The only legitimate objective of any firm is Maximization of Shareholder Wealth free essay sample

1. Introduction â€Å"Corporate finance theory, teaching and the typically recommended practice at least in the US are all built on the premise that the primary goal of a corporation should be the maximization of shareholder value.† (Krishnan, 2009) One often stumbles upon such statements while reading about shareholders value or maximization of shareholders wealth. This is also a typical answer to questions such as â€Å"what is the best and primary objective of a company in a competitive market†. But should it be the only and most important objective in a firm? Must it be fulfilled first and foremost, or is there the possibility of generating more wealth for company, shareholders and stakeholders with other, different approaches? It has to be kept in mind that there are multiple strategies to running a business. One of the strongest opponents of the maximization of shareholder wealth paradigm are the supporters of the so-called stakeholder theory, which claims corporate social responsibility (CSR) and the satisfaction of stakeholders should be the most important objectives for any company. On the one hand, there is the accepted, popular and traditional paradigm of maximization of shareholder wealth which tries to reach maximization of shareholders wealth with certain management strategies as their main objective. On the other hand there is the stakeholder theory which expresses the worries that the mere focus on shareholders is â€Å"often misplaced† (Krishnan, 2008) and that social responsibility and, more importantly, the interests of stakeholders should be the leading objective for a company. Beyond that there are also approaches, introduced by experts of the field that mixes features of both concepts; nevertheless, the majority of the companies prefer either the maximization of shareholder wealth or stakeholder theory as their primary strategy. This research paper aims to figure out if maximization of shareholder wealth is the only legitimate strategy for a firm or whether other approaches – including potentially a mixture of the two main theories of corporate governance – are equally as or more viable to corporate survival in a competitive market. Before any analysis is possible it ´s necessary to understand the characteristics and differences between the various options. 2. Shareholder Wealth Maximization Paradigm and Stakeholder Theory The debate regarding the question which corporate objective is appropriate has its origins back in the 19th century and remains far away from settled. Nevertheless, most businesses, especially in the field of finance, have adapted shareholder value maximization as their management strategy. Textbooks tend to confirm this logic without questioning its usefulness (Sundaram, Inkpen, 2004). 3. General definitions of both approaches To understand the similarities and differences between these two objectives, it ´s important to know how they are essentially defined. Even supporters of the same goal, whether of shareholder wealth maximization or gratification of stakeholder, have different opinions on how they should be construed. Stakeholder theory was first discussed in detail by R. Edward Freeman in his book â€Å"Strategic Management: A Stakeholder Approach†. It identifies stakeholders in a corporation and suggests ways managements can protect their interests. In general, it can be said that the stakeholder theory aims to distribute value and wealth equally among the stakeholders of a firm. The main challenge of this theory is addressing all stakeholders (customers, suppliers, community, etc.) and their various needs equally. The paradigm of wealth maximization first became very popular during the 1980 ´s and is based on the principles of competitive free markets. This approach dictates that shareholders receive the remaining revenues after all other claimants of the firm have been paid or satisfied. In Krishans paper (2009), it is stated that this procedure is fair because shareholders bear the total risk of failures with their invested capital. As a result, managers of a business often face the difficult decision which claimants of the company should be served first, either shareholders or stakeholder (Sundaram, Inkpen, 2004). 4. Creation of Shareholder Value and protection against threats To increase and maximize the wealth/value of shareholders, it is necessary that the company is competitive in their market and can reliably â€Å"earn a considerable return on its investments above their cost of capital† (Doyle, 2000). The increasing rates of return of well performing companies attract new investors who invest money to become shareholders. These outside funds from investors are essential for growth of businesses and the expansion into new markets. Measurements of generated shareholder returns over a certain time period deliver the company useful information on whether their objectives have been achieved or should be new adjusted (Atrill, 2009). Nevertheless if companies operate in weak markets and fail to create growth and profit the concept of maximization