Maximizing Shareholders Wealth As A Primary Corporate Objective Finance Essay - Free Essay Example

Shareholders wealth is basically the value of shareholders ownership of shares in a firm at a particular period of time. Shareholders wealth is measured by two major financial concepts, namely: by capital gain increase, which results from an increase in the prices of shares or by increase in dividend payments. Consequently, maximizing the capital gains or dividend payments of a firm can maximize shareholders wealth. Notwithstanding, an optimal level needs to be maintained, as a firm needs to balance the risk and return involved in growing its capital gains or dividend payments arising from the firms investing activities. On the other hand, managing the firm requires engaging on purposeful business activities on the part of top management staff members and members of the board of directors. In turn, all purposeful business activities are aligned with corporate goals and objectives. Parsons (1960) have argued that the firm, as a legal corporate entity, is a collectivity whose defining characteristic is the realization of a specific goal or purpose. On this premise, it is therefore evident that it would not be sensible enough to believe that a discussion on corporate entities would be complete without an unequivocal mentioning of the normative and positive scopes of the corporate objectives of the firm let alone the structure and processes of its governance. Therefore, questions that often arise in clude: Who should the firm serve? Who does it serve? The debate on corporate purpose is by no means a relatively new concept in the financial literature, however, there have been varying levels of considerations from the different fields of studies (ranging from management and business strategy to law and ethics) on the issues of purposes and accountability of a corporation, and sharply differing views still exist. In finance, the debate is established on the notion of shareholders value maximization (and in economics, an equivalent notion arises as the maximization of private wealth in a competitive economy). The notion of shareholders value maximization has been widely and generally accepted in the financial world, and has formed part of very strong assertions in the financial literatures and textbooks. A deviation from this corporate objective is typically thrown in the light of an agency problem, which results from the debate on the separation of ownership and control, whi ch is an immediate integral feature of the modern corporate financial practice. Berle and Means (1932) emphasized on the problems of managerial carefulness and self-dealing when handling issues that pertain to the preservation of shareholders wealth under the regime of the principle of separation of ownership and control, as a major issue that characterizes the widely held belief about corporations. Based on assumptions of property rights in democratic capitalist societies, Berle and Means (1932) premised their arguments on the view that managing the firms business activities on behalf of the shareholders was the prerequisite of managerial decision-making, since shareholders were property owners. In Brealey and Meyers (2000: 24-26), for instance, the assertion that ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦a financial manager should act in the interest of the firms owners stockholdersÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ is not an accident. Like every human, each stockholder (or shareholder) d esires to be as rich as possible, and craving for the need to be able to seamlessly transform that wealth generated from investing in the firm into whatever time pattern of consumption of his or her choice, and choosing the risk characteristics of the consumption plan. In situations where the firms management fails to collaborate with the shareholders on their interests in the firm, it amounts to an intervention by the firms corporate board; or by verbal articulation, whereby shareholders can call for a meeting to replace the corporate board; or by exit, a situation whereby shareholders dispose their stake in the firm selling off shareholders stakes in a firm can send a powerful signal to the firms entire system and its immediate environment; or by a collective shareholders decision to remove top management members through the market system for corporate control. Notwithstanding, it should be noted that in the situation whereby managers and directors do not maximize their value of (or stake in) a firm, it usually results to the threat of a hostile takeover by competitors. Rappaport (1986) has provided a more simplified assertion on how shareholders wealth creation should be viewed in relation to a firms corporate objectives. Therein, it was held that any management that contravenes the objective of maximizing shareholders value, no matter how influential or independent, does so at its own risk. This can be taken seriously since shareholders make up the most power reference point within a corporate organization where managements financial power is derived. In contrast to the finance view, in recent years, scholars in the management and strategy discipline have increasingly leaned towards one of two overlapping viewpoints that are sharply at contrast with the financial view of shareholders value maximization. One of the viewpoints is that governance should be understood using a stakeholders lens. The second viewpoint pursuits that rather than debating whe ther stakeholders or shareholders matter, corporate organizations should have multiple goals existing in a convoluted hierarchy (Freeman and McVea, 2001; and Quinn, 1980). Similarly, Drucker (2001) argued that Shareholder sovereignty is bound to struggle; ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦it is a fair weather model that works well only in times of prosperity (Drucker, 2001:17). On this note a constructive conclusion can be drawn. Following the importance of preserving shareholders wealth while ensuring good governance, it is therefore imperative that top management of the firm should strike a balance amongst the three scopes (or objective functions) of the corporate organization, which involve regarding the corporation: as an economic organization, whose aim is to maximize profit (or returns on investment); as a human organization, which should form a seamless relationship with other human organizations within its immediate environment, and without the fear of domination of one on the other; and as an increasingly important social organization that cares and prides itself about corporate social responsibility to the immediate community to which it belongs and/or operates from. The Role of the Efficient Market Hypothesis in the Post-Financial Crisis Period The sharp economic slump in the financial markets around the globe, typically and generally referred to as the global financial crisis, has generated a remarkable spate of blames on the active market players (banks and other financial institutions as well as consumers, surprisingly) from different economic stakeholders the free market economics has been attacked vigorously. Particular attention has been paid on the notion of the Efficient Market Hypothesis (EMH) an idea that supports that competitive financial market should exploit all available market information when setting security prices. EMH asserts that the financial market is informationally efficient. In other