Critical Evaluation Of Shareholder Wealth Maximisation - Research Paper Example

CRITICAL EVALUATION OF SHAREHOLDER WEALTH MAXIMISATION Introduction ‘Maximise’ as everyone knows means to gain the highest achievable number for something. Although originally used for mathematical programming, it is now widely used in a broader sense. The next word ‘shareholder’ includes owners, stockholders and the other principals of the organization which are a common and readily understood terminology. The last word ‘wealth’ according to the dictionary means any resource that has some value in terms of utilization and trade. If the whole axiom is to be translated it would be ‘to gain the highest achievable value for the owners of the company. Therefore in order to achieve this axiom, managers especially finance managers take decisions that are in accordance with this statement. These decisions can be related to investment as well as finance decision. The pursuit of such goals is sometimes not free from critics. Therefore the aim of this theoretical research is based on the critical evaluation of the shareholder wealth maximisation axiom. Critical Evaluation of Shareholder Theory As we enter the 21st century, calling it the postindustrial era or postmodern era, the moral status of the shareholder wealth maximisation for the corporate activity has changed. Shareholder wealth maximisation is exempt for moral scrutiny, within the disciplines of financial economics and corporate culture. This concept is undeniably protected against the critics by the theory of invisible hand that each individual company that competes in pursuit of shareholder wealth maximisation ultimately leads to maximum cumulative economic advantage. “Many managers have considerable discretion to substitute their own interest for that of the stockholders. Stockholder and manager interests can conflict or be independent in significant respects. The extent to which firms are managed in stockholder interests vary considerably” (Findlay & Whitmore, 1974). The term itself appears to entail a narrow worldly focus on shareholders but in reality it really stands for a focus on the equity market value disclosed in the company’s price of stock. In this respect, the finance manager who is in pursuit of shareholder wealth maximisation is in fact only concerned with the things that can have an affect or impact on the company’s price or value of stock and therefore, other stakeholders can influence company value. Critical Evaluation of Stakeholder Approach An approach to strategic management was proposed by Edward Freeman in 1984 called stakeholder approach. The traditional view of corporate strategy, stakeholders were associated with terms such as owners or stockholders of a company. According to Freeman, he described the term stakeholder more broadly and included in his definition that any group or an individual who can influence or is influenced by the company’s objectives and goal is a stakeholder of that company. In order to understand the stakeholder model it should be recognized that this model does not only imply any concern only for the stockholders but also for the stakeholders such as animals or the environment. The concern for finance managers at this point is ineradicably inter-twined with a company’s finance concern. A company that is insensitive to the concerns of the stakeholders will not be able to rise financially and therefore would not be able to cater the needs of the stakeholders. The stakeholder model also has many drawbacks. The interests of the stakeholders of any company can deviate sharply from one another and managers pursing the path to keep all the stakeholders happy, who have no sense of compromise, can do more damage than those managers who put the shareholders first in their doctrine and objectives. In the modern times, the interests of the stakeholders are inter-twined as aforementioned. To elaborate, employees are shareholders in the company due to the investment in the pension funds. The stakeholders of the corporations in today’s world are more concerned about the decisions taken by the executives whether they meet the expectations of the stakeholders or not. Not only the shareholders and the employees, but customers as well as investors, governments and competitors are becoming more out-spoken in order to improve the behaviors of the organizations. But it should be kept in mind that the stakeholder approach is just to generate academic interest because the management of companies will be only concerned for the persons holding the shares rather than all the stakeholders. Contrasting & Criticising Shareholder Theory & Stakeholder Theory If the shareholder wealth maximisation and stakeholder theory are compared together, it would seem that they both are diametrically opposing each other which mean that the company and its management cannot serve the shareholders and the stakeholders at the same time. The critics of the shareholder theory usually claim that the because management and executives are given big incentives and rewards such as stock options so that they would maximise shareholder’s wealth, they would do every manipulation in their power to achieve this goal. The shareholder theory encourages manipulation behavior such as illegal partnerships of which after the work traces can be removed so that the people involved do not get caught. Many such evidences have been seen which prove the failure of the shareholder theory such as the “Scandals at Enron, Global Crossing, ImClone, Tyco International, World Com,” (Arthur et al. 2004). The stakeholder on the other hand is not free from any criticisms. The basic criticism of this concept is that the theory contravenes the nature of the shareholder-manager relation based on the fiduciary duties of the managers. In addition, not all stakeholders are beneficial from the stakeholder theory. Some stakeholders have a special relation with the management of the company that can be discriminated by this theory. Another criticism associated to the