of shareholder wealth is also an opportunity for self-regulation and security against threats for a company. This approach is in particular useful for safeguarding against difficulties arising from wrong or misguided leadership within a corporation. Shareholders of a company have the strongest interest in a company’s success because they often invest a lot of capital in the business and require revenues for their deposit (Moore, 2002). As a matter of fact, they become more active in attempts to remove leading managers who don ´t act on their behalf and harm the firm (Arnold, 2005). This self-protection behavior benefits not only the shareholders but also the stakeholders involved in the business. Furthermore, the danger of takeover of a struggling company by another business can be reduced through the creation and increase of shareholder value. (See Chapter â€Å"Agency Problem†) 5. Maximization of Shareholder Wealth – Conflicts with stakeholders 5.1 Agency Problem Recently, shareholder wealth maximization has been criticized by opponents of encouraging short-term managerial thinking (Morris, Heck, Shaffer, 2008). This accusation is not completely unfounded because some business managers primary pursue their own interests rather than act on the behalf of shareholders. Their eagerness to secure personal rewards often results in the prioritization of short-term growth strategies that do not necessarily align with the interests of shareholders. This specific conflict of shareholder vs. stakeholder problem is called â€Å"principle – agent problem†. This means that shareholders (principles) in a company usually authorize the CEO (agent) to act on their behalf. In order to motivate managers to pursue maximization of shareholder wealth, regulations and control systems to survey management behavior have to be established. However, this creates additional costs, on top of any other regulatory systems in place, if â€Å"managers continue to pursue non-shareholder wealth goals† (Arnold, 2005). Moreover, if investment projects fail due to poor management decisions the company is more vulnerable to takeovers by another company, â€Å"with managers who are dedicated to maximizing shareholder return† (Atrill, 2009). 5.2 The relation between Stakeholders and Shareholder Wealth creation Not only managers of firms struggle in their performance to figure out the right strategy to run a business successfully; conflicting interests between stakeholders of the company can potentially lead to conflicts as well. Stakeholders such as employees have an emotional tie and long-term dependence on the business and tend to demand security for their jobs rather than maximization of shareholder wealth (Arnold, 2013). Also, suppliers and communities require long-term security respective to improvement of social welfare â€Å"which involves attention beyond shareholder wealth maximization.† (Krishnan, 2008). The conflict is most visible if you compare the goals of customer satisfaction and increasing shareholder ´s wealth. Without customer satisfaction the primary objective of maximizing shareholder wealth is not realizable because shareholder wealth depends upon selling products to customers. If customers as very important stakeholders cannot be pleased sufficiently or are even neglected, the company will have enormous problems creating shareholder wealth in the long run. 5.3 A compromise between the two theories As seen above it is anything but easy to set up a suitable main objective for a firm and to cover the needs of all parties within a business simultaneously. Some of the scholars in the field of business have realized that relying on only one company strategy ultimately fails to satisfactorily cater to the interests of both shareholders as well as stakeholders. An attempt at a â€Å"hybrid strategy† is mentioned by Jensen (2002) and is called â€Å"’enlightened value maximization’ or, equivalently, the ‘enlightened stakeholder theory’†. This and other efforts have tried to develop approaches which best combine success without compromising the interests of business participants. It is essential, especially for company with fixed primary objectives, to take objectives of other theories into account. Moreover, it is essential that companies direct shareholder interests towards paying fair salaries and, providing safety and attractive working conditions for their employees as a way to improve competitiveness in the market (Koslowski, 2002). Furthmore, it is suicidal for the competitiveness of a firm if they underestimate the importance of constant Research Development, Quality Improvements and appropriate customer service as another central task in running a business. The same applies to companies which act on stakeholder preferences rather than maximizing value for shareholders of the firm. Companies have to find ways to attract new, well-educated workers to enhance their work efforts in order to maximize a firm ´s competitiveness. Indeed, there are some experts for example Jensen (2002), who claim that value maximization is beneficial not only for shareholders but also for stakeholders. Further he argues that value maximization is impossible if companies ignore the needs of their relevant stakeholders (Benson, Davidson, 2010). However, if companies are reluctant to accept value maximization as important, negative effects for not only shareholders but also for employees, management and suppliers can emerge. That means that the â€Å"interests of stakeholders can only be satisfied if the firm remains financially strong† (Morris, Heck, Shaffer, 2008). 