Shareholder Wealth Maximization

To understand and make it clearer, we should pay attention to several definitions of shareholder, stakeholder and theories of shareholder and stakeholder and what the differences between them are, and what debates between them?

First, what is shareholder? According to the web page of “defining the world of investing-Investor Glossary”,” A shareholder is an individual or organization owning stock in a company. Shareholders have a legal claim on a percentage of the company’s earnings and assets, and share the same level of limited liability as the company itself. In cases of bankruptcy, shareholders generally lose the entire value of their holdings”.

Next, what is stakeholder? According to “Business dictionary.com”, it is “a person, a group, or an organization that has a direct or indirect stake in an organization because it can affect or be affected by the organization’s actions, objectives and policies. Key stakeholders in a business organization include creditors, customers, directors, employees, government (and its agencies), owners (shareholders), suppliers, unions, and the community from which the business draws its resources”.

Form the financial point view, the objective of a firm is to maximize the wealth to the shareholders. Nevertheless, nowadays people say that the wealth maximization is only focused on its shareholders. The followings below are some views supporting and not supporting to demonstrate to the things above.

According to H. Jeff Smith (2003), Shareholder theory asserts that shareholder advances capital to a company’s managers, who are supposed to spend corporate funds only in ways that have been authorized by the shareholders.

Furthermore, Milton Friedman (1970) is the man supporting this theory very much. He made the most well-known version of the shareholder theory in the following passage in “Capitalism and Freedom”: “In such an economy [“a free economy”], there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game…without deception or fraud”. In his essay “The Social Responsibility of Business Is To Increase Its Profits” Friedman gives a somewhat different statement of the theory: In a free-enterprise, private property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance to with their desires, which will generally be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and in ethical custom.

One more view supporting this theory is posted by Todd Henderson (2010). He argued that while the duty to maximize shareholder value may be a useful short hand for a corporate manager to think about how to act on a day to day basis, this is not legally required or enforceable. The only constraint on board decision making is a pair of duties – the “duty of care” and the “duty of loyalty.”The duty of care requires boards to be well informed and to make deliberate decisions after careful consideration of the issues. Importantly, board members are entitled to rely on experts and corporate officers for their information, can easily comply with duty of care obligations by spending shareholder money on lawyers and process, and, in any event, are routinely indemnified against damages for any breaches of this duty. The duty of loyalty self evidently requires board members to put the interests of the corporation ahead of their own personal interest. And, Dodge v. Ford Motor Co., (1919) supposed corporations are organized and acted for carrying on primarily profit of the stockholders. Directors are employed on behalf of owners, has responsibility to bring more profit into strongbox of employers. They are simultaneously assigned power and duty for making decision so as to reach purpose of proprietors.

Different with the above mentioned views, the stakeholder theory says that corporations should be run for the benefit of all “stakeholders”, not just the shareholders (Thomas L. Carson -2003). Also, R. Edward Freeman (2004) is the most prominent defender of the stakeholder theory. In his paper “A Stakeholder Theory of the Modern Corporation” Freeman writes: “Corporations shall be managed in the interests of its stakeholder, defined as employees, financiers, customers and commodities”.

Moreover, in an earlier paper written together with William Evan, Freeman states as follows: “The corporation should be managed for the benefit of its stakeholder: its customers, suppliers, owners, employees, and local communities. The rights of these groups must be ensured, and further, the groups must participate in some sense in decisions that substantially affect their welfare. Management bears a fiduciary relationship to stakeholders and to the corporation as an abstract entity. It must act in the interests of the shareholders as their agent, and it must act in the interests of the corporation to ensure the survival of the firm, safeguarding the long-term stakes of each group”.

Also, according to H. Jeff Smith stakeholder theory asserts that managers have a duty to both the corporation’s shareholder and “individuals and constituencies that contribute, either voluntarily or involuntarily, to [a company’s] wealth-creating capacity and activities, and who are therefore its potential beneficiaries and/or risk bearers.” Managers are agents of all stakeholders and have two responsibilities: to ensure that the ethical rights of no stakeholder are violated and to balance the legitimate interests of the stakeholders when making decisions. The objective is to balance profit maximization with the long-term ability of the corporation to remain a going concern.

From the above views of the shareholder and stakeholder theory, I support the ideal “shareholder wealth maximization should be a superior objective over stakeholder interest” because as follows:

As we know, from a modern financial perspective a firm’s main objective is to maximize its shareholder wealth. The wealth is shown via the market by the price of company’s common stock, which is a reflection of the 3 key variables: timing of cash flows, magnitude of cash flows and the risk of the cash flows that investors expect a firm to generate over time.

