Maximizing shareholder wealth as an adequate goal of management in a modern world
There are two major approaches in which businesses seek to meet their objectives; these are profit maximization and wealth maximization. In this essay, wealth maximization is explored as business objective which primarily is to maximize on shareholder wealth as the best management approach in the modern world (Starovic, Cooper and Davis, 2004, p 3). Corporate finance theory revolves round the fact that a business entity’s financial managers have the primary endeavor to maximize on the business’ market worth as expected by its shareholders as the most appropriate means to manage operations and adequately realize the creation of wealth on capital invested whether as equity or debt(Madden, 2005, P 12). This is referred to as maximizing shareholder wealth, a modern approach to managing investments and resource utilization as opposed to the traditional approach commonly referred to as profit maximization. It is accredited with portraying a true and fair view of a business entity’s overall performance, promoting professional ethics, enhancing employee productivity and contributes positively to a society’s welfare.
Fig 1.1 Approaches to Finance Management. Sourced (New age publishers, n.d, p 7)
Financial management in this context involves planning and instituting control measures over a corporate business’ financial resources with the main aim of ensuring returns are made on capital invested. Maximizing shareholder wealth entails realizing increases in earnings per share and more so ensuring that a business’ net present worth is maximized (Dayananda, et al. 2002, p 3).
Fig 1.2 Corporate goal, financial management and capital budgeting. Sourced, (Dayananda, et al. 2002, p 2)
Wealth or value can be defined as to be equal to the difference arrived at from the gross present value of a decision or decisions or choice of exploit and the total investment needed to achieve forecasted returns. Gross present value relates to capitalized value of perceived benefits (Starovic, Cooper and Davis, 2004, p 6). The value has to be discounted at a rate dependent on uncertainty or certainty aspects such as taxes and interest rate variations in the forecasted returns. Maximizing shareholder wealth can also be defined as an approach that is expressly concerned with cash flow amounts generated through a specific course of action or decision taken other than profit making (Starovic, Cooper and Davis, 2004, p 6). Thus for wealth creation to be realized, the net present value of a course of action or decision taken has to be greater than zero.
W = V – C
Where W = Net Present Wealth
V = Gross Present Wealth
C = Capital Outflow
V = E / K
Where E = Quantity of future benefits
K = Capitalization rate representing risk
and terminal benefits related to E.
E = G- (M +I +T)
Where G = mean of anticipated future cash inflows
M = mean annual re-investment necessary to sustain G at projected levels in anticipated out flows of yearly payments related to accrued interest and dividends
T = predetermined annual tax outflows
Sourced, (Financial management: An introduction, P 11)
Pros for maximizing shareholder wealth
Proponent for maximization of shareholder wealth argue that the modern approach is more favorable to a business entity rather than the traditional concept of profit maximization due to the fact that long term objectives spur growth through innovation and more so through efficient and effective allocation of ever diminishing resources (Starovic, Cooper and Davis, 2004, p 12). Another positive outcome realized through the wealth maximization approach is the intricate comparison of value of a business as a going concern rather than the perceived cost of a business entity (Newagepublishers, n.d, p 6). That is, a business entity will endeavor to ensure that cost accrued to realize that a business is operational will be less than the total value realized from the business being in operation. The third argument presented by proponents of wealth maximization is that this modern approach seeks to address time parameters and risk concerns that may affect the business as a going concern whether positive or negative thus ensuring that the true value of the business is adequately reflected (Newagepublishers, n.d, p 6). The fourth argument is the fact that wealth maximization ensures that a business entity’s assets and resources are allocated with the highest level of efficiency possible through effective channels (Newagepublishers, n.d, p 6). The fifth and most significant argument put across by supporters of wealth creation is the fact that with long term goals as the driving force for innovation and optimization of resources guarantees that the society in which the business concern operates has its best economic interests supported by the business entity (Newagepublishers, n.d, p 6).
Case against maximizing shareholder wealth
Opponents of the modern approach of wealth maximization argue that this approach tends to be prescriptive to perceived future risks and as such does not take into consideration short term business operation such as day to day functions (Newagepublishers, n.d, p 6). Another argument raised against wealth maximization is that at the heart of wealth maximization is the need to maximize on profits, and as such wealth maximization is only other term for profit maximization (Newagepublishers, n.d, p 6). The third argument suggests that wealth maximization tends to strain the relationship between shareholders and the management. They also argue that maximizing on shareholder wealth can only be realized when a business entity is making profits (Newagepublishers, n.d, p 6).
