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Unit 1: Financial Management in Global Context

foreign operations of a firm expand and diversify, managers of these foreign operations become Notes
more concerned with their respective subsidiary and are tempted to make decisions that maximise
the value of their respective subsidiaries. These managers tend to operate independently of the
MNC parent and view their subsidiary as single, separate units. The decisions that these managers
take will not necessarily coincide with the overall objectives of the parent MNC. There is less
concern, here, for how the entity can contribute to the overall value of the parent MNC. Thus
when a conflict of goals occurs between the managers and shareholders, it is referred to as the
‘Agency Problem’.
MNCs use various strategies to prevent this conflict from occurring. One simple solution here is
to reward the financial managers according to their contribution to the MNC as a whole on a
regular basis. Still another alternative may be to fire managers who do not take into account the
goal of the parent company or probably give them less compensation/rewards. The ultimate
aim here is to motivate the financial managers to maximize the value of the overall MNC rather
than the value of their respective subsidiaries.

1.2.2 Objectives of the Firm and Risk Management

Most companies have certain goals such as profit maximization, increasing market share, or cost
reduction. These goals help the company in the short term, but the ultimate goal of a company
should be taking care of the interests of the stockholders. In this section, you will first learn
about profit maximization as an objective and why this may not be an acceptable goal for a
company. Because the accepted objective of a company is the maximization of shareholders’
wealth, you need to learn about this objective, as well as how to evaluate the objective and its
impact on the shareholders, management, and society.

Profit Maximization

Companies whose goal is profit maximization make decisions that maximize the overall profits.
Profit maximization is not regarded as an appropriate objective for several reasons. In the short
run, a finance manager can easily maximize profits by deferring maintenance, eliminating
research and development expenditures, or cutting other vital costs. These and other short-run
cost-cutting measures can result in increased profits, but are clearly not desirable for the long-
run interests of a company. The objective of profit maximization is not very specific with respect
to the time frame over which to measure profits.

There are three important reasons why profit maximization cannot be an acceptable goal. First,
profit maximization ignores the timing of the cash flows, and the reference to the current year’s
profits or the profits for future years is unknown. The timing and uncertainty associated with
the cash flows should be considered.
Second, the risk associated with the various projects is not taken into account. At any particular
point in time, finance managers face various projects with various levels of risk. Failure to
consider the risk levels of the separate projects in decision-making can lead to incorrect decisions.
If a company tries to maximize only the average of future profits, it can end up with the wrong
set of projects because projects with maximum expected cash flows can possess a high risk.
Another drawback of profit maximization is that it is based on book values and not on cash
flows. When evaluating projects, finance managers are more concerned with cash flows than
accounting profits because companies need cash for various activities, such as paying dividends,
salaries, and wages.
Maximization of Shareholders’ Wealth

The goal of a company should be the maximization of shareholders’ wealth or the maximization
of the market value of the existing shareholders’ common stock. Any investment, financing,

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