6. Objectives in crisis As we learned above the traditional corporate scholars mainly agree – with certain constrains taken into account that the primary duty of a manager is the maximization of shareholder wealth (Alpaslan, 2009). However in crisis this objective has to be adapted to circumstances. Anyway, in crisis the objective of firms should change to the concept of minimizing shareholder losses. This approach leads to conflicts between both goals and have to be solved (Alpaslan, 2009). Some experts claim that in crisis companies should deviate from their aim of shareholder wealth maximization and concentrate on the minimization of stakeholder losses which is strongly related to the stakeholder theory. However, Michael C. Jensen recommended another way which can – if introduced properly help to stay competitive in the crisis. As already mentioned earlier, the concept of â€Å"enlightened value maximization† combines the shareholder and stakeholder paradigm (Benson, Davidson, 2010). When utilized suitable and alterations of the core concept in the directions of minimization of stakeholder losses are made, â€Å"enlightened value maximization† is probably the best solution to cope with crisis. 7. Conclusion In summary, it can be said that to run a business successfully is a very hard task. Even more challenging is figuring out the right strategies and objectives to achieve success. Considering the continuous discussion between the two guiding principles of management, this research paper tried to figure out advantages and drawbacks of each principle in order to give a statement which approach is best suitable for any kind of business. It could be clearly identified that neither the maximization of shareholder wealth nor stakeholder theory is fully agreed upon within the academic community. Surprisingly, however, is the fact that most companies in the economy adopted maximization of shareholder wealth as their primary objective even though it is not considered the perfect objective for a firm. Obviously, the main reason for this is that companies pursue growth and increasing value in order maximize their competitiveness and withstand external threats, even if it comes at the cost of stakeholders and social responsibility. On the other hand, growth in value and competitiveness are still very important to the survival of the company. Thus, the best solution to address the needs of shareholders and stakeholders at the same time is a combination of the features of both theories. Nevertheless this approach requires compromises and concessions to be successful, whether from the perspective of the shareholder or stakeholder. Finally, this means that maximization of shareholder wealth is a very popular but not the most appropriate and only legitimate objective to be successful and beneficial to all participants of the business in the same way. Anyway it has to be said that suggested improvements at this stage seemingly don ´t convince most companies to change their strategy until now. 8. Reference list Books: 1. Arnold, G. (2005). The Handbook of Corporate Finance. Harlow, England : Financial Times Prentice Hall 2. Arnold, G. (2013). Corporate Finance Management (5th ed.). Harlow ; New York : Pearson 3. Atrile, P. (2009). Financial management for decision makers (5th ed.). Harlow : Financial Times Prentice Hall 4. Doyle, P. (2000). Value-based Marketing: marketing strategies for corporate growth and shareholder value. Chichester : Wiley 5. Moore, G. A. (c2002). Living on the fault line: managing for shareholder value in any economy (Rev. ed.). New York: HarperBusiness E-Articles and Journals: 6. Alpaslan, C. M. (Winter 2009). Ethical Management of Crises: Shareholder Value Maximisation or Stakeholder Loss Minimisation?. Journal of Corporate Citizenship 36. Greenleaf Publishing 7. Benson, B. W. Davidson, W. N. (Autumn 2010). The Relation between Stakeholder Management, Firm Value, and CEO Compensation: A Test of Enlightened Value Maximization. Financial Management. pp. 929 – 963 8. Jensen, M. C. (2002). Value Maximization, Stakeholder Theory, and the Corporate Objective Function. Business Ethics Quarterly, Volume 12, Issue 2. ISSN 1052-150X. pp. 235-256 9. Krishnan, V. S. (?). Stakeholders, Shareholders and Wealth Maximization. University of Central Oklahoma 10. Koslowski, P. (2000). The Limits of Shareholder Value. Journal of Business Ethics 27: 137-148. Kluwer Academic Publishers. 11. Sundaram, A. K. Inkpen, A. C. (May – June 2004). The Corporate Objective Revisited. Organization Science. Vol. 15. No. 3. pp. 350–363 12. Morris, D. G., Heck, J. L, Shaffer, D. R. (Fall/Winter 2008). Shareholder Theory – How Opponents and Proponents Both Get It Wrong. Journal of Applied Finance