Question

Chapter 1 Discussion: Primary Goal of Management

Currently, maximization of shareholder wealth is widely accepted as the primary goal of management. However, like most economic theories, certain conditions must exist in order for the theory to accomplish its potential . Now, compare the theoretical world with the real world--if you were in charge of management decisions, how might you balance the theory with reality?

Answer 1

The wealth of a shareholder maximizes when the net worth of a company maximizes. A shareholder holds share in the company/business and his wealth will improve if the share price in the market increases which in turn is a function of net worth. This is because wealth maximization is also known as net worth maximization.

From a financial management perspective, this means maximizing the price of a firm's common stock.

In pursuing this objective, managers consider the risk and timing associated with expected earnings per share to maximize the price of the firm's common stock.

When this is properly executed, management will also have maximized the future stream of dividends and capital gains that accrue to its shareholders. The most defensible form of Shareholder wealth maximization looks to long-term rather than short-term maximization.

Capital investment decisions of a firm have a direct relation with wealth maximization. All capital investment projects with an internal rate of return (IRR) greater than cost of capital or having positive NPV or creates value for the firm. These projects maximize the wealth of the shareholders because they are earning more than what they can earn by investing themselves.

By analyzing the projects with the methods of capital budgeting, it can be determined whether wealth will or won’t be created in a particular project.

Two main sources of wealth creation or value creations are the industry attractiveness and competitive advantage of the firm.

a) Industry attractiveness:

One of the most important factors for a firm to make profits is its industry attractiveness. There are five forces of industry attractiveness which are as follows:

1. Barriers to Competitor’s Entry:  Higher the entry barrier, higher is the chances for a firm to sustain for a long term.
2. Substitutes: Lower the substitutes, lesser are the chances of consumers switching the products.
3. Bargaining Power of Buyers: Lesser the bargaining power of buyers, the firm becomes in a better position to dominate terms.
4. Bargaining Power of Suppliers: Lesser the bargaining power of suppliers and buyers, the firm becomes in a better position to dominate terms.
5. Competition among Competitors: It emphasizes the degree of competition which exists between the current competitors of the industry. Amicable conditions among the competitors would make the firms enjoy the better position.

b) Competitive advantage:

There are two elements of competitive advantage which are cost advantage and differentiation advantage.

1. Cost advantage means the cost at which a firm producing the goods cannot be produced by the competing firms at that cost. Due to this advantage, the firm can sell products at a lower price than the competitors and still earn profit out of that. Customers are cost conscious and therefore they are attracted towards the firm’s products. The firm enjoys good sales which lead to more profits and better cash flows and therefore achieve wealth creation.
2. Differentiation advantage means the product offered by the firm can be easily differentiated from other competitor’s products. The customers are convinced with a different product which is available only with the firm under concern. In such cases where the product is unique, firms enjoy higher price and therefore this becomes the real source of value creation for those firms.