Concept Of Maximising Shareholder Wealth And Competing Theories Finance Essay
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Published: Mon, 5 Dec 2016
Maximizing share holder wealth is a concept in which optimally increasing the long-term value of the firm is emphasized.
Milton Friedman recipient of the Nobel Memorial Prize in Economic Sciences is often quoted as saying “The business of business is business” He actually did say “”there is one and only one social responsibility of business-to use it resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” Friedman used the term profits, rather than “shareholder wealth” but the two are often seen as interchangeable. Not only is this not true, there is an increasing body of opinion that views the prime motive of “maximizing shareholder wealth” as deeply flawed.
In the history accounting and finance, it is assumed that the objective of the business is to maximize the value of a company. Put simply, this means that the managers of a business should create as much wealth as possible for the shareholders. Given this objective, any financing or investment decision that is expected to improve the value of the shareholder’s stake in the business is acceptable. In short, the objective for managers running a business should be profit maximization both in the short and long-term. Shareholders are deemed as the owners of the business. Their main aim is to increase their wealth, finance managers are employed to achieve this aim. In order to maximise shareholder wealth it would mean “Maximising the flow of dividends to shareholders through time there is a long term prospective” (Arnold, 2005)
Shareholder wealth is a short-term gain, and can be artificially increased without adding any tangible assets or products to the company’s rooster. You can, for example, simply lay off an entire short-term unessential department; say Research and Development – rather than the shop floor, and the next quarters profits will be increased. But what about the social responsibility of the workers made redundant in order to make share price healthy? That is the fallacy with an unthinking mantra of maximizing. Almost any executive decision, no matter how socially irresponsible or unethical can be justified as intended to increase the stock price. Managers on short term leash might stay at the same point on the demand curve but economize more on resource if they must maximize shareholder wealth. Economizing inputs tend to offset the maximiser’s reducing output. In an economy with widespread monopoly some firms encouraged to maximize shareholder wealth would primarily encourage while others should slash production and reduce allocative efficiency one cannot predict which effect would dominate.
Traditional theory suggests that the key aim of any business is to generate the greatest possible value for the company, leading to the maximum possible return for shareholders. As Ian Davies argues, this so-called Shareholder Theory is based on the idea that the ultimate aim of a company is to generate profit and pass this profit, along with any associated value, on to the shareholders who took the risk of purchasing those shares in the first place (Davies, 2007); furthermore, any approach that minimises the company’s outgoings will, in theory, contribute to the growth of the asset-value of the company and therefore to the ultimate return to shareholders.
Within the concept of Shareholder Theory, there is technically no limit to the methods that might be used in order to maximise shareholder wealth. One of the most commonly used methods, according to Jill H. Ellsworth and Matthew V. Ellsworth, is “strategies for the reduction of tax liabilities, in other words reducing the amount of tax paid in order to increase the amount of money that can be paid out as dividends to shareholders” (Ellsworth & Ellsworth, 2007 ed., p. 58). However, arguably, this theory is overly simplistic: for example, while one strategy might generate greater short-term wealth for shareholders, a less obvious strategy might, in the longer-term, generate far greater wealth. For example, while a company could use surplus profits in order to increase the dividend, it could also use them to invest in projects that could yield far greater gains in the future. This, in turn, could increase the overall share price. This approach highlights an important problem: not all shareholders are the same, and while some are willing to wait for the longer-term results, others are after short term gain. There is no guarantee that both can be satisfied by the same approach.
Other theories for example Stakeholder theory asserts that managers should make decisions that take into account the interests of all stakeholders of the firm. Such stakeholders include not only financial claimholders but also employees, managers, customers, suppliers, local communities, government, and others. Thus, stakeholder theory involves trying to maximize multiple objectives. Maximization of shareholder wealth focuses on owners and is a single-valued objective. This does not mean that corporate managers should disregard stakeholders other than owners. On the contrary, they need to be aware of the needs, wants, and interests of these other constituencies, but the owners come first.
