Do you think that maximising shareholder wealth is an adequate goal of management in a modern world? Identify the points for and against, and then develop an argument defending your particular position in this debate………..
Traditionally, the main objective of firms was to realize profits. According to Adams, (2002), there were various constraints accrued to this main goal of financial management attributed to the fact that a business had many other objectives to pursue. Some of the objectives may be to achieve higher market share, superior sales volume, and better stability among other objectives. Besides, in profit maximization, many parameters were assumed such as the time limit for the profit maximization. Is it a short term, medium term or long term profits? Nevertheless, the concept of a firm’s social responsibility was never considered under the traditional approach and yet it counts as a big objective to firms that intend to do maximize the profits. In this discussion, the argument for presence of other goals other than shareholder wealth maximization will be analyzed. Various theories will be used in defending the argument for and a conclusion will be provided on why there other goals.
Theories that support shareholder wealth maximization
In the modern world, the main goal of most organization is to maximize shareholder wealth. This comprise of improving the shareholders earning per share and maximizing the net present worth. In wealth maximization, the main concern is the amount of cash flow that is generated from the business as opposed to the profits accrued in the business (William & Mary, 2000). There are theories which support the ideology of shareholder maximization such as positive theory and contract theory.
The theory envisages how people act and assume that everybody will act in the way which will suit himself most. Friedman who is the father of MM1, 2, 3 advanced that the ultimate objective of positive science is the advance of a theory or hypothesis that gives convincing and significant forecasts about an occurrence not yet discovered. The theory attempts to describe the choices made by a manager in terms of self-interest, the association between the shareholders and what financial accounting can be applied to lessen costs by allying contending interests.
The genesis of it all is the efficient market hypothesis, which is found on the hypothesis that the capital market responds in a well-organized and unprejudiced comportment to openly accessible information. That share prices reflect the content of publicly accessible information which is not constrained to accounting disclosures. When new information is released into the public it is immediately incorporated in the share price such that no one can use the information to arbitrage profits. This is efficient market Hypothesis. The manager has no choice but to use the laid accounting methods in reporting income. The agency theory comes in which gives an elaboration of reasons as to picking on a particular method of accounting and focuses on the association between agents and principals. The manager is therefore, expected to take the methods which minimizes the cost and maximizes the share value of the stakeholder.
There is no assumption by the agency theory that a manager will ever take actions to key to the growth of the firm but would rather act in self-interest. It is therefore necessary to lay down mechanism that will foresee that the actions will benefit the manager and the firm as well. This is what stipulates to contracting theory. In the early 1970s the theory proposed that all capital markets were efficient and contractual mechanism could be applied to manage the efforts of agents who are self-interested through corporate governance system. Later on, other hypothesis came up which called for bonus plans, debt/equity hypothesis and political cost concept. It was supposed that a manger might be motivated if given bonus plans commensurate to the accounting methods used to increase the reported income. Hence reward is attached to the performance contract and bonus plans to be given (Niskamen, 2005).
Besides, debt/equity concept forecasts that managers are likely to apply the accounting methods that report higher income if the debt/equity ratio is high. Such managers will realize debt constrain hence reducing a possibility of default.
By use of perspective on efficiency, different contractual arrangements can be applied to reduce the agency of the company associated with passing on the decision making power to the agent. On the other hand, by adoption of perspective on opportunity, explanation and forecast of particular behaviors that are opportunistic in nature will consequently take place. Nonetheless it is not probable to make complete contracts that will give direction on all accounting procedures to be applying in all situations hence a possibility of opportunistic managers.
An entity’s incentives to apply fair value concept may tend to be targeting the entity a lone hence tension may be placed on the firm in relation to factors in the outside environment. Some times a serious scrutiny may be exerted towards a reported profit amount by an outside agency like the trade unions. They will push to demand for higher pay. Other bodies like regulatory agencies may have a perception of monopoly market within a particular industry. All these constitutes to political cost. It is therefore important for an entity to consider all stakeholders in the effort to maximize the wealth of the firm’s shareholders.
Theories to support Business has other responsibilities
There are other business objectives which a firm may be pursuing as their major goals. They include sales maximization where a business will pursue for the growth and sustenance of the share of the market. Some will make survival certain through increased sales maximization; others will scare away new competitive entrants as opposed to some firms which will achieve fame of the senior administrators through achieving bonuses based on the revenues collected rather than profits realized.
Other firms may have building on the management discretion as their major goal. This applies mostly to managers who are self-interested. The business will run to attain personal achievement rather than the welfare of other investors. Such a firm will tend to offer high levels of compensation to managers as opposed to the highest quantity of profits realized from the entire business. Therefore various theories exist to support the notion that businesses do have other objectives to pursue rather than the shareholders wealth maximization. These include; sustainability theory, legitimacy theory and stakeholders theory.
