Does a Company Exist Only for the Benefit of Shareholders - Literature review Example

Running Header: To what extent does a company exist only for the benefit of shareholders? Student’s Name: Instructor’s Name: Course Code: Date of Submission: To what extent does a company exist only for the benefit of shareholders? Introduction The recent developments in corporate governance regulations have facilitated the increase of pressure on the need of organisations to act responsibly. Most organisations now act with their shareholder’s interest in mind. Most public traded companies exist only for the benefit of their shareholders by maximising shareholder wealth and providing more benefits rather than acting in a self-opportunistic manner. Austin (2001) shows that to improve shareholder’s value, companies have introduces strategies such as through merger and acquisitions. The focus of this study is to show to what extent companies exist for the benefit of their shareholders. Shareholders own parts of the company and invest money for future dividends or to increases the value of their shares. This is mostly experienced in large organizations while in small businesses; shareholders are the individuals who establish the business. Bahli and Rivard (2003, p. 211) describes that shareholders are entitled to various decisions for example in voting for a corporate president and the board of directors. They are also responsible in making significant changes in business such as change of company name or introducing mergers and acquisition. Shareholders therefore have a great influence in the operation of a business for example those institutional investors such as insurance companies, banks and investment companies. Most companies therefore exist for the benefit of shareholders due to shareholders’ influence caused and also to avoid principal- agent conflicts. According to Bamberg and Klaus (1997) when shareholders buy shares from a company, they always expect the company to be successful in order for it to offer more dividends and to increases share prices. Some companies offer bonus benefits to their companies. These benefits improve the relationship between the company and its shareholders therefore adding value to the company. These benefits also allow the shareholders to experience company’s goods and services and also facilitate attendance at meetings for example by offering discount voucher to individuals who attend the meetings. Some of the benefits offered include discounts in travel and leisure for example the British Airways offers about 10 percent discount to its shareholders. The Eurotunnel ores 30 percent discount for three return journeys though one has to be a regular traveler (Mitchell et al. 1997, p. 853). Most managers and especially in the public traded companies acknowledge creating value for their shareholders and this is their corporate objective. Shareholders are therefore considered as important components in the management’s assessment of key decisions. (Fama and Michael 1993, p. 327-349) shows how the CEO of the Indian Head Mills states that the objective of their company is to increase the intrinsic value of the common stock but not to grow bigger, nor to be diversified nor to provide jobs. They are also not in business to lead in new product development or to achieve any status. He says that any of the above aspect may come time to time as a means to the main objective of the company which is to improve the inherent value of their stockholders. Shareholders’ control According to Phillips and Edward (2003) corporate directors being appointed by the shareholders also receive restrictions for control and decision making. Shareholders therefore tend to influence company’s policies and directors fear being fired if they do not satisfy the needs of their shareholders. However, most shareholders are interested in increased return on investment and do not necessarily play a major role in corporate governance. Unlike individual investors, institutional shareholders own large quantities of company’s stock. Shareholders use various techniques to link top management and shareholders goals. This is by giving managers options of purchasing stock in future at a predetermined price. If this stock price rises over time, the shareholders receive a substantial profit opportunity. This technique is preferred as it benefits both the managers and the shareholders. Shareholders and management perspective There are two perspectives that exist in the field of management. These include choosing between the fulfillment of shareholders interest and the employee interest. Managers experience difficulty in making successful decisions on the above perspectives. However, the interest of shareholders, employees, customers and other players in business are interconnected (Shankman 1999). Shareholder value As a result of direct and indirect influence from shareholder, companies that depend on shareholders make shareholder value the major goal of business. Shareholder value is equal to the company’s value without debts. This shows that companies develop shareholders value when the return on investment is more than the investment costs. Francalanci and Galal (1998, p. 227) describes that shareholders normally expect a minimum return on investment equal to return on low risk investments for example the case in the US treasury bills. They also expect a risk premium associated with a company for example a new internet company in the stock market delivers a higher return than those that have been there for a long time such as IBM. A company is therefore said to deliver shareholder value if it delivers higher return in form of dividends or appreciating share price. Companies focus on increasing shareholder wealth in order to