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Justifying Shareholder Wealth Maximisation

Corporations require fl nancial capital, and this comes from investors. They contract with uppliers to get the raw materials that they need, and they contract with their workforce to do things with the raw materials that generate value. They sell their output to customers, which generates more cash. Some of the cash is needed to pay their suppliers and their workforce, and the remainder fl Ows back to the investors. How should we think about corporations? Management theorists have come up with a number of answers.

Many see organisations in organic terms, drawing upon similar conceptualisations of society which date back at least to Plato’s writings, and which are developed by modern sociologists such s Auguste Comte, Herbert Spencer, and Emile Durkheim. A related vision is one of an organisation as a cultural entity, with its own personality and ways of doing things. Marxist thinkers have viewed organisations as mechanisms for sustaining the cultural hegemony of the ‘Boss Class’, which uses them to extract surplus value from the proletariat.

And post-modernists reject grand unifl ed theories of this type, and see organisations as refl ecting constructed reality. Economists, and fl nancial economists in particular, tend to approach this question from a different angle. Finance and economics ely upon a number of assumptions about corporations, the role that they play in the economy, and the right way to think about the employees, managers, shareholders and, for want of a less ugly word, the other stakeholders.

For example, in fl nance and economics we tend to analyse corporate activity at the level of the individual actor, and we tend to assume that, most of the time, this actor is rational. Economists are extremely skeptical of arguments that ascribe person-like characteristics to corporate bodies, rather than to the agents who work within them. We assume that markets are populated by rational agents, who aim to rofi t from their information and their skills.

And we think that this is a good thing: rational agents operating in a competitive environment face incentives that tend to result in effi cient outcomes. Effl cient outcomes make people happier: corporations are only worthwhile if they increase effi ciency. These themes are addressed in the opening discussion of the Oxford Finance Programme for Senior Executives. This lecture note summarises and expands upon some of the points mentioned in class; as there are very few easy text book treatments of this topic, I hope that it will be useful if you want further information.

THE OXFORD FINANCE PROGRAMME FOR SENIOR EXECUTIVES Figure 1: A very simple picture of a corporation This is obviously a very simplifi ed version of reality. I have been completely vague about what the company produces, what the suppliers provide, and how the employees add value. This way of viewing the company is therefore extremely general: it applies equally to a huge manufacturing concern and to a small software house.

The former sinks most of its fl nancial capital into physical assets like machines, buildings, unfl nished metal, fuel, and concrete; the latter buys a few computers and spends most of its money on talented eople (‘human capital), who turn their ideas into instructions that a machine can execute: although software enhances productivity elsewhere in the economy, you couldn’t exactly stub your toe on it. From our point of view, this generality is a strength, rather than a weakness.

If we can say something useful about our model then it will be very widely applicable. The most fundamental question is corporate fl nance is the following: What is the company’s purpose? If we want to provide an answer in terms of fl gure 1 then we must avoid responses like “to give ordinary folk the chance to buy the same hings as rich people”l or “to give unlimited opportunity to women,”2 both of which are less general than our framework. Perhaps we could adopt Walt Disney’s mission statement: “to make people happy. This is certainly general, and it’s a pretty good manifesto for an economist, but its even less specifi c than fl gure 1, so it’s not going to help us to understand what corporate fl nance is about. Corporate fl nanciers adopt the following position: Companies should maximise the combined value of their investors’ claims. This statement needs some explanation. Recall from fl gure 1 that investors provide companies ith fl nancial capital. They do so in return for rights to some of the company’s returns, which we generally refer to as claims.

For example, they might be entitled to 10% of their investment every year for 20 years, at which time their cash is returned to them. If we combine this statement with rules that explain what happens when the company cannot afford to pay, and possibly also some rules restricting the nature of future investments in the company, this equates to a standard debt contract, and its holders are generally referred to as debt-holders. Alternatively, some investors may be entitled to