Although Shareholder Theory has been the dominant approach for many years, the new Stakeholder Theory is gaining ground. This theory suggests that Shareholder Theory is merely one part of the overall strategy that should be employed, with the others including such relatively unfixed concepts as earnings per share, employee satisfaction and environmental protection. Andy Coulson-Thomas argues that Stakeholder Theory is “based on the idea that a business is an organic creature that will produce better results for everyone if holistically managed and, overall, led towards a situation in which every aspect of the company is performing well” (Worthington et al., 2008, p. 147). This is clearly not a short-term theory, and one again illustrates the dramatic divide between the aims of different shareholders. However, Stakeholder Theory does have one major advantage, which is that it allows a more organic, cross-company angle to be applied, one which allows for stable long-term growth at the expense, perhaps, of short-term profit and wealth maximisation.
It’s also important to consider the size of the company and its location. Size affects such matters as taxation liability and economy of scale, and there are dramatically different rules when it comes to larger corporate entities. Although generalisations are dangerous, it’s true to say that smaller companies face less legislation in terms of moves to prevent tax avoidance etc., although to compensate for these larger companies often employ legal teams to address such issues. Davies argues that this “balances out… leading to virtual parity in terms of how companies of different sizes deal with taxation… (and) they end up paying virtually the same rates, albeit from very different starting points” (Davies, 2007, p. 37). It’s also possible to relocate the company’s base to a state with little or no corporate income tax, or where potential lawsuits are far more likely to be resolved in the company’s favour. This may generate subsequent problems for shareholders, however, since their profits will be considered to be coming from abroad and may therefore be subject to additional taxation. This is an example of what McLaney calls “blind strategy” (Davies, 2007, p. 6), whereby something that initially seems to be good (for the company) is ultimately bad for the shareholders.
In light of the factors above, CEO’s of major companies are being urged, to look to other theories of corporate purpose. In this theory, the customer comes first.
Perhaps the most notable change of purpose, as advocated by Richard Ellsworth and Ian Davies, is to change corporate focus from the shareholder to the customer. For example, in his book “Leading with purpose” Ellsworth offers statistics, drawn from a study of 23 companies that show those businesses that were mostly customer-focused exceeded their industries median performance by 36 per cent. But what does “focusing on the customer” mean? Isn’t it something that successful businesses have always done? Yes and no. In his book, “The New Business Road Test” John W. Mullins defines customer focus as a corporation’s ability to “resolve customer’s pain”. Mullins then goes on to highlight the case of Nike who impacted on the sports shoe market by designing shoes that met the specific speed and endurance needs of distance runners. In 1972, eight years after Nike (then known as Blue Ribbon Sports) was formed, four of the top seben finishers in the Olympic marathon wore Nike shoes. Two decades later, after many years of strong growth, Nike targeted women, for whom it’s products seemed to hold limited appeal. Nike’s researchers found that for active women, clothes had to perform a double-duty, handle an intense workout and look good on the street. Nike turned their research iinto new product lines and in 2005 their combined women’s business grew by almost 20% outpacing even the companies overall growth. But away from Mullins, Naomi Klien’s book, No Logo, shows there is more to Nike’s corporate purpose than target markets. Klien points out that Nike is also probably the most famous case of western companies using “sweatshop labour” a scandal that was bought to national USA attention in 1995-96 and has dogged the company ever since. The question is this: how do we interpret Nike’s repeated attempts to change unethical working practices at it’s various sites around the world? What do we say about the introduction of schools, donations and increased wages it has given out to workers it previously exploited? Can they be seen as cynical attempts by a panicked business to maintain shareholder value, or genuine efforts to resolve their customer’s “moral” pain?