A firm must consider all economic, environmental and social responsibility in the course of its operation. Sustainability is the ability to tolerate or long term preservation of interests which has social dimension, economic dimension and environmental dimension. It involves the process of stewardship and obligatory control of resources. Sustainability theory then enables an organization to integrate preservation of environment and considering the health and the general wellbeing of individuals to prolong yield of welfare, profits margins and resources which are competitive which must be done using proper strategies that can split the connection amid economic growth and environmental or resource depletion (Hart and Milstein, 2002). Three key observations are made concerning greening; that greening helps increase wealth, produce higher Gross domestic Product at the same time eradicating poverty. Julian, (2005) observes that an organization that promotes a green economy improves on job opportunities, and improves on the general growth of the firm hence achieving the intended objectives (Werther and Chandler, 2006).
It purports that business are entrusted by the society in which the firms consent to act on a variety of communally desired actions in exchange for its goals and other incentives which guarantees its perpetual life. Hence the firms have social contract which is the function of economic, social and political environment. The organization has a duty to offer accountability to the community in exchange for the liberty to operate as an entity (O’Donovan, 2002). Institutional legitimacy theory is concerned with entire structure of the organization which has acquired acceptance from the community. Organizations are empowered mainly by portraying them as accepted and momentous. The theory comprise of the government, religion, society and capitalism at the institutional level while at the organizational level it has establishment, maintenance, extension and defense. In the process of legitimating a firm searches for approval from the society which is related to their activities that are in conformity with the larger social structure. The firm then extracts at a competitive rate resources from the cultural environments in pursuit of its targets. Legitimacy is a great resource that a firm would need in order to carry out its business. In case a firm will have low legitimacy, then there are serious consequences which may lead to denial of their rights to conduct its business. Hence by virtual of acquiring legitimacy, an organization will acquire important resources essential for survival.
It stipulates that an organization has to jargon between conflicting demands of different interest groups such as government agencies, community groups, suppliers, employees, shareholders among others. The owners of a business are the shareholders of the organization have a binding duty to consider their needs first that is to increase the firm’s value for them. Therefore the firm places the inputs the shareholders, suppliers, employees into outputs that are salable to customers. Hence this action returns the benefit of capital to the organization. However as the theory argues, there are other parties at stake which include prospective employees, government agencies, trade unions, society, political groups and the general public. Therefore strategy is significant in incorporating market based view as well as resource based view on top of social political level (Robert and Freeman, 2003). Hence the firm should find how these parties should be treated to realize the firms’ main objectives.
The best stand on the objectives of organizations
In regard to the above theories I am of the opinion that the shareholder wealth maximization is not the only main objective of the firm. There are other objectives or goals which the firm has to pursue in order to remain in business. Maximizing earnings per share has various weaknesses which have to be considered. For instance, it does not factor in the projects’ uncertainty because some ventures are more risky than others. Therefore if undertaken they would lead to loss of investors funds. Moreover, a firm will be more prone to financial risk which will contribute to uncertainty of the projected streams of cash flows and earnings per share hence such uncertainty will reflect on the market share price. The market price per share is normally an indicator of performance index of the company’s progress; it shows how good the management is performing on behalf of shareholders (Bhagat & Bolton, 2008).
Serving shareholders interests is not prudent as to neglecting social responsibilities. Protecting consumers, giving considerable wages to employees, supporting communities and conserving the environment is very critical to the organization. Firms must not just concentrate on one goal but be multidimensional. The society may have the power to detect which firm operates in their locality and which one should not. Any organization that may pose hazardous to the surroundings may be easily rejected by the community. According to legitimacy theory such an organization must prove to the society that its main goal is to serve their interests in order to be granted the right to exploit the resources around. The society demands support of education, health care, infrastructure and other social amenities (Buchholz & Rosenthal, 2002).
The law and political organs are equally similar in influencing the firm’s goals. The firm must prove to the regulatory bodies and agencies that it has the interests of the people at stake. Trade unions are usually on the look out on reported income by the companies. Any company that reports very high profits at the same time have high earnings per share, but do not give fair remunerations is usually attacked by the trade unions to hike the wages. Conflicts will arise if the firm does not does not conform to the demands of the unions. Hiking wages may be in contrary to the objective of shareholder wealth maximization. Failure to abide by the regulations may also comprise to the main objective of wealth maximization. From the numerous strikes, litigations and loss of customer confidence in the firm will portray poor management which in turn affects the share price of the firm. It is therefore necessary to reiterate that firms must have other objectives to pursue not only focusing on wealth maximization.
The government regulations on the other hand, may impose the firm to pay a considerable amount of taxes basing on the reported profits and share price movement. Besides, the firm must also prove to the government that it has incorporated in their objectives the concept of economic development and green economy sustenance. Through the various environmental agencies the government ascertains the ability of the firm to maintain a sustainable environment through its operations. With satisfaction that these regulations have been met, the firm can then be given the license to operate. In this scenario, the location of the firm is very important and it must conform to the standards of the government.
Setting firms’ objectives is very critical for any management board. As much as investors may want to be assured of their interests, they must be made to understand that it is not effectual to achieve such demands without factoring in other people. An accord must therefore be put forward on how to trade between the interests of other parties at the same time fulfilling shareholders’ wellbeing. However, some managers might want to capitalize on such to meet their own personal needs hence the concept of corporate governance must be factored in to ensure that managers conform to the standards as they are required of.
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