Effective financial decision making requires an understanding of the goal(s) of the firm. What objective(s) should guide business decision making that is, what should management try to achieve for the owners of the firm? The most widely accepted objective of the firm is to maximize the value of the firm for its owners, that is, to maximize shareholder wealth. Shareholder wealth is represented by the market price of a firm’s common stock.
Warren Buffett, CEO of Berkshire Hathaway, an outspoken advocate of the shareholder wealth maximization objective and a premier “value investor, ” says it this way:
Our long-term economic goal . . . is to maximize the average annual rate of gain in intrinsic business value on a per -share basis.We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.
The shareholder wealth maximization goal states that management should seek to maximize the present value of the expected future returns to the owners (that is, shareholders) of the firm. These returns can take the form of periodic dividend payments or proceeds from the sale of the common stock. Present value is defined as the value today of some future payment or stream of payments, evaluated at an appropriate discount rate. The discount rate takes into account the returns that are available from alternative investment opportunities during a specific (future) time period.
The longer it takes to receive a benefit, such as a cash dividend or price appreciation of the firm’s stock, the lower the value investors place on that benefit. In addition, the greater the risk associated with receiving a future benefit, the lower the value investors place on that benefit. Stock prices, the measure of shareholder wealth, reflect the magnitude, timing, and risk associated with future benefits expected to be received by stockholders.
Shareholder wealth is measured by the market value of the shareholders’ common stock holdings. Market value is defined as the price at which the stock trades in the market place, such as on the New York Stock Exchange. Thus, total shareholder wealth equals the number of shares outstanding times the market price per share.
The objective of shareholder wealth maximization has a number of distinct advantages. First, this objective explicitly considers the timing and the risk of the benefits expected to be received from stock ownership. Similarly, managers must consider the elements of timing and risk as they make important financial decisions, such as capital expenditures. In this way, managers can make decisions that will contribute to increasing shareholder wealth.
Second, it is conceptually possible to determine whether a particular financial decision is consistent with this objective. If a decision made by a firm has the effect of increasing the market price of the firm’s stock, it is a good decision. If it appears that an action will not achieve this result, the action should not be taken (at least not voluntarily).
Third, shareholder wealth maximization is an impersonal objective. Stockholders who object to a firm’s policies are free to sell their shares under more favorable terms (that is, at a higher price) than are available under any other strategy and invest their funds elsewhere. If an investor has a consumption pattern or risk preference that is not accommodated by the investment, financing, and dividend decisions of that firm, the investor will be able to sell his or her shares in that firm at the best price, and purchase shares in companies that more closely meet the investor’s needs.
For these reasons, the shareholder wealth maximization objective is the primary goal in financial management. However, concerns for the social responsibilities of business, the existence of other objectives pursued by some managers, and problems that arise from agency relationships may cause some departures from pure wealth-maximizing behavior by owners and managers. (These problems are discussed later.) Nevertheless, the shareholder wealth maximization goal provides the standard against which actual decisions can be judged and, as such, is the objective assumed in financial management analysis.
Social Responsibility Concerns
Most firms now recognize the importance of the interests of all their constituent groups, or stakeholders customers, employees, suppliers, and the communities in which they operate and not just the interests of stockholders. For example, Tucson Electric Power Company (now part of UniSource Energy Corporation) the public utility providing electric service to the Tucson, Arizona area recognizes responsibilities to its various constituencies:
Tucson Electric Power sees no conflict between being a good citizen and running a successful business.
A wide diversity of opinion exists as to what corporate social responsibility actually entails. The concept is somewhat subjective and is neither perceived nor applied uniformly by all firms. As yet, no satisfactory mechanism has been suggested that specifies how these social responsibility commitments can be balanced with the interests of the owners of the firm. However, in most instances, a manager who takes an appropriate long-term perspective in decision making, rather than focusing only on short -term accounting profits, will recognize responsibility to all of a firm’s constituencies and will help lead the company to the maximization of value for shareholders.
The goal of shareholder wealth maximization specifies how financial decisions should be made. In practice, however, not all management decisions are consistent with this objective. For example, Joel Stern and Bennett Stewart have developed an index of managerial performance that measures the success of managers in achieving a goal of shareholder wealth maximization.9 Their performance measure, called Economic Value Added, is the difference between a firm’s annual after -tax operating profit and its total annual cost of capital.
Many highly regarded major corporations, including Coca-Cola, AT&T, Quaker Oats, Briggs & Stratton, and CSX, have used the concept. The poor performances of other firms may be due, in part, to a lack of attention to stockholder interests and the pursuit of goals more in the interests of managers.
