CHAPTER 2 RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND OTHER ORGANIZATIONAL OBJECTIVES INTRODUCTION ~ Finance permeates the entire business organization by providing guidance for the firm’s strategic (long-term) and day-to-day decisions. For long range planning and management control, a business firm establishes its overall objectives. Such objectives are developed by the top management and they usually consist of general statement .or a series of statements in general terms stating what the company expects to achieve. © Objective setting is thus, an important phase in the business enterprise since upon correct objectives setting will the entire structure of the strategies, policies and plans of a company rest. Firms have numerous goals but not every goal can be attained without causing conflict in reaching other goals. Conflicts often arise because of the firm’s many constituents who include shareholders, managers, employees, labor unions, customers, creditors, and suppliers. There are those who claim that the firm’s goal is to maximize sales or market share; others believe the role of business is to provide quality products and service; still others feel that the firm has a responsibility for the welfare of society at large. For example, the objective may be stated in such broad terms as: © ‘itis the goal of the company to be a leader in technology in the industry, or * Toachieve profits through a high level manufacturing efficiency, or ¢ Toachieve a high degree of customer satisfaction.14 Chapter 2 For the purpose. though of measuring performance and degree of control, it is necessary to set objectives or goal in more precise terms. The objectives are usually in quantitative terms ‘and are set within a time frame. The setting of physical targets to be.accomplished within a set time period. would provide the . basis of conversion of the targets into financial objectives. - STRATEGIC FINANCIAL MANAGEMENT - Strategic planning is long-range in scope.and has its focus on the organization as a whole. The concept is based on an objective and comprehensive assessment of the present situation of the organization and the setting up of targets to be achieved in the context of an intelligent and knowledgeable anticipation of changes in the environment. The strategic financial planning inyolves financial planning, financial forecasting, provision of finance and formulation of fi finance policies which should lead the firm’s survival and success. The responsibility of a finance manager is to provide a basis and information for strategic positioning ‘of the firm in the industry. The firm’s strategic financial planning should be able to meet the challenges and competition, and it would lead to firm’s failure or success. B The strategic financial planning should enable the firm to judicious allocation-of funds, capitalization of relative. strengths, mitigation of weaknesses, early identification of shifts in environment, counter possible actions-of competitor, reduction in financing costs, effective use of funds deployed, timely estimation of funds requirement, identification of business and financial risk, and so forth. ‘The strategic financial planning is likewise needed to counter the uncertain and imperfect market conditions and highly competitive business environment. While framing financial strategy, shareholders should be considered as one of the constituents of a group of stakeholders, debenture holders, banks, financial institutions, government, managers, employees, suppliers and’ customers. The strategic planning should concentrate on multidimensional objectives like profitability, expansion growth, survival, leadership, ‘business success, positioning of the firm, reaching global markets and brand positioning. The financial policy requires the deployment of firm’s resources for achieving the Corporate strategic objectives. The financial policy should align with the company’s strategic planning. It allows the firm in overcoming its weaknesses, enables the firm to maximize the utilization of its.competencies and to direct the prospective business opportunities and threats to its advantage. Therefore, theRelationship of Financial Objectives to Organizational Strategy and... _15 finance manager should take the investment and finance decisions in consonance with the corporate strategy. 4 A company’s strategic or business plan reflects how it plans to achieve its goals and objectives. A plan's success depends on an effective analysis of market demand and supply. Specifically, a company must assess demand for its products and services, and assess the supply of its inputs (both labor and capital). The plan must also include competitive analyses, opportunity assessments and consideration of business threats. Historical financial statements provide insight into the success of a company’s strategic plan and are an important input of the planning process. These statements highlight portions of the strategic plan that proved profitable and, thus, warrant additional capital investment. They also reveal areas that are less effective and provide information to help managers develop remedial action. Once strategic adjustments are planned and implemented, the resulting financial statements provide input into the planning process for the following year, and this process begins again. Understanding a company’s strategic plan helps focus our analysis of the company’s short-term and long-term financial objectives by placing them in proper context. SHORT-TERM AND LONG-TERM FINANCIAL OBJECTIVES OF A BUSINESS ORGANIZATION Among are the primary financial objectives of a firm are the following: SHORT AND MEDIUM-TERM © Maximization of return on capital employed or return on investment ¢ Growth in earnings per share and price/earnings ratio through maximization of net income or profit and adoption of optimum level of leverage ¢ Minimization of finance charges ¢ Efficient procurement and utilization of short-term, medium-term, and long-term funds16 Chapter 2 LONG-TERM © Growth in the market value of the equity shares through maximization of the firm’s market share and sustained growth in dividend to shareholders © Survival and sustained growth of the firm There have been a number of different, well-developed viewpoints concerning what the primary financial objectives of the business firm should be. The competing viewpoints