theory is that the managers will be in a competitive disadvantage position if it serves all stakeholders because their ability to maximise shareholder value will fall. In addition to this, the stakeholder theory has been criticized on the basis of normative validity that it is wrong of the management to use people to fulfill the needs of the one’s (management) own self. The theory also fails to provide the mentioned stakeholders with any rights except for their consent in the activity of the company. A further criticism states that the theory gives no suggestion as “the rights of the different groups can be upheld through other means rather than through specific management practice,” (Cooper, 2004). All in all, stakeholder theory is not considered a theory at all by many critics but as a framework rather than a theory. Other theorists who have criticised the above two models of shareholder theory and stakeholder theory is Ian Davis and Ellsworth. Stakeholder Theory and Ian Davis Approach Ian Davis who is the Managing Director of McKinsey said that both the above views of shareholders are incomprehensible to the real business relationship to the so-called external issues. He contravened the Friedman stakeholder approach directly saying that “the problem with the business of business is business mindset is…that it can blind management to two important realities. Social issues are peripheral to the challenges of corporate management. The sole legitimate purpose of business is to create shareholder value,” (Ian Davis on business and society, 2005). Davis further points out that the theories are inaccurate. According to Davis, shareholder value is should only be considered as a critical measure for success of any company. He points out that shareholder value concept is used by 80% of the companies in US and UK who base the market value on projected cash flows. Therefore large companies are advised to incorporate social issues into their business goals and strategies so that it can reflect actual business performance. Another point that Davis makes in criticising the stakeholder theory and the shareholder theory is that the companies have a tendency to overlook the economic, political and cultural impacts on their companies in future as they focus single mindedly on shareholder value. Davis says that “the language of shareholder value may hinder companies from maximizing shareholder value in this respect,” (Savitz & Weber, 2006). Commercial Example Ben & Jerry’s Ice-Cream: Ben & Jerry’s recently discovered that unless the financial considerations of the shareholders and the stakeholders are not taken into account, profits cannot be achieved. Therefore if any social responsibility is to be carried out, the first priority is to maximise the shareholders wealth (Clement, 2005). Royal Dutch/Shell Group Shell had been on the newspaper heading for quite some time due to its decision of reversing its plan to dispose Brent Spar oil platform in Atlantic Ocean. An outrage from certain stakeholders and environmentalists, forced Shell to change its decisions and act on the decisions of the stakeholders choosing economic benefits over social benefits (Clement, 2005). Monsanto Company The company was trying to commercialize seed sterilization technology in India and therefore become the global life science organization. The company was focused on the maximisation of the company’s shareholder wealth because of their high investment and took little account of the environment. The company had taken account of all the stakeholders and their profits but forget a certain fringe of stakeholders. These stakeholders protested against the company and the result was the wound up of the company from India (Clement, 2005). Conclusion The focus of this research was to evaluate the models critically based on recent business management focuses. The stakeholder theory and shareholder theory are considered inappropriate in today’s world because they do not take into account the other factors that have an influence on the company as suggested by Ian Davis. Also in the past and the present, the use of these theories has led to unethical behavior on part of the management in order to maximise the shareholder value in monetary values. As it can be seen from the examples, many companies do use shareholder wealth maximisation axiom in today’s world. In addition to this, it is legal in most states for the companies to put a single minded focus on how to maximise the shareholder’s wealth. If the maximisation models are legal, the companies can use it to pursue it own profit goals as well. REFERENCES Arthur, T., Strickland, A. & Gamble, J. (2004). Crafting and Executing Strategy: Text and Readings with Online Learning Center with Premium Content Card. (Eds.4). McGraw Hill Professional. ISBN 0073023078, 9780073023076 Beaver, W. (1999). Is Stakeholder Model Dead? Business Horizons. Clement, R. (2005). The lessons from stakeholder theory for U.S. business leaders. Business Horizons. Vol.48. Pg 255-264 Cooper, S. (2004). Corporate Social Performance: A Stakeholder Approach. Ashgate Publishing Ltd. ISBN 0754641740, 9780754641742 Dobson, J. (1999). Is Shareholder Wealth Maximization Immoral? Financial Analysts Journal. Findlay, C. & Whitmore, G. (1974). Beyond Shareholder Wealth Maximization. Financial Management. Frankfurter, G. (1995). Is a Misconception a Paradox. European Journal of Finance. Vol.1. Routledge. Freeman, R. (1984). Strategic Management: A Stakeholder Approach. Pitman. Boston Friedman, A. & Miles, S. (2006). Stakeholders: Theory and Practice. Oxford University Press. ISBN 0199269874, 9780199269877 Ian Davis on business and society. (2005). The Economist. Available from Khurana, R. & Nohria, N. (2008). It’s Time to Make Management a True Profession. Harvard Business Review. Savitz, A. & Weber, K. (2006). The Triple Bottom Line: How Today's Best-run Companies are Achieving Economic, Social, and Environmental Success-and how you Can Too. John Wiley and Sons. ISBN 0787979074, 9780787979072 Read More