words, given the publicly available market information at the time of making an investment, one cannot achieve returns in excess of average market returns on the risk-adjusted basis consistently. Since the wake of the recent financial crisis many people have called for careful scrutiny, revamped criticism and ev aluation of the EM hypothesis. In fact, the crisis has urged many to conclude that the excessive negligence in the proper regulation and supervision of the financial market activities due to the immensely mistaken belief in the supremacy of the thought behind the EMH, gave rise to the current financial crisis. For instance, Jeremy Grantham popularly referred to as the market strategist has stated, without reservation, that EMH is responsible for the global financial crisis that currently rocks the world financial markets. In his claims, he believes that the general acceptance of the idea behind EM hypothesis led financiers to have a habitual underestimation of the underlining dangers surrounding the breaking of asset bubbles. Justin Fox, the Myth of the Rational Market, as he is fondly called, appears to support the same claim made by Jeremy. Ray Ball wrote: ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦swayed by the notion that market prices reflect all available information, investors and regul ators felt too little need to look into and verify the true values of publicly traded securities, and so failed to detect an asset price bubbleÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ The following excerpt was also taken from Ball (2009: 11) (cited from the UKs Turner Review): The predominant assumption behind financial market regulation-in the US, the UK and increasingly across the world-has been that financial markets are capable of being both efficient and rational and that a key goal of financial market regulation is to remove the impediments which might produce inefficient and illiquid marketsÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦. In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism. Others who also believe that the EMH is not unconnected with failure of the financial system include the financial journalist, Roger Lowenstein who stated that: The upside of the current Great Rec ession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis. The chief economics commentator of the financial times, Martin Wolf, has dismissed the EM hypothesis on the premise that the hypothesis is a useless way of carrying out a careful examination of the functionality of the market. Nevertheless, Paul McCulley, the MD of PIMCO, said that the hypothesis did not fail but was seriously flawed in neglecting human behaviour. According to Ball (2009:11), the depiction of what the EMH portrays in the mind of regulators makes sense in one respect. Stating that regulators can focus well enough in ensuring an adequate flow of reliable information to the public where, however, the market can be relied upon in incorporating public information into asset prices, while less attention is paid on investors propensity to invest even in the riskiest assets without fear of losing the lots. This view is, however, consistent with the fa ct that in recent times there does appear to have been increased emphasis on ensuring adequate and fair public disclosure by regulatory and supervisory bodies worldwide. However, the notable Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business and grand proponent of the EM hypothesis, Eugene Fema has refuted the above claims but stated that: the hypothesis held up well during the crisis and that the markets were a casualty of the recession, not the cause of it. Ball (2009:2) says: I have argued in the past and will argue below that the EMH like all good theories has major limitations, even though it continues to be the source of important and enduring insights. Despite the theorys undoubted limitations, the claim that it is responsible for the current worldwide crisis seems wildly exaggerated. If the EMH is responsible for asset bubbles, one wonders how bubbles could have happened before the words efficient market was first set in print and that was not until 1965, in an article by Eugene FamaÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ But all of these episodes occurred well before the advent of the EMH and modern financial economic theory ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ Its only the idea of market efficiency that is relatively new to the scene. After all said and done, one would like to know what awaits the EM hypothesis in the post-financial crisis era. As the saying goes: you do not throw away the baby with the bath-water. There is need to relax and critically evaluate the entirety of the EM hypothesis in relationship to what it can help achieve in the market and the limit inherent in its application in ascertaining how the market behaves. It is overtly true that anomalies in the market efficiency hypothesis abound. These include over-reactions of prices and excess volatility; under-reactions of prices and momentum, especially with respect to earnings annou ncements; the relation between future returns and many variables such as accounting accruals, market-to-book ratios, price-earnings ratios, market capitalization, and dividend yields; and seasonal patterns in returns. One should therefore expect that while not entirely relying on the EM hypothesis in assessing market activities, the hypothesis would still be expected to hold sway. This is consistent with the results of Aroskar, et al (2004) and Kan and Andreosso-OCallaghan (2007). Furthermore, market regulators are rather expected to carry out proper regulatory functions irrespective of the presence or absence of the market hypothesis. A Reflective Statement After a critical discussion of these sorts (first, it was the discussion on: the adoption of maximizing shareholders wealth as a primary corporate objective, which was then followed closely by a discussion on: the role of the efficient market hypothesis in the post-financial crisis period) one would wonder at the efficacy of what could be achieve with such a short piece. Anyway, it is not the length alone that matters when crucial issues like the ones discussed in this piece are considered. While length may be important, what matters the most is the depth of what has been discussed. Going back, two schools of thoughts were covered in the first section, namely: those that believe that the adoption of maximizing shareholders wealth should form a core part of the corporate objectives of any corporate organization, and those who believe that corporate governance should be discharged under the watchful eyes of the stakeholders while having an organization that is built around a compl ex hierarchy of a collection of goals. One would then like to take a stance between these two schools. Notwithstanding, there is sense in both thoughts; however, a deep look and critical evaluation of both thoughts may likely reveal a common ground. Therefore, one should not be tempted in judging the supremacy of one school over the other. Now with the discussion on the EM hypothesis in relation to its role in the financial market after the crisis, it should be proper to evaluate its worthiness just like every theory ever propagated was evaluated. Like Ray Ball had said one could not blame a theory for people misusing it, as every theory comes as an abstraction no theory can be taken in its raw and literal form.