERE MAY BE LAWSUITS AND SALES WILL FALL AND COSTS WILL INCREASE, AFFECTING SHAREHOLDERS WELFARESOCIETY? NO. IF THE FIRM FAILS TO FOLLOW THE LAWS OF THE SOCIETY AND/OR ENGAGES IN ETHICAL VIOLATIONS, IT MAY FACE LITIGATION, FINES AND SOCIAL OSTRAZIATION, RESULTING IN REVENUE DECLINES, COST INCREASES, PROFIT DECLINES, ALL AFFECTING SHAREHOLDERS WELFARE.THUS, SHAREHOLDERS WEALTH MAXIMIZATION IS A CONSTRAINED OPTIMIZATION PROBLEM.AGENCY PROBLEMS GIVEN THE GOAL OF SHAREHOLDERS WELFARE MAXIMIZATION, WHAT IS THE GUARANTEE THAT MANAGERS WILL PURSUE THIS GOAL DILIGENTLY? THE PROBLEM WHEN MANAGERS FAIL TO PURSUE THE GOAL OF OWNERS WELFARE MAXIMIZATION IS REFERRED TO AS AGENCY PROBLEM. AGENCY PROBLEM INVOLVING MANAGERS MAY BE OF TWO KINDS:A. MAMGAERS VS SHAREHOLDERS MANAGERS MAY SQUANDER RESOURCES MAY NOT TAKE APPROPRIATE RISK MAY STRIVE TO DEPRESS STOCK PRICES FOR LEVERAGED BUYOUT MAY ENGAGE IN OTHER SIMILAR ACTIVITIES RESOLVED BY THREAT OF FIRING BY STOCKHOLDERS THREAT OF OUSTER AFTER A HOSTILE TAKEOVER COMPENSATION STRUCTURED TO REWARD GOOD PERFORMANCE INCLUDING INCENTIVES LIKE BONUS SHARES, STOCK OPTIONS B. STOCKHOLDERS VS CREDITORS: MANAGERS MAY BE PREVAILED ON BY STOCKHOLDERS TO TAKE MORE RISK THAN ANTICIPATED BY CREDITORS MAY INCREASE DEBT LEVEL DRIVING DOWN THE VALUE OF OUTSTANDING DEBT RESOLVED BY STRICT OVERSIGHT BY TRUSTEES STRINGENT DEBT COVENANTS, ETCCapital Market Equilibrium/Capital Market EfficiencyCapital market (securities market) equilibrium/efficiency refers to the way in which relevant information about capital assets are accessed, processed and impounded in asset prices.For capital markets to be efficient, the following are necessary:1. Easy and ready access to relevant information about assets2. Proper and accurate processing of the relevant information3. Rapid impounding of the processed information in asset pricesThe stronger the above requirements are met, the greater the efficiency. Thus, efficiency is a matter of degree rather than an absolute. Three levels of efficiency are recognized in finance literature:Weak-Form Efficiency: when current security prices reflect historical information. The prevalence of such an efficiency strikes a blow to “technical analysis”Semi-strong form efficiency: when current prices reflect all publicly available information such as managements forecasts, analysts reports etc. The prevalence of such an efficiency strikes a blow to “fundamental analysis”Strong-form efficiency: when current prices reflect all information, public and private. Capital markets in developed nations such as the U.S. are considered to be generally “semi-strong” efficient, i.e., they are efficient most of the times, reflecting all publicly available information, even though they may be inefficient sometimes. When markets are efficient, assets are considered be to priced efficiently (fairly) and are in equilibrium. In such cases the price of an asset is considered to reflect the assets intrinsic value. When the market for an asset (or assets) is not efficient, the asset is not efficiently/fairly priced. In such a case, the asset is considered to be mispriced. The assets price may be greater or less than its intrinsic value. If the assets price is greater than its intrinsic value, the asset is overpriced. If the assets price is less than its intrinsic value, it is under priced. Thus the following relationships can be enunciated:IF PRICE = VALUE (VALUE = PRICE), ASSET IS FAIRLY/ EFFICIENTLY PRICED AND AN INVESTOR WOULD BE INDIFFERENT/NEUTRAL ABOUT INVESTING IN THAT ASSET (MAY OR MAY NOT BUY).IF PRICE VALUE (VALUEPRICE), ASSET IS OVERPRICED AND AN INVESTOR SHOULD NOT BUY THE ASSET.IF PRICE PRICE), ASSET IS UNDERPRICED AND AN INVESTOR SHOULD BUY THE ASSET.SINCE CAPITAL MARKETS IN DEVELOPED ECONOMIES SUCH AS THE U.S. ARE GENERALLY “SEMI-STRONG” EFFICIENT, HOW CAN A MANAGER INFLUENCE AND MAXIMIZE STOCK PRICE? BY PROVIDING THE RELEVANT INFORMATION ABOUT THE FIRM AND THE STOCK TO MARKET PARTICIPANTS ON A TIMELY BASIS. THIS CAN BE DONE IN ONE OF TWO WAYS:DIRECT DISSEMINATION OF RELEVANT INFORMATION VIA PUBLIC REPORTS, REGULAR MEETINGS WITH ANALYSTS., ETCINDIRECT DISSEMINATION O