In other words, there often may be a divergence between the shareholder wealth maximization goal and the actual goals pursued by management. The primary reason for this divergence has been attributed to separation of ownership and control (management) in corporations. Separation of ownership and control has permitted managers to pursue goals more consistent with their own self -interests as long as they satisfy shareholders sufficiently to maintain control of the corporation.
Instead of seeking to maximize some objective (such as shareholder wealth), managers “satisfice, ” or seek acceptable levels of performance, while maximizing their own welfare.
Maximization of their own personal welfare (or utility) may lead managers to be concerned with long-run survival (job security). The concern for long-run survival may lead managers to minimize (or limit) the amount of risk incurred by the firm, since unfavorable outcomes can lead to their dismissal or possible bankruptcy for the firm. Likewise, the desire for job security is cited as one reason why management often opposes takeover offers (mergers) by other companies. Giving senior managers “golden parachute” contracts to compensate them if they lose their positions as the result of a merger is one approach designed to ensure that they will act in the interests of shareholders in merger decisions, rather than in their own interests.
Other firms, such as Panhandle Eastern, International Multifoods, and Ford Motor Company, for example, expect top managers and directors to have a significant ownership stake in the firm. Panhandle Eastern’s president was paid entirely in the company’s common shares, 25, 000 per quarter no severance, no retirement plan, just stock and medical benefits. Ford requires each of its top 80 officers to own common stock in the company at least equal to their annual salary. As the company’s chairman explained, “I want everyone thinking about the price of Ford stock when they go to work.”
The existence of divergent objectives between owners and managers is one example of a class of problems arising from agency relationships. Agency relationships occur when one or more individuals (the principals) hire another individual (the agent) to perform a service on behalf of the principals.12 In an agency relationship, principals often delegate decision-making authority to the agent. In the context of finance, two of the most important agency relationships are the relationship between stockholders and creditors and the relationship between stockholders (owners) and managers.
Stockholders and Creditors
A potential agency conflict arises from the relationship between a company’s owners and its creditors. Creditors have a fixed financial claim on the company’s resources in the form of long -term debt, bank loans, commercial paper, leases, accounts payable, wages payable, taxes payable, and so on. Because the returns offered to creditors are fixed whereas the returns to stockholders are variable, conflicts may arise between creditors and owners.
For example, owners may attempt to increase the riskiness of the company’s investments in hopes of receiving greater returns. When this occurs, bondholders suffer because they do not have an opportunity to share in these higher returns. For example, when RJR Nabisco (RJR) was acquired by KKR, the debt of RJR increased from 38 percent of total capital to nearly 90 percent of total capital. This unexpected increase in financial risk caused the value of RJR’s bonds to decline by nearly 20 percent.
In response to this loss of value, Metropolitan Life Insurance Company and other large bondholders sued RJR for violating the bondholders’ rights and protections under the bond covenants. In 1991, RJR and Metropolitan settled the suit to the benefit of Metropolitan. The issue of bondholder rights remains controversial, however. In order to protect their interests, creditors often insist on certain protective covenants in a company’s bond indentures.These covenants take many forms, such as limitations on dividend payments, limitations on the type of investments (and divestitures) the company can undertake, poison puts, 14 and limitations on the issuance of new debt.
The constraints on the owner-managers may reduce the potential market value of the firm. In addition to these constraints, bondholders may also demand a higher fixed return to compensate for risks not adequately covered by bond indenture restrictions.
Stockholders and Managers
Inefficiencies that arise because of agency relationships have been called agency problems. These problems occur because each party to a transaction is assumed to act in a manner consistent with maximizing his or her own utility (welfare). The example cited earlier the concern by management for long-run survival (job security) rather than shareholder wealth maximization is an agency problem. Another example is the consumption of on -the -job perquisites (such as the use of company airplanes, limousines, and luxurious offices) by managers who have no (or only a partial) ownership interest in the firm. Shirking by managers is also an agency-related problem.
In October 2001, Enron Corporation took a $1.01 billion charge related to losses on investments it had made that went bad. In 1991, the board of Enron permitted its CFO, Andrew Fastow, to set up and run partnerships that purchased assets from and helped to manage the risk of Enron. Fastow stood to make millions personally. This conflict-ofinterest arrangement between the board and Enron’s CFO caused the losses cited here and helps to explain how the company’s stock could decline from a high of nearly $85 in October 2000 to $11 in October 2001. By late November, Enron’s stock traded below $1 per share and in early December, Enron filed for Chapter 11 bankruptcy protection.