Nike’s efforts at ethical working practices brings me to CSR Corporate Social Responsibility CSR has become the basis on what organisations do well. There are several studies as to what CSR is, several researchers (Friedman, Rudolf, Davis etc.) have given their own definitions, the World Business Council has defined it as ‘the continuing commitment by business to behave ethically and to contribute to economic development while improving the quality of life of the workforce and their families, as well as of the local community and society at large’. (Source: Xrefer, definition of Corporate Social Responsibility)
Companies usually implement CSR into their policies and practices so the effects of their activities have a positive social, environmental, legal and economic impact on the communities in which they operate and on their stakeholders. Some organisations behave more socially responsibility because it is an obligation by the managerial board, but also because of fear of backlash from environmentalist and consumer pressure groups and the media, and negative corporate image. It has been argued that behaving in a more socially responsibility manner can be beneficial to an organisation in the long run. A good example of an ethical organisation is the Body Shop.
The Body Shop was founded by Anita Roddick in 1976, and has achieved worldwide status for being profitable and socially responsible, which proved that an organisation can be ethical and successful and reward shareholders and satisfy stakeholders at the same time. It has achieved worldwide popularity due its ethical practices, famously recognised for being against animal testing and promoting cosmetic products that have not been tested on animals, . They had a business case to provide body care products that have not been tested on animals and their business case just provides further support that an organisation can be profitable whilst being ethical.
SHAREHOLDER WEALTH CRITICISM
Another difficulty with Shareholder Theory is that aspects of wealth growth, most notably those related to tax, are increasingly complex and require a variety of forensic-level approaches that are often impossible for a large corporation to undertake. For example, some shareholders might benefit from a corporation-based tax reduction strategy, while others might be better off utilising their own such systems. It’s impossible to tell which system will suit which shareholder, and it’s also impossible to mix the two systems. There is therefore a fundamental need to balance competing needs and, often, to find a balance that generates the best average result for shareholders.
To compensate for such problems, companies can help their shareholders to form their own corporation designed to either own stock or to act as consultants (mainly for smaller companies). A. McNeil notes that such tactics are likely to appeal only to “shareholders who are more proactive in their involvement in the company, whereas research shows that over three quarters of shareholders prefer a far more passive involvement” (McNeil, 2007, p. 85). Furthermore, a number of commentators have argued that such tactics usually offer fewer benefits than they promise on paper, since there must be consideration given to the costs of incorporation and the operation of such a company. Turner and Johnson, for example, argue that “the hidden costs in such an operation almost always outweigh the possible benefits” (Turner & Johnson, 2003, p. 238).
Ultimately, the concept of maximising shareholder wealth represents a return to the principle of using a business in order to increase the wealth of individuals. As Andy Coulson-Thomas has suggested, this approach “has often been lost in recent years as individuals… (instead) work for the greater good of the company, which is often valued more highly than the wealth of the shareholders” (Worthington et al., 2008, p. 58). It’s clear that attempts to focus on the maximisation of shareholder wealth often involve increased complexity and, as a result, present a number of potential points at which profit can be lost. There are a number of conflicting theories in terms of which approach might be best when it comes to maximising shareholder wealth, but it’s clear that the most fundamental problem is that shareholders often have different, and in many cases competing, aims – the key difference is in terms of how quickly they want to see a profit, and the needs of short-term profit-seekers are likely to contradict the needs of those seeking a longer-term profit generation system.
There is even the problem with the stock price itself as illustrated in my third paragraph above. It simply isn’t always in management control. Again, as we have seen recently, share value largely depends on the confidence the market has in a corporation or the sector that the corporation operates in. as confidence in the banking sector has recently plummeted, even organizations with a healthy balance sheet have seen their share prices tumble. Consider the monopolist in a nation that denigrates shareholder wealth maximization and has rules and norms that discourage lay-offs. Employees cannot easily be laid off. Their jobs cannot be radically reconfigured without their consent.