Maximizing shareholder wealth as the best approach for management
A critical assessment of the pros and cons of maximizing on shareholder wealth as the optimum approach in corporate finance management, the advantages of taking this modern approach far outweigh the arguments against it. In recent years, business entities listed in sock exchanges all around the world have reasserted their commitment to maximizing shareholder wealth (Starovic, Cooper and Davis, 2004, p 7). This has brought about a heated debate with the core issue being the relationship between a business entity’s success and corporate governance principles. Corporate governance can be considered as a coordinated system through which shareholders in a business entity can guarantee that a defined objective is adequately allocated fund and resources with no deviations from the core objective (Starovic, Cooper and Davis, 2004, p 7). Success on the other hand is generally assumed to be in terms of profits realized which tend to inadequately describe whether returns on investments have been positive or not. As such a company may earn profits but shares may continuously decline or remain unchanged thus misleading potential investors.
Investors and financial securities analysts define maximizing shareholder value through framework formulated to explain the share price as a present value in net cash receivables from a business’ long term projections (Starovic, Cooper and Davis, 2004, p 7). Maximizing shareholder value should be realized by a business’ top management teams through addressing decision making processes that focus on long term and product or service lifecycle determinants. maximizing shareholder value is profoundly different when compared to maximizing on short term earnings and as such it is significantly critical that a business’ board of directors understand the mechanisms which actively and passively affect stock price levels and what brings about such share price changes (Starovic, Cooper and Davis, 2004, p 8). Fourthly, a corporation’s employees, customers and more so shareholders have vested mutual interests which are basically long term and at times each group’s interests may or may not collided as circumstances dictate. A shareholder worth compass to continuously assess progress is thus essential if such trade-off quagmires are to be avoided.
Decision makers in corporations often try to work against the wealth maximization approach and often are under the illusion that corporate governance can be tamed and as such later determine means with which to improve on creating value. These illusions have left management teams reeling under the pressure to compete with corporation which ultimately embrace the wealth maximization approach as it promotes innovation and optimization of resources (Starovic, Cooper and Davis, 2004, p 8). Corporate governance serves to institute systems of control that scrutinize management by both the public domain and the investors. As such corporate governance ensures that a business entity only focuses on the interests envisioned by the shareholders that limiting the deviation of resources and funds to other interests. This ultimately enhances overall wealth creation and social welfare improving the corporation’s image ensuring it is a going concern in the long term (Starovic, Cooper and Davis, 2004, p 8).
As much as corporations may insist on how much they ensure adherence to the modern financial management approach that is maximizing on shareholder wealth. However, in the recent past huge corporations such as Enron publicly expressed their commitment to corporate finance management policies supposedly in place to ensure maximizing shareholder value and stakeholder wealth, only to be engulfed into scandals that destroyed shareholder value as well as massive job losses detrimental to society (Starovic, Cooper and Davis, 2004, p 7). This highlighted the fact that top management fail to clearly distinguish between the financial management approach that maximizes profits and those that lead to the maximization of value . As such, earnings per share as a profit measurement do not reflect the true value of a company’s creation of wealth. Wealth maximization management approach keeps top managers in a business entity in check through ensuring that value created is realized after the difference in return on investment and the cost of acquiring the investment. It also ensures that the management is accountable to the shareholders by adhering to the principles of corporate governance (Arias & Patterson, 2009, p 108).
The modern financial management approach that is maximizing on shareholder wealth became the new sensation in the business world as corporations like Cadbury Schweppes committed their decision making processes to this approach (Starovic, Cooper and Davis, 2004, p 6). Superb returns on equity realized by the company created a buzz in the financial markets. However, when the market boom bubble bust in 1998, this approach became an issue for ridicule. It became apparent that the maximization of shareholder wealth approach was severely affected when the economic position of financial markets was on a decline (Branco and Rodrigues, 2007, p 8). Thus, wealth maximization as a financial management approach has its own share of setbacks but primarily due to operational and strategy related predicaments. This is mainly due to the fact that at such a period, access to capital for investments is hit hard by fiscal policy measure set up by governments to contain economic regression (Branco and Rodrigues, 2007, p 11).
As financial markets improve and the abuse of office by top level managers is thoroughly checked through corporate governance, wealth maximization on shareholder investment greatly helps improve activity in capital markets (Starovic, Cooper and Davis, 2004, p 7). Maximization of shareholder wealth has its strengths at providing credible performance metrics and more so strong accountability requirements. This ensures that focus on operational efficiency is reinforced while at the same time instituting and effecting checks and balances on management focus on core objectives through corporate governance. As such, corporate governance is accredited ensuring that senior managers in a business entity are more accountable as key to enhancing growth in the intrinsic wealth as the top priority relative to safeguarding the interests of shareholders (Arias & Patterson, 2009, p 108). Cases such as Enron’s collapse are therefore easily avoided as the management is closely monitored by the shareholders (Starovic, Cooper and Davis, 2004, p 7). In the US, a highly competitive economy, academics and respected business circles agree to the fact shareholder wealth maximization serves to realign the duty of management to the shareholders. Managers are in essence agents acting on behalf of the owners of a business entity who are primarily the shareholders (Starovic, Cooper and Davis, 2004, p 7).
