In general stockholders are risk aversethat is they

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Unformatted text preview: will have to pay out a large amount of cash some time in the future to eliminate or fully satisfy the claim. Simply put, the increased risk reduces the firm’s share price. In general, stockholders are risk-averse—that is, they want to avoid risk. When risk is involved, stockholders expect to earn higher rates of return on investments of higher risk and lower rates on lower-risk investments. The key point, which will be fully developed in Chapter 5, is that differences in risk can significantly affect the value of an investment. Because profit maximization does not achieve the objectives of the firm’s owners, it should not be the goal of the financial manager. Maximize Shareholder Wealth The goal of the firm, and therefore of all managers and employees, is to maximize the wealth of the owners for whom it is being operated. The wealth of corporate owners is measured by the share price of the stock, which in turn is based on the timing of returns (cash flows), their magnitude, and their risk. When considering each financial decision alternative or possible action in terms of its impact on the share price of the firm’s stock, financial managers should accept only those actions that are expected to increase share price. Figure 1.3 depicts this process. Because share price represents the owners’ wealth in the firm, maximizing share price will maximize owner wealth. Note that return (cash flows) and risk are the key decision variables in maximizing owner wealth. It is important to recognize that earnings per share (EPS), because they are viewed as an indicator of the FIGURE 1.3 Share Price Maximization Financial decisions and share price Financial Manager Financial Decision Alternative or Action Return? Risk? Increase Share Price? No Reject Yes Accept 16 PART 1 Introduction to Managerial Finance FOCUS ON PRACTICE Creating Shareholder Value and WaMu Once a small Northwest thrift, Washington Mutual (WaMu) is now the nation’s largest savings institution and the seventh largest U.S. bank. Its financial performance has been as exceptional as it...
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This document was uploaded on 01/19/2014.

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