As such, the monopolist might not cut production and raise prices further, despite the shareholder-wealth-maximization basis for doing so, because it must pay the employees anyway if labor markets are rigid and if it cannot costlessly redeploy its workforce. In such circumstances, not only are the employees with jobs protected, but national wealth is increased (or at least not decreased) by slack agency controls on managers. A weak shareholder primacy norm facilitates greater production. I would say there is the problem of the shareholders themselves. These are not necessarily long-term investors with the interests of the company at heart, but transient individuals, some of whom, as we have seen lately, may actually look to make money out of a business by betting on the share price going down .i.e. taking the fall of shareholders like Conrad Black and Bernard Madoff.
As per tutor2u, “Managers of a business should create as much wealth as possible for the shareholders. Given this objective, any financing or investment decision that is expected to improve the value of the shareholder’s stake in the business is acceptable. “This is based on the assumption that managers operate in the best interests of stockholders, not themselves, and do not attempt to expropriate wealth from lenders to benefit stockholders. Another assumption is that managers act in a socially responsible manner and do not create unreasonable costs to society in pursuit of stockholder wealth maximization. (Blackwell publishing, 2009)
Wealth maximization is achieved by maximization of the cash flows of the organization. Cash flow is a better yardstick than the profits. There are several objections against the profit maximization:
One it is vague; there are multiple meanings of Profit. For example profit after tax, retained earnings. Thus profits cannot be the ultimate goal.
Two it is uncertain; as per Freemba, “Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not at possible to maximize what cannot be known.” Hence the timing of the profit can’t be estimated.
Three it ignores time value of money; Profits ignore the time value of money which is not in the case of cash flows. One can exactly find the timing of cash flows. Hence cash flow is a better measure.
Despite its advantages of greatly simplifying directors’ decision making we should discard the fictional undiversified shareholder concept for two reasons. First, it is highly unrealistic, more so than the other alternatives here considered. Second, it is indeterminate as to the degree of risk-aversion that should be ascribed to this fictional shareholder, and this degree of freedom completely undercuts ability of the shareholder wealth maximization norm to constrain director conduct. The goal of Maximization of profits I think to be a narrow outlook. Evidently when profit maximization becomes the basis of financial decisions of the concern, it ignores the interests of the community on the one hand and that of the government, workers and other concerned persons in the enterprise on the other hand.
Hence profit maximization is not considered as the ultimate financial objective. Wealth maximization is considered to be the most important financial objective
Organization should also consider non financial objectives too to satisfy the other stakeholders of the organization. Stakeholder can be a person, group, organization, or system who affects or can be affected by an organization’s actions. This means satisfying the objectives of customers, suppliers, government agencies, families of employees, special interest groups. This will help in achieving the success in long term too.
Ultimately, the concept of maximising shareholder wealth represents a return to the principle of using a business in order to increase the wealth of individuals.This approach has often been lost in recent years as individuals work for the greater good of the company, which is often valued more highly than the wealth of the shareholders It’s clear that attempts to focus on the maximisation of shareholder wealth often involve increased complexity and, as a result, present a number of potential points at which profit can be lost. There are a number of conflicting theories in terms of which approach might be best when it comes to maximising shareholder wealth, but it’s clear that the most fundamental problem is that shareholders often have different, and in many cases competing, aims the key difference is in terms of how quickly they want to see a profit, and the needs of short-term profit-seekers are likely to contradict the needs of those seeking a longer term profit generation system
I also conclude that from above highlights it shows just how complex and interlinked all the financial and psychological aspects of business are. It is no longer enough (if it ever was) for businesses to concentrate soley on their shareholders. In the current climate of a credit crunch fuelled by a potent mix of incompetence and greed, with business ethics under scrutiny like never before, the customer is all of us. And the pain we need resolving is not just economic, but social and environmental as well if corporation investment decisions are best pursued through the use of a fictional shareholder concept, rather than through attempts by directors to ascertain and satisfy to the extent possible the conflicting preferences of their corporation’s actual shareholders and perhaps other stakeholders as well then the fictional diversified shareholder concept, despite its significant implementation difficulties, is the preferred alternative among those here considered.
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