In Enron’s case, the agency conflict between owners and managers was handled poorly. These agency problems give rise to a number of agency costs, which are incurred by shareholders to minimize agency problems. Examples of agency costs include
A number of different mechanisms are available to reduce the agency conflicts between shareholders and managers. These include corporate governance, managerial compensation, and the threat of take overs.
As a result of recent accounting scandals and perceived excessive executive compensation (relative to company performance), the Securities and Exchange Commission (SEC), the securities exchanges (NYSE, AMEX, NASDAQ), The Conference Board (a business research organization), and other experts have made various proposals concerning how best to deal with the issues of corporate governance.
First, the board of directors of a corporation should have a majority of independent directors. Independent directors are individuals who are not current or former employees of the company and who have no significant business ties to the company. Additionally, the committee responsible for nominating members of the board of directors must be composed only of independent directors.
Further more, the post of chairman of the board of directors should be split from the CEO position or, alternatively, an independent lead, or presiding, director should chair board meetings. Also, all members of the audit and compensation committees, must be independent directors. Finally, the company must disclose whether it has adopted a code of ethics for the CEO and senior financial officers and, if not, explain why it has not done so.
Many of these proposals have been or are in the process of being implemented by public companies. In addition to these proposed changes in how corporations govern themselves, the Sarbanes Oxley Act, passed by Congress in 2002, mandated various changes in the processes used by corporations to report their financial results.
Properly designed compensation contracts can help to align shareholder management conflicts. For example, providing part of the compensation in the form of stock or options to purchase stock can reduce agency conflicts. Stock options granted to managers entitle them to buy shares of the company at a particular price (exercise price). Typically, the options are set at an exercise price greater than the price of the stock at the time options are granted and can be exercised only after a certain period of time has elapsed.
These conditions are imposed so that managers won’t be tempted to cash in their options immediately and leave the company. More important to stock value, this is an attempt to align their interests more closely with those of the shareholders. Many firms, including Disney and Oracle, provide key executives with significant stock options that increase in value with improvements in the firm’s stock price. Two of the largest payoffs from the exercise of options were the $706 million received in 2001 by Lawrence Ellison, chairman and CEO of Oracle, and the $570 million paid in 1998 to Michael Eisner, chairman and CEO of Disney.
Some critics have argued that stock options tend to distort executive decisions by emphasizing short -term performance and giving them incentives to engage in accounting tricks to inflate the company’s stock price. As a result, some firms have adopted alternative incentive compensation policies. One plan is to offer “restricted stock” to company executives. Such stock cannot be sold unless the manager remains with the company for a stated period of time. Microsoft, for example, stopped issuing stock options in 2003 and instead began offering restricted stock to its executives (and all other employees). For Microsoft managers, the restricted shares vest, or can be sold, over a 5 -year period. Another approach is to offer executives “performance shares”, that is, stock grants based on the company meeting specific performance targets. For example, in 2003 General Electric (GE) stopped issuing stock options to its CEO and instead offered 250, 000 performance share units.
Each performance share unit was equal to one share of common stock. Half of the performance share units will vest in 5 years if GE’s cash flow increases at an average rate of 10 percent or more per year. The other half of the performance share units will vest in 5 years if GE’s shareholder return meets or exceeds the cumulative 5-year return of companies in the Standard & Poor’s 500 Stock Price Index.15 The potential value of these performance share units at the time of issue was approximately $7.5 million, which was more than half of the CEO’s total compensation package.
Threat of Takeovers
Takeovers also can serve as an important deterrent to shareholdermanagement conflicts. The argument goes as follows: If managers act in their self -interest then share values will be depressed, providing an incentive for someone to take over the company at a depressed level. The acquirer can then benefit from instituting policies that are consistent with shareholder wealth maximization, such as eliminating underperforming units and cutting overhead.
In addition to these mechanisms, we will learn in later chapters that certain corporate financial policies, such as dividends and capital structure, can also serve to control agency conflicts. Remaining agency problems give rise to costs that show up as a reduction in the value of the firm’s shares in the marketplace.
Financial Management Related Interview Questions
|Financial Planning Interview Questions||Financial Accounting Interview Questions|
|Cost Accounting Interview Questions||Management Accounting Interview Questions|
|Financial Statement Interview Questions||Corporate Finance Interview Questions|
|Financial Analyst Interview Questions||Financial Services Interview Questions|
All rights reserved © 2020 Wisdom IT Services India Pvt. Ltd
Wisdomjobs.com is one of the best job search sites in India.