Normally, profit maximization after tax (ETA) is considered as the main purpose of the firm, but it is not regarded as a objective to maximize shareholder wealth because earnings per share (EPS) will be more important than total profits. A company can increase its total profits by making an issue of stocks and using the returns to invest in other bonds for profits. Even maximizing profit per share, but, is not a completely suitable goal, firstly because it does not show the time factor or period of expected interest. Secondly, next mistake of maximizing EPS is that it does not take interest in the risk or uncertainty of the future return flow. So, there are several investment projects will more risky than others. Consequently, the prospective flow of EPS would not be more ensured if these projects were undertaken. Besides, a firm will be more or less risky to be conditional on the total of debt relevant to equity in its capital structure. This risk is considered as financial risk and it contributes to the uncertainty of the future flow of earnings per share too. For instance, there are two companies A and B with the same of the expected future EPS. However, the earnings flow of the company A depends significantly more uncertainty than the earnings flow of the company B, so the market price per share of the company A’s stock may be lower.

For the mentioned-above reasons, a maximization objective of EPS may not be the same as those maximizing market price per share. The value of a company’s stock in the market shows the focal judgment of overall market participants with what the value is of the specific business. It mentions to present and prospective EPS, the timing, duration, and risk of these returns, and any other factors relating to market price of stock. The market price is regarded as a performance index of firm’s progress and this let us know that how well management is running in behalf of its stockholders.

In some circumstances the management goals perhaps differ from those of the firm stockholders. In a corporation (especially it goes stock market) whose stock is extensively held, stockholders give a bit of their control or influence over the company operations. When the company control is segregated from its ownership, management does not completely try their best to do jobs for the best benefits of the stockholders. They perhaps feel satisfied to run and seek a growth level accepted and concerned a lot with maintaining their own existence than with firm’s value maximization to its shareholders. The top important purpose to this management may be its own survival. Consequently, this leads to unwilling to face with reasonable risks for their fear of making a mistake, hence becoming easily seen to the suppliers of capital from outside. Then, these suppliers may give out a threat to management’s existence. To exist over a long time, management has to know to behave by a way that is reasonably suitable with maximization of shareholder value. However, the objectives of the parties are not always necessary the same. Maximizing shareholder value, subsequently, is a consistent example for how a firm should act. When management does not follow these guides, we must recognize this as a restriction and make decision for the opportunity cost. This cost is measurable only if we decide what the result would be had the firm attempted to maximize value to shareholder.

The purpose of capital markets is to effectively apportion savings in an economy from last savers to last users of capital who invest in real properties. If savings are interested in the top auspicious investment chances, a reasonable economic criteria must exist that manages their flows. In general, the savings allocation in an economy happens on the foundation of expected earnings and risk. The value of a business’s stock in the market is both of these factors. Accordingly, it reflects the market’s equilibration process between returns and risk. If making decisions in accordance with the probably effect upon the market value of its stock, a business will only be able to attract capital from outside when its investment chances defend the use of that capital in the whole economy.

However, this does not mean management will not mention to social responsibility and stakeholders’ interests. Namely, Social responsibility of a firm towards shareholders is to ensure good return on investment, towards employees is fair pay and working conditions, towards suppliers is prompt payment and fair procurement process, towards customers is fair price, safe product and after sales service and towards local community is providing jobs and supporting the community development activities, supporting education, and becoming actively involved in environmental issues like clean air and water.

Hence, the stakeholders’ interest is the interest of stakeholders said above. The stakeholder interests sometimes conflict or influence with the shareholder’s interests in maximizing wealth. Furthermore, the criteria for social responsibility and stakeholder’s interests are not clearly specified, making formulation of an appropriate goal function difficult. Therefore, manager has to know to coordinate between the shareholder wealth maximization and its stakeholder interests with superior financial results.

In conclusion, maximizing shareholder wealth is a superior objective which a business firm must obligatorily fulfill to survive. If firms do not operate with the goal of shareholder wealth maximization in mind, shareholders will have little incentive to accept the risk necessary for a business to thrive. However, this maximization of wealth is not understood to be at all costs. It will be a contented combination between shareholder and stakeholder interests with best financial results. Depending on each specific situation, each specific circumstance and each specific condition of firms, they can sort out what is the best solution for their organization.