For senior managers to make investment decision that serve to ensure maximization of shareholder wealth, an important question has to be addressed. This query should relate directly to what the consumer expects from a given product or service (Arias & Patterson, 2009, p 108). Rational consumers are always willing to spend their financial resources on products that generally improve on their well being and as such will pay more for goods and services that tend to improve on their standards of living. It is therefore important for managers to incorporate these aspects in their decision making through innovation to guarantee a firm’s value creation objective is realized (Madden, 2005, P 19). This also goes hand in hand with ensuring that a business entity’s employees are well catered for in terms of remuneration, working conditions and other related incentives that ensure employee productivity.
The maximizing on shareholder wealth approach motivates management to be very objective in making decisions that brings to fruition both the financial and non financial goals of a business entity. Financial goals relate to short term objectives such as profit maximization, increasing sales volumes, improving on growth margins, growth in earnings per share etc. Non financial objectives on the other hand relate to strategies that tend to contribute positively to financial objectives in the medium or long term (Branco and Rodrigues, 2007, p 10).
Non financial objectives include creation of strong brand names, innovation through sustainable research and development initiatives, product development, capitalizing on niche markets, ensuring customers are adequately satisfied with the services and products produced and continuously improving on employee motivation (Arias & Patterson, 2009, p 97). There are also some non financial objectives that management teams can adapt that greatly determine a the rate of wealth creation these include; provisions for welfare for all employees, provision of quality after sale services to ensure customer satisfaction, environmental initiatives such as investing in green energy, upholding social responsibility to consumers and contributing to the overall welfare of the society (Arias & Patterson, 2009, p 97).
Corporate social responsibility contributes greatly to creating wealth as opposed to profit maximization (Branco and Rodrigues, 2007, p 8). Most organizations do not give considerations to corporate social responsibility on the precept that this should be undertaken by governments and large multinationals. However, the wealth maximization approach accommodates the fact that contributions to the society through co-sponsoring and participating in social events such as environmental conservation initiatives and sport events go along way in enhancing wealth maximization (Madden, 2005, P 12). The society reacts well to a company that gives back to the society in one way or another thus ensuring company loyalty, better staff recruitment, retention and more so motivation as well as keeping a business entity in the good books of the law (Branco and Rodrigues, 2007, p 8).
In conclusion, the society as a whole tends to benefit from a corporation’s managements decisions which maximize on shareholder value. This is primarily because maximizing on shareholder wealth works to promote market oriented processes which have the effect of matching resources to areas in which the best possible outcomes can be achieved in the most efficient manner. In other words, the long term gains to a society under the principle of maximizing shareholder wealth are far much greater thus the tendency for the society to soak up short term hiccups.
Dayananda, Don., Irons, Richard., Harrison, Steve., Herbohn, John., & Rowland, Patrick. (2002). Financial Appraisal of Investment Projects. Capital Budgeting. Cambridge: Cambridge University press.
Arias, J. C. & Patterson, Kate. (2009). Relationships between Corporate Social Responsibilities’ Promotion and Corporate Performance in the Multinational Corporations. Business Intelligence Journal – January, 2009 Vol.2 No.1. Pp 93-12. J.C.
Branco, Manuel, C. and Rodrigues, Lucia. L. (2007). Positioning Stakeholder Theory within the Debate on Corporate Social Responsibility. EJBO Electronic Journal of Business Ethics and Organization Studies.Vol. 12, No. 1. Pp5-15.
Madden, Bartley, J. (2005). Maximizing Shareholder Value and the Greater Good. Naperville, IL: Learning What Works. Pp 1-65.
Starovic, Danka., Cooper, Stuart. and Davis, Matt. (2004). Maximizing Shareholder Value
Achieving, clarity in decision-making. 26 Chapter Street,London: CIMA. Pp 1-29.
Brealey, Richard A., Myers, Stewart, C. and Allen, Franklin. (2008). Principles of corporate finance. New York: McGraw-Hill/Irwin.Pp 1-976.
Newagepublishers. (n.d). Introduction to Financial Management. Introduction to Financial Management. Retrieved September 29, 2011 from http://www.newagepublishers.com/samplechapter/001683.pdf
www.egyankosh.ac.in (n.d). Financial Management: An Introduction. Financial and Investment Analysis. Retrieved September 29, 2011 from http://www.egyankosh.ac.in/bitstream/123456789/38348/1/Unit-11.pdf