Rania El Ghalbzouri 1
IBT 2B1
,1.1 Finance and the firm
What is finance?
Finance is a multifaceted field encompassing both the science and art of effectively
managing money. At the individual level, finance revolves around the crucial
decisions people make regarding their finances, which include:
➢ Expenditure Choices: Deciding how much of one's earnings to spend, considering
factors such as daily expenses, bills, and lifestyle preferences.
➢ Savings Strategies: Determining the amount to save for future goals and financial
security. This entails understanding the importance of building a financial safety
net.
➢ Investment Selection: Deliberating on how to allocate savings into various
investment opportunities. This involves assessing risk tolerance, financial goals, and
market dynamics.
In the realm of business, finance encompasses a range of critical activities that
collectively drive the financial health and success of a company. These activities
include:
➢ Capital Acquisition: The process through which companies secure funding from
various sources, including investors, lenders, and shareholders. This financial influx
is essential for the company's operations and growth.
➢ Investment Strategies: The prudent allocation of funds by businesses into ventures
and assets with the aim of generating returns and profits. This involves assessing risk,
evaluating potential projects, and optimizing resource utilization.
➢ Profit Management: The decision-making process regarding the allocation of
profits earned by the company. Businesses must choose between reinvesting these
profits back into the company for expansion and development or distributing them
to shareholders as dividends.
What is the goal of the firm?
In the realm of corporate finance, the overarching objective of a firm is to maximize
the wealth of its shareholders, who are the ultimate owners of the company. This
central goal entails several key considerations:
➢ Wealth Maximization: The primary responsibility of company managers is to work
towards enhancing the overall wealth of the firm's shareholders. This involves
making decisions that are in the best interests of the owners.
➢ Stock Price Maximization: In practice, the pursuit of shareholder wealth
maximization often translates into efforts to maximize the firm's stock price. A higher
stock price reflects increased shareholder value and wealth.
Rania El Ghalbzouri 2
IBT 2B1
,While maximizing profit might seem like a straightforward goal, it does not necessarily
align with maximizing shareholder wealth. This discrepancy is due to several factors:
➢ Timing: Profit maximization might not coincide with the optimal timing of cash flows
and returns, which can affect shareholders' wealth differently.
➢ Cash Flows: The focus on profit alone may not account for the timing and
sustainability of cash flows, which are crucial in determining the true value of a
firm.
➢ Risk: Profit maximization does not inherently consider the level of risk associated
with various decisions, whereas shareholder wealth maximization often involves risk
assessment and management to protect and enhance wealth over the long term.
Example:
Nick Dukakis serves as the financial manager at Neptune Manufacturing, a company
that specializes in producing marine engine components. He is currently faced with a
decision between two investment options: Rotor and Valve. The table below illustrates
the expected earnings per share (EPS) for each investment over a 3-year period. If
Dukakis prioritizes maximizing profits, he would advise Neptune to opt for the Valve
investment over Rotor. This choice is based on the fact that Valve is projected to yield
higher total earnings per share during the 3-year timeframe, with $3.00 EPS as opposed
to Rotor's $2.80 EPS.
Rania El Ghalbzouri 3
IBT 2B1
, What is the goal of the firm?: Maximizing Stakeholders' Welfare?
In discussions surrounding the objective of a firm, an alternative perspective suggests
a more balanced approach that takes into account the well-being of not only
shareholders but also other key stakeholders associated with the firm. These
stakeholders encompass a broad spectrum, including employees, suppliers,
customers, and members of the local community where the firm operates.
This viewpoint emphasizes the following:
➢ Balanced Welfare: Advocates of this approach argue for a balanced
consideration of the interests and welfare of both shareholders and these diverse
stakeholders. It suggests that a firm should aim to create positive outcomes for all
parties involved.
➢ Stakeholder Inclusion: Recognizing that businesses have a broader impact beyond
just their shareholders, it acknowledges the significance of fostering positive
relationships with employees, suppliers, customers, and the local community.
In contemplating the goal of maximizing stakeholders' welfare, it is imperative for
managers to recognize and prioritize the interests of all parties associated with a firm.
Several key principles underpin this perspective:
➢ Holistic Consideration: Managers should refrain from disregarding the concerns
and interests of all individuals and entities connected to the firm, including
shareholders, employees, suppliers, customers, and the broader community.
➢ Long-Term Perspective: In their pursuit of maximizing shareholder value, managers
must adopt a forward-looking approach that carefully evaluates the enduring
consequences of their decisions. This entails considering the long-term implications
of actions, rather than focusing solely on short-term gains.
➢ Ethical and Legal Boundaries: An essential component of maximizing stakeholders'
welfare is the adherence to established legal and ethical standards. Managers
are obligated to operate within these boundaries to ensure that the interests of all
stakeholders are protected and promoted.
Rania El Ghalbzouri 4
IBT 2B1
