In old times, the traditional approach of companies was to maximize the owner’s profit. Modern approach puts more emphasis on Shareholder Wealth Maximization rather than owner profit maximization. This includes increasing the earnings per share (EPS) of every shareholder so that their net worth is maximized. Wealth increase is equal to what gross present worth in needed for raising profits in the future. This value needs to be discounted as per the time frame to found out the annualized rate of return for the shareholder. In Shareholder Wealth Maximization, it places priority before any other objective for the organization. Any action which has positive effective on Shareholder Wealth Maximization needs to be given priority.
In any capitalistic society, the goal of business should be Shareholder Wealth Maximization as mostly the ownership of goods and services is by individuals, since, they own all the means so that they can make money. Shareholder Wealth Maximization at the end leads to rise in value of the shares which at end maximizes wealth of the shareholder.
Maximizing Shareholder Wealth as the Primary Goal
Any financial decision to become effective needs better understanding of organizational goals. Shareholder Wealth Maximization should guide the decision making of the firm which needs to be represented in the common stock price. Profit maximization shouldn’t overshadow Shareholder Wealth Maximization as many a times decisions taken to maximize profits of the owner has a short term view and in the long term erodes the value of shareholder wealth. Warren Buffet, who has been the advocate of Shareholder wealth, says that long term economic goal of any organization should be increasing the average annual gain of the intrinsic business value in their firm for their shareholders. Economic progress isn’t shown by size of firm but by per share progress.
Shareholder Wealth Maximization goal should be about management of firm seeking to increase the present value of their future of their shareholder but not increasing the profits of promoters. This return to shareholder needs to be given in the form of periodic dividends as well as if any shareholder decided to sell of the stock. As long as the dividend stream or the value stream is flowing, it increases the value of shareholder. Also, the higher the risk for future wealth growth, it reduce the faith of shareholders on the company. Stock prices always show what is the timing and risk associated with the future benefits which can be reaped by the shareholders. Shareholder wealth is defined as per the total number of shares times the value of per share at which it trades in the stock exchange the company is listed.
The advantages of using Shareholder Wealth Maximization as an objective are:
- This considers the time period as well as the risk in investing in the firm. Managers must take in account this while making decisions like expenditure so that in contributed to increase shareholder wealth.
- Shareholder Wealth Maximization can be tested with every decision which is made by organization so that consistency in decisions can be maintained. If the decision increase shareholder wealth it is a good decision, otherwise it isn’t, hence it shouldn’t be taken.
- Shareholder Wealth Maximization is impersonal by nature. Shareholder is free to take their funds out and sell the shares and invest anywhere. If the shareholders risk preference isn’t according to the decisions made by the firm, the shareholder will sell the sticks owned by him and invest in the organization which has best profile as per his investment needs.
For all of these reasons, Shareholder Wealth Maximization should be the primary goal to be achieved by any firm. But, the issues like social responsibilities managerial objectives, agency problems can create departure from pure Shareholder Wealth Maximization behavior shown by managers as well as promoters and more considerate in profit maximization. Nonetheless, Shareholder Wealth Maximization objective gives a standard on which every managerial decision can be judged and screened on.
Divergent Objectives
The goal of shareholder wealth maximization is about how financial decisions should be made in an organization. But, not all management decisions need to be made by this. Using the index of managerial performance, we can measure the managerial success in achieving the shareholder wealth maximization objective. They should try and work to maximize Economic Value addition which is the difference between profit after tax and the cost of capital employed to generate that profit. Multiple corporations like Coca Cola, AT & T, and General Electric use this concept of Economic Value Added (EVA).
It has been seen that all those firms which don’t give attention to stockholder interests and are more indulged in promoter profit maximization perform poorly in long term. There is always a divergence in shareholder wealth maximization goal and the other objectives which are undertaken by management. The main reason for this divergence is shareholders are real owner but control is with promoters in all corporations. This separation of ownership and control allows manager to pursue self-promoting goals which are not in line with shareholder wealth maximization. They are consistent to maintain the control of the company. Instead of pursuing the goal of shareholder wealth maximization, managers just work for satisfying or look for acceptable levels of shareholder wealth increase, while working for their interest improvement.
The maximization of personal welfare of managers can lead to long run job security of themselves. The focus on long term survival of managers limits the risk taken by firm as unfavorable outcomes can lead to disastrous outcomes for the firm. Similarly, the need for job security is one reason why management doesn’t allow any merger offers given by other companies. The “Golden Parachute” approach is usually in the interests of managers more than the shareholders wealth. Now days, multiple companies give top management stock options which ensures their ownership in the company. Some organizations give retirement option in common stocks which ensures that they think on the options to increase the share price. This helps in alignment of interests of managers with those of shareholders.
Agency Problems
The presence of different objectives of owners and managers is one kind of agency relationship problem. Agency relationships happen when one individual hires other individual so that he can perform duties on behalf of his. They delegate the decision making to the agent. These kinds of agency relationships exist between stockholders and managers and those of stockholders and creditors. When we talk about agency relationship between stockholders and managers, the inefficiency rises as each party works in a way to maximize its interests and utility. The management thinking for looking for long term survival rather than thinking about shareholder wealth maximization. Other example is about using company airplanes, limousines and offices without having any ownership in the firm. This shirking by managers is an issue.
Managerial motivation act in the stockholder interest when they have stock in form of compensation, the threat of losing their job and threat of being taken over by any other organization. Agency problems and related costs can be decreases if financial markets are efficient enough. Also, it can be done with the use of complex contracts in financial terms. Agency problems lead to costs which reduce the value of firm on market place.
The other agency conflict is between shareholder and creditors starts from the relation between owners and creditors. Creditors always stake a fixed claim on company’s resources in lieu of long term debts, bank loans, commercial agreements and other instruments. The returns given to creditors are fixed while those to shareholders are variable due to stock price. Owners can try to make risky investment decisions, but creditors need to be paid back in full but investments need to be made as early as possible. Creditors to protect their money ask for other protective covers from company line bond indentures, limitation on dividend payments, types of investments company can make, poison pills and new debt application. This all can reduce the potential market value of the firm.