Financial Management

Financial Management

Business Organization Wealth Maximization

Introduction

This series of essays is intended to give students in the beginning corporate finance course the opportunity to read about and reflect on some of the major theoretical constructs upon which that course is based. Students often become overwhelmed with the details of the introductory finance course and fail to see the more critical overarching themes that pervade the subject. By providing short essays designed to supplement the managerial finance course, this series attempts to remedy that situation.

Topics will include financial analysis, leverage, security valuation, capital structure, capital budgeting, dividend policy, mergers and acquisitions, and working capital management. The series begins with the concepts of Business Organization wealth maximization and agency theory, because each of the remaining topics relies on the organization assumption yet offers challenges to managers as agents of the shareholders, covered under the rubric of agency theory. A theoretical section lays the foundation and is followed by an overview of how organization should apply to some of the decisions the financial manager commonly faces.

Part A.

Critically evaluate the need to manage capital structure effectively in maximising the wealth of business organisations

Theoretical Background

Textbooks promote the theory that Business Organization wealth maximization represents the overarching goal of the financial manager. While bearing some relationship to Milton Friedman's contention, "There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it...engages in open and free competition, without deception or fraud" [Friedman, 1962, p. 133], the contemporary stance broadens the definition. Typically textbook authors go to great lengths to present this as a long-run concept and caution students about the negative ramifications of managers' attempting to maximize short-term profit (net income) or earnings per share. In addition, maximizing returns with no consideration of commensurate risk is inappropriate, because investors prefer smooth earnings streams to erratic ones. Furthermore, maximization of Business Organization wealth must be accomplished in conjunction with consideration for other stakeholder groups.' Finally, financial managers are to consider cash flows rather than accounting income, and the timing of those cash flows matters. So what is a student to make of all this? '

Economic theory illustrates that risk and return commonly exhibit a positive relationship. That is, as risk increases, investors demand a higher return, because rational economic participants are risk-averse, preferring less risk to more, and they must be compensated for assuming additional risk. Risk is defined as the variability of potential returns, and the field of statistics offers a variety of measures of dispersion related to this concept. For the purposes of this introductory essay, suffice it to say that, in theory, financial managers generally should attempt to either maximize the return per unit of risk or minimize the risk per unit of return in their effort to help maximize Business Organization wealth. This "decision rule" plays a major role throughout this series.

A related concept, efficient markets, assumes that as investors in the marketplace receive ...