Goal of a firm : Profit or wealth maximization? PDF

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Goal of a firm : Profit or wealth maximization?????...

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Master of Professional Accounting University of Dhaka

Assignment # 01 Course: MPA 502 (Principles of Finance)

Submitted ByMd. Zakaria Roll # MPA 18010604 Batch-6th Semester: Jan.-Jun. Year: 2018

1–7: What is the goal of the firm and, therefore, of all managers and employees? Discuss how one measures achievement of this goal. Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s owners—the stockholders. The simplest and best measure of stockholder wealth is the firm’s share price, so manager's primary goal would be to take actions that increase the firm’s share price. We argue that the goal of the firm, and also of managers, should be to maximize the wealth of the owners for whom it is being operated, or equivalently, to maximize the stock price. This goal translates into a straightforward decision rule for managers—only take actions that are expected to increase the share price.

1–8: For what three basic reasons is profit maximization inconsistent with wealth maximization? For at least three reasons profit maximization does not always lead to the highest possible share price i.e. wealth maximization to the shareholders. First, timing is important. An investment that provides a lower profit in the short run may be preferable to one that earns a higher profit in the long run. Second, profits and cash flows are not identical. The profit that a firm reports is simply an estimate of how it is doing, an estimate that is influenced by many different accounting choices that firms make when assembling their financial reports. Cash flow is a more straightforward measure of the money flowing into and out of the company. Companies have to pay their bills with cash, not earnings, so cash flow is what matters most to financial managers. Third, risk matters a great deal. A firm that earns a low but reliable profit might be more valuable than another firm with profits that fluctuate a great deal (and therefore can be very high or very low at different times).

1–9: What is risk? Why must risk as well as return be considered by the financial manager who is evaluating a decision alternative or action? The chance that actual outcomes may differ from those expected. A basic premise in managerial finance is that a trade-off exists between return (cash flow) and risk. Return and risk are, in fact, the key determinants of share price, which represents the wealth of the owners in the firm. Cash flow and risk affect share price differently: Holding risk fixed, higher cash flow is generally associated with a higher share price. In contrast, holding cash flow fixed, higher risk tends to result in a lower share price because the stockholders do not like risk. Simply put, the increased risk reduced the firm’s share price. In general, stockholders are risk averse —that is, they must be compensated for bearing risk. In other words, investors expect to earn higher returns on riskier investments, and they will accept lower returns on relatively safe investments.

1–10: Describe the role of corporate ethics policies and guidelines, and discuss the relationship that is believed to exist between ethics and share price. Business ethics are the standards of conduct or moral judgment that apply to persons engaged in commerce. Violations of these standards in finance involve a variety of actions: “creative accounting,” earnings management, misleading financial forecasts, insider trading, fraud, excessive executive compensation, options backdating, bribery, and kickbacks. The goal of these ethical standards is to motivate business and market participants to adhere to both the letter and the spirit of laws and regulations concerned with business and professional practice. Most business leaders believe businesses actually strengthen their competitive positions by maintaining high ethical standards. An effective ethics program can enhance corporate value by producing a number of positive benefits. It can reduce potential litigation and judgment costs, maintain a positive corporate image, build shareholder confidence, and gain the loyalty, commitment, and respect of the firm’s stakeholders. Such actions, by maintaining and enhancing cash flow and reducing perceived risk, can positively affect the firm’s share price. Ethical behavior is therefore viewed as necessary for achieving the firm’s goal of owner wealth maximization.

5 Corporate Scandal 1. Waste Management Scandal (1998) Company: Houston based publicly traded waste management company. What Happened: Reported $1.7 billion in fake earnings How they did: The company allegedly falsely increased the depreciation time length for their property, plant, equipment on the balance sheet. How they got caught: A new CEO& management team went through the books. Main players: CEO/Chairman and Arthur Anderson Company (Auditors)

2. Enron Scandal (2001) Company: Houston based commodities, energy and service corporation. What Happened: Shareholders loss $74 billion How they did: Kept huge debt off the balance sheets. How they got caught: Turned in internal whistle blower Sheron Watkins; hight stock prices fueled suspicions Main players: CEO

3. Worldcom Scandal (2001) Company: Telecommunications Company What Happened: Inflated assets as much as $11 billion. How they did: Underreported line costs by capitalizing rather than expensing, and inflated revenues with fake accounting entries. How they got caught: WorldCom's internal auditing department uncovered $3.8 billion in fraud. Main players: CEO.

4. Tyco Scandal (2002) Company: New Jersey based blue-chip Swiss security systems company. What Happened: CEO & CFO stole $150 million and inflated company income by $500 million. How they did: Siphoned money through unapproved loans and fraudulent stock sales. Money was smuggled out the company disguised as executive bonuses or benefits. How they got caught: SEC and Manhattan D.A. investigations uncovered questionable accounting practices. Main players: CEO & CFO.

5. Healthsouth Scandal (2003) Company: Largest publicly traded health care company in the U.S. What Happened: Earning numbers were allegedly inflated $1.4 billion to meet stockholders expectations. How they did: Allegedly told underlings to make up numbers and transactions from 19962003. How they got caught: Sold $75 million stock in a day before the company posted a huge loss, triggering SEC suspicions. Main players: CEO....