The Shareholder Wealth Maximization Model - Case Study Example

Shareholder and Corporate Wealth Maximization Models According to Brigham et al (1999 p13 Shareholders are the owners of a corporation, and they purchase stocks because they want to earn a good return on their investment without undue risk exposure… Since managers are supposed to be working on behalf of shareholders, it follows that they should pursue policies which enhance shareholder value.” This is essentially what the shareholder wealth maximization model emphasizes. The Board of Directors of corporations is normally elected by shareholders. The directors in turn employ managers to plan, organize, control, lead and recruit staff to carry out functions to enable goal achievement. The Shareholder Wealth Maximization Model is one in which, the main focus is on the owners of the business – its shareholders. Shareholders want to see increases in earnings per share (EPS) and share price and therefore expect that managers will make decisions that will ensure that these goals are met. In doing so, however, other stakeholders’ goals may or may not be met. See diagram in the Appendix showing how decisions are made. In recent years however, firms have broadened their focus to include all stakeholders. Gitman (1997, p21) points out: “A firm with a stakeholder focus consciously avoids actions that would prove detrimental to shareholders by damaging their wealth positions through the transfer of stakeholder wealth to the firm. The goal is not to maximize stakeholder well being, but preserve it.” He further points out that: “The stakeholder view, although not altering the shareholder wealth maximization goal, tends to limit the firm’s actions to preserve the wealth of stakeholders. Such a view is often considered part of the firm’s ‘social responsibility’ and is expected to provide maximum long-run benefit to shareholders by maintaining positive stakeholder relationships. Such relationships should maximise stakeholder turnover, conflicts, and litigation. Clearly, the firm can better achieve its goal of shareholder wealth maximisation with the cooperation of – rather than conflict with – its other stakeholders.” “A stakeholder is any individual or organization that is affected by the activities of a business. They may have a direct or indirect interest in the business, and may be in contact with the business on a daily basis, or may just occasionally” (tutor2u.com). Stakeholders include the employees, creditors, and customers who will receive value for their money as it relates to their purchase of goods and services. Employees are individuals employed by the company to ensure that the goals of the organization are met in an effective and efficient manner. In so doing, shareholders goals of wealth maximization are likely to be met. In return, employees expect to be given proper working conditions such as: adequate compensation, proper working environment and to be dealt with in a humane manner. In the same way creditors for loan and suppliers of goods and services would like to know that they will be paid on time. They also want to ensure that management has their interest at heart and will act in a responsible manner to ensure that they are not placed at risk in order to satisfy any other stakeholder. Further, suppliers will want to be assured that the company will remain in business in the future so that they can continue doing business with them and therefore satisfy their goals. Customers are the main stakeholders that determine whether the company remains in business. They are the group who demand the goods and services that the company produces. If they refuse to buy it because of quality and other ethical concerns then the shareholders will lose out. It is only when the company creates value that meets the needs of customers that they will become profitable. Of course, the efficiency with which they operate is equally important as customers want value for money. It therefore means that the company cannot charge customers for its inefficiencies. The community in which the company operates sees the company as very important in providing jobs and in helping them to achieve some of their community-wide goals. The company has a responsibility to ensure that it produces its goods and services in such as way that it does not pollute the environment. This is one of the company’s main social responsibilities to the community. Not to be out done, however, is the fact that it needs to make its contribution to the economy by paying taxes (in the correct amount) to the government, when they become due. In so doing the government will be able to fix roads, carry out garbage collection and other services that they would normally provide for communities. This stakeholder view is really what the corporate wealth management model is all about. It’s about taking a holistic view of the organization - its owners, the community in which it operates suppliers, creditors for loans and goods, and its employees. It is about corporations taking care of their social responsibilities in ensuring that they do not do anything to harm the environment, paying taxes, providing jobs and ensuring that all health and safety guidelines for workers and the public with whom they have to deal are met. Employers are required to provide proper working conditions for employees. It is really about corporate governance. “Corporate governance is the system by which companies are directed and controlled” (BPP Publishing 1995). One of the main stalwart’s behind this view is Sir Adrian Cadbury. "Corporate Governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The corporate governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society" (Sir Adrian Cadbury in Global Corporate Governance Forum, World Bank, 2000) (as cited on corpgov.net). In comparing shareholder and corporate wealth maximization models it is clear that by satisfying its stakeholders the organization will be able to satisfy shareholders need to maximize their wealth. Therefore, it is fair to say both models seek to maximize shareholder wealth. The only difference with the corporate wealth maximization model is that it does not focus solely on the shareholder, it maximizes their wealth indirectly – that is without having shareholders as their main focus. There are advantages associated with each model. The shareholder wealth maximization model’s advantage is that it focuses on the owners. The owner is an important element in any organization, without them the organization would not exist. If management takes the corporate view they may just end up ‘satisficing’ – where they seek satisfy their own goals to the detriment of the shareholders and other stakeholders. The Corporate Wealth Maximization model on the other had seeks to promote all the stakeholders in the business. These are the stakeholders who help to ensure the continuity of the business. In satisfying the needs of other stakeholders the company is better able to satisfy the needs of shareholders, that of wealth maximization. There are also disadvantages associated with both models. The shareholder wealth maximization model has a number of disadvantages. It is too focused; and it may force management to make decisions that are detrimental to other stakeholders. This model does not appear to recognize that the company cannot exist without the other stakeholders, especially its employees and its customers. As it relates to the corporate wealth maximization model, one can only say: Management really cannot serve two masters much more so many stakeholders all at once. Management could end up being between a rock and a hard place. However, when all is said and done the corporate wealth maximization model is very advantages to all stakeholders. Once this model is applied conscientiously, it will bring satisfaction to all concerned. The organization is dependent on all stakeholders for its survival. If it focuses on one group to the detriment of the other, then it simply does not have a future. It therefore follows that this model will achieve more for the organization. References Brigham, E. F., Gapenski, L. C. & Ehrhardt, M. C. (1999). Financial Management: Theory and Practice. USA: Addison Wesley. Gitman, L. J., (1997) Principles of Managerial Finance. USA: Dryden. Corpgov.net. Corporate Governance. Retrieved from http://www.corpgov.net/library/definitions.html BPP (1995) Financial Reporting Environment. 59 tutor2u.com. Stakeholders. Retrieved from http://tutor2u.net/business/gcse/organisation_stakeholders_ethics.htm Appendix Financial Decisions and Share Price Diagram - Share Price Maximization Decisions Read More