Without objectives, there is no systematic way to select a decision. If we choose a wrong objective then the costs are going to be phenomenal. What is a good objective?
- It should be clear and unambiguous
- Comes with a clear and timely measure to evaluate success
- Doesn’t cause conflict of interest and deterrent in existing
Traditional corporate finance: The objective is to maximize the value of the firm.
Narrower objective: maximize stockholder wealth. The objective in an efficient market is to maximize the stock price (provided the business communicates its information transparently1)
All other goals of the firms are intermediate ones.
Why traditional corporate financial theory often focuses on maximizing stock prices as opposed to firm value?
- Stock prices are easily observable
- Investors are rational (are they? assumed!)
Maximize stock prices as the only function
Assumptions:
- decision makers are responsive to the owners of the firm
- stockholder wealth is not being increased at the expense of the bondholders are lenders to the firm
- Markets are efficient.
- There are not significant social costs.
The Classical Objective Function
A flow (transmission diagram)
The Agency Cost Problem
- The interest of managers, stockholders, bondholders and society can diverge2.
- Managers may have other interest
- Stockholders…
- Society…
- Financial Markets…
- Bondholders…
Transclude of The-Objective-in-Corporate-Finance-2024-12-11-09.25.08.excalidraw
Conflict in interest of the various agencies is the “Agency Cost Problem”