are: ¢ The owner’s perspective which hold that the only appropriate goal is to maximize shareholder or owner's wealth, and; © The stakeholders’ perspective which emphasizes social responsibility over profitability (stakeholders include not only. the owners and shareholders, but also include the business’s customers, employees and local commitments). While strong arguments speak in favor of both -perspectives, financial practitioners and academics now tend to believe that the manager’s primary responsibility should be to maximize shareholder's wealth and give only secondary consideration to'other stakeholders’ welfare. Adam Smith, an 18" century economist was one of the first and well known proponent of this viewpoint. He argued that, in capitalism, an individual pursuing his own interest tends also to promote the good of his community. He also pointed out that acting through competition and the free price system, only those activities most efficient and beneficial to society as a whole would survive in the long run. Thus, those same activities would also profit the individual most. Owners of the firm hire managers to work on’ their behalf, so the manager is morally, ethically, and legally required to act in the owners* best interests. Any relationships between the manager and other firm stakeholders are necessarily secondary to the objective that shareholders give to their hired managers. The financial manager must have some goals or objectives to guide decision involving the management of the firm’s assets, liabilities and equity. Hence, priorities must be set to resolve conflicting goals.Relationship of Financial Objectives to Organizational Strategy and... _17 To reiterate, the primary financial goal of the firm is to maximize the wealth of its existing shareholders or owners. Therefore, the overriding premise of financial management is that the firm should be managed to enhance owner(s),well-being. Shareholder’s wealth depends on both the dividends paid and the market price'of the equity shares. Wealth is maximized by providing the shareholders with the target attainable combination of dividends per share and share price appreciation. While this may not be a perfect measure of shareholders’ wealth, it is considered one of the best available measures. The ‘wealth maximization goal is advocated on the following grounds: It considers the risk and time value of money © It considers all future-cash flow, dividends and earnings per share © It suggests the regular and consistent dividend payments to the shareholders : © The financial decisions are taken with a view to improve the capital appreciation of the share price © Maximization of firm’s value is reflected in the market price of share since it depends’ on shareholder’s .expectations regarding profitability, long-run prospects, timing difference of returns, risk distribution of returns of the firm Critics of the wealth maximization objective however say that, this objective is narrow and ignores the concept of wealth maximization of society since society’s resources are used’ to the advantage only of a particular firm. The optimal allocation of the society’s resources should result in capital formation and growth of the economy which should ultimately lead to maximization of economic welfare of the society. RESPONSIBILITIES TO ACHIEVE THE FINANCIAL OBJECTIVES INVESTING The finance. manager is responsible for determining how scarce resources or funds are committed to projects. The investing function deals with managing the firm’s assets. Because the firm has numerous alternative uses of funds, the financial manager strives to allocate funds wisely within the firm. This taskWn 18 Chapter 2 requires both the mix and type of assets to hold. The asset mix refers to the amount of pesos invested in current and fixed assets. The investment decisions should aim at investments in assets only when they are expected to earn a retum greater than a minimum acceptable return which is also {called as hurdle rate. This minimum return should consider whether the money ‘raised from debt or equity meets the returns on investments made elsewhere on similar investments. The following areas are examples of investing decisions of a finance manager: a. Evaluation and selection of capital investment proposal b. Determination of the total amount of funds that a firm can commit for investment c. Prioritization of investment alternatives d. Funds allocation and its rationing e. Determination of the levels of investments in working capital (i.e. inventory, receivables, cash, marketable securities and its management) f. Determination of fixed assets to be acquired g. Asset replacement decisions h. Purchase or lease decisions Restructuring reorganization mergers and acquisition j. Securities analysis and portfolio management FINANCING The finance manager is concerned with the ways in which the firm obtains and manages the financing it needs to support its investments. The financing objective asserts that the mix of debt and equity chosen to finance investments should maximize the value of investments made. Financing decisions call for good knowledge of costs of raising funds, procedures in hedging risk, different financial instruments and obligation attached to them. In fund raising decisions, the finance manager should keep in view how and where to raise the money, determination of the debt-equity mix, impact of interest, and inflation rates on the firm, and so forth.Relationship of Financial Objectives to Organizational Strategy and... _19 The finance manager will be involved in the following finance decisions: a. Determination of the financing pattern of short-term, medium-term and long-term funds requirements b._ Determination of the best capital structure or mixture of debt and equity financing, c.. Procurement of funds through the issuance of financial instruments such as equity shares, preference shares, bonds, long-term notes, and so forth d. Arrangement with bankers, suppliers, and creditors for its working capital, medium-term and other long-term funds requirement e. Evaluation of alternative sources of funds OPERATING This third responsibility area of the finance manager concerns working capital management. The term working capital refers to a firm short-term asset (i.e., inventory, receivables, cash, and short-term investments) and its short-term liabilities (ie, accounts payable, short-term loans). Managing the firm’s working capital is a day-to-day responsibility that ensures that the firm has * sufficient resources to continue its operations and avoid costly interruptions. This also involves a number of activities related to the firm’s receipts and disbursements of cash. Some issues that may have to be resolved in relation to managing a firm’s working capital are: a. The level of cash, securities and inventory that should be kept on hand b. The credit policy (ie, should the firm-sell on credit? If so, what terms should be extended?) Source of short-term financing (i.e., if the firm would borrow in the short-term, how and where should it borrow?) d, Financing purchases of goods (i.