avoid losing investors confidence. To achieve this, a company may sell off its shares and to improve performance the company may also replace top executives. In order to maintain shareholder value, managers have to think like entrepreneurs and strive to remain abreast of the interests of the shareholders. They should also concentrate on the company’s revenue generation functions and should maximize effectiveness. Managers should also ensure that the company becomes a service leader for example through establishing closer ties with consumers. Growth strategies should also be implemented to benefit the needs of investors. However, this method has recently been attacked by the needs of employees and other players in business. In corporate theory, companies are viewed according to the stakeholders’ model which shows that a company improves its financial benefits by fulfilling the needs of stakeholders who include employees, distributors and customers and not only for the benefits of shareholders only. The interests of shareholders and those of employees are said to conflict for example due to layoffs. The stakeholders’ model shows that managers strike a balance between the interests of possible group of people against the interest of the other. Individuals advocating for shareholders value argue that if a company focus on more than one interest group, then the company is capable of facing a dilemma in deciding what factors to satisfy first. For a company to decide between competing interests, it must base its decision on other reasons (Michael and William 1996, pp. 305-360). Companies are therefore hard pressed to increasing shareholder value since other reasons come after this interest. A company should form a decision criterion that enables it face dilemmas which might slow down the decision making process. The dilemma might also manifest itself in a way that increases shareholder value and also meets the needs of customers though this might then lead to reduced workforce. A company should therefore not ignore the interest of other stakeholders while focusing on those of the shareholders. This is because skillful employees will quit once they realise that their needs are not well attended to and the customers will support competition once their needs are not met. Management must ensure that other needs of stakeholders are well balanced and taken into consideration. The supporters of this approach argue that if a company is not profitable in the long run then it will be closed down which would not benefit any stakeholder (Shankman 1999). Agency theory This is defined as the relationship between the principal who is the shareholder and the agent who is the company’s managers. Gurbaxani and Seungjin (1999, p. 29) shows the principal hires the agent or delegate agents to work for them and control the decision making process. Agency theory therefore tries to resolve conflicts between the two parties who have different interest in same asset which is the company. There are various mechanisms used in linking the needs of both parties. These include commissions, profit sharing and giving efficiency wages. There are two problems that arise in the relationship between the principal and the agent. One is that the desires and goals of the principal might differ from those of the agent in that it might be difficult for the principal to be aware of the work that the agent does. The second problem is that of risk sharing where parties have conflicting attitudes towards risks. Such risks include compensation, regulation, vertical integration and leadership. Leland (1998) describes that agency theory therefore shows the contract made between resource holders. Agency theory shows implication of corporate governance and business ethics. In order to sustain an effective agency relationship several expenses are incurred which involve encouraging managers to act according to shareholders’ interests. This conflict between managers and shareholders of a particular company form a fundamental problem. Some of the sources of conflict includes where a manager have personal goals different from those of the owner of maximising shareholders’ wealth. Agency theory shows that in capital markets, managers seek to their own interest at the expense of the shareholders. Donaldson and Preston (1995) describes that this problem occurs due to asymmetric information and uncertainty for example managers are capable of determining the company’s position and whether it can meet the needs of shareholders while shareholders and usually not aware. Shareholders are also not aware of the factors that contribute to company’s outcome and have no evidence of uncertainties. One character of self-interested managerial behaviour shows how they consume corporate resources in form of perquisites. It also shows how managers avoid optimal risk positions for example through avoiding profitable opportunities that would have been preferred by shareholders. Donaldson and Preston (1995, p. 71) describes that agency conflict arises for example when the manager of a company owns common stock that is less than 100 percent. This is seen in large publicly traded corporations where managers own a small percentage. This therefore makes managers focus on other objectives such as maximising the size of the firm or on growth of the firm rather than maximising shareholders’ wealth. In these corporations, agents tend to improve their status and enhancing their job security. Due to these factors, shareholders opt to diversify their portfolios by buying shares of other companies. To minimize these conflicts, managers should ensure that they act to the best interest of their shareholders. This can be encourages through incentives, constrains on the agreement or punishments. These