¢., should the firm purchase its raw materials or merchandise on credit or Should it borrow in the short-term and pay cash?)x £20 Chapter 2 _ ENVIRONMENTAL “GREEN” POLICIES AND THEIR IMPLICATIONS FOR THE MANAGEMENT OF THE ECONOMY AND FIRM. 0 q H) Private property rights can promote prosperity and cooperation and at the same time protect the environment, but do they protect the environment sufficiently? In recent years, people have increasingly turned to the government to achieve additional environmental improvements. Sometimes, people turned to government because property rights failed to hold polluters accountable for the costs they were ‘imposing on others. In these “external cost cases”, government may be able to improve accountability and protect rights more efficiently by regulation. In other instances, people with strong desires for various environmental amenities (for example, green spaces, hiking trails and wilderness lands) want the government to force others to help pay for them. Courts help owners protect their property against invasions by others, including polluters. In some cases however, it is difficult — if not impossible — to define, establish and fully protect property rights. This is’ particularly true when there is either a large number of polluters or a large number of people harmed by the emissions, or both. In these large numbers of cases, high transaction costs undermine the effectiveness of the property rights - market exchange approach. For example, consider the air quality in a large city sucti as Manila or Quezon City. Millions of people are harmed when pollutants are put into the air. But millions of people also contribute to the pollution. as they drive their cars. Property rights’ alone will be unable to handle large-number cases like this efficiently. More direct regulations may generate a better outcome. Although government regulation is an alternative method of protecting the environment, the regulatory approach also’ has a number of deficiencies. First, government regulation is often sought precisely because the harms are uncertain and the source of the problem cannot be demonstrated, so relief from the courts is difficult to obtain. But when the harms are uncertain, so are the benefits of reducing them. Second, by its very nature, regulation overrides or ignores the information and incentives. provided by market signals. Accountability of regulators for the costs they impose is lacking, just as accountability for polluters is missing in the market sector when secure and tradable property rights are not in place. The tunnel, vision of regulators, each assigned to oversee a small part of the economy, is not properly constrained by readily observable costs. Third, regulation allows special interests to use political power to achieve objectives that may be quite different from the environmental goals originally announced. The global warming issue illustrates all of these problems and the uncertainties that they generate.Relationship of Financial Objectives to Organizational Strategy and ...__21 People turn to government to get what they cannot get in markets. In many cases, they are seeking to get what they want with a subsidy from others. Government can provide protection from harms, as in regulation that reduces pollution, or production of goods and services, as in the provision of national parks. Government can indeed shift the cost of services from some citizens to others, and can do the same with benefits from its programs. There is little reason; however, to expect a net increase in efficiency when the government steps in. That is true in environmental matters, as well as in many other areas of citizen concern. When it is difficult-to assign and enforce private property rights, markets often result in outcomes that are inefficient. This is often the case when large numbers of people engage in actions that impose harm on others. Government regulation has some premise but also poses some problems of its own. Global warming could exert a sizeable adverse impact ch human welfare, but there is considerable uncertainty about both its cause and the potential gains that might be derived from regulations such as those of the Kyoto treaty. Global temperature changes have been observed previously. We do not know that the current warming is the result of human activity. We do not even know whether on balance, a warming would exert an adverse impact. These uncertainties increase the attractiveness of adaptation as an option to regulation. Market-like schemes can reduce the costs of reaching a chosen environment goal, but the programs provide little help in choosing the right goal. Government ownership of. national parks, as with other lands, has brought troublesome results along with benefits, but there seems to be progress in moving closer to market solutions that provide better information arid incentives for government managers. . Giyen that stock market investors emphasize financial results and the maximization of shareholder value, one can wonder if it makes sense for a company to be socially responsible. Can companies be socially responsible and ,oriented toward shareholder wealth at the same time? Many businessmen think so and so do most hig business: establishments that they have adopted well-laid environmental-saving strategies that can observe such as recycling programs, pollution control, tree-planting activities and so forth, The benefits come a little at a time but one can be sure they will add up, If an investor wants wealth maximization, management that minimizes wastes might do the other little things right that make a company well-run and profitable.