techniques however effective can only be applied in situations where the shareholders are aware of all the managers’ actions. Myers and Nicholas (1994) argue that this moral hazard problem can be reduced through agency costs used by shareholders to encourage managers to focus on maximizing shareholders wealth before other business objectives. The agency costs include expenses for monitoring all managerial activities for example through auditing. They also involve expenses for structuring the organisation in a way that limit moral hazard problem for example by appointing other people to restructure the company’s business units and changing the managerial hierarchy. The final agency cost involves opportunity cost spent on restrictions imposed by the shareholders. These restrictions include limiting managers to take up decisions that would maximise shareholders’ wealth and interest. There are two ways used in dealing with the principal-agent conflicts. Incentives reduce agency costs and encourage managers to focus on benefiting the company’s shareholders this is by compensating managers according to the prices of stock in the stock market. Monitoring manager’s action can also reduce conflicts though it is costly and inefficient. The optimal solution of solving these conflicts is by linking executive compensation to managers’ performance. There are factors that encourage managers to focus only on benefiting the interests of the company’s shareholders (Freeman 2004). These factors include use of performance based incentive plans where manager’s activities are monitored and evaluated and once performance is acceptable they are compensated for their actions. The other factor involves forming direct intervention by shareholders. Some shareholders may be involved in running the company and making decisions for the company that reduces agency costs. Shareholders may use threats of firing managers once their actions are not for the interest of the shareholders. Threats of take over may also be used to encourage managers to focus on maximising shareholders value. According to Choudhury and Sampler (1997, p. 25) most of the companies whose stock is traded in the stock exchange have now introduced performance shares given to managers according to their performance which is shown by the financial measures for example the earning received per share, the return on assets, return on equity or the changes in prices of stock. These performance shares are meant to satisfy two business objectives. One is that they give incentives to managers in order for them to be involved in activities that improve shareholders’ wealth. The other reason is that it enables companies to attract and retain managers who take actions of improving their performance by risking their financial future and abilities. Agency theory is therefore the separation of ownership and control in that individuals who make business decisions do not bear the risk connected to their decisions or management practices. This forms a risk sharing problem that arises due to differences in goals. Among other factors of adopting the method of maximising the value of shareholders’ as the company’s governing objective, two factors are important to consider. One is the company’s decision-making process. Since business is a game of choices, the decisions made in large organizations for example involving complex trade offs maintain profit margins and also the market share of the organization. It is therefore important for companies to have a clear objective that is easy to translate into a decision criterion. One method would be to compare the impact of various strategies and choosing the best option that mostly creates the value for shareholders. This yields to a clear and consistent objective that is operational in a large and complex organization. This is because choosing an objective such as global dominance, increased growth or maintaining quality will only yield to overinvestment, losses or harmful investment (Chen and Edgington 2005, p. 279). The other benefit is the positive feedback attained when a company succeeds in making value its core competency. To achieve this objective, a company needs to have better information and effective strategic analysis of the business environment. Norman and Freeman (2002) states changes in the organizational structure and management processes also lead to effective learning and decision-making. Once the institutional advantage grows, the human and the financial resources of the company also expand as well as the strategic advantages. The company is therefore able to secure a better competitive position which eventually leads to increased cash flow for shareholders and also economic benefits to the stakeholders. Conclusion Despite the fact that companies are complex institutions of contractual relations and despite the fact that shareholders do not contribute to decision making process of companies, the ultimate right of guiding the firm remains with the shareholders since they value the company more. This shows the reason why the governing objective of all the publicly traded companies should be to maximize shareholders value. Companies that achieve this objective do not only serve the interest of shareholders but also serve the economic interests of all stakeholders. However, this approach may harm the some situations of stakeholders for example if a firm restructures leading to layoffs. In the end, stakeholders’ economic interest will be maximised by the decisions made of improving shareholders’ value. This shows that maximising the shareholders’ value is not just the best way forward but the only way of maximising the future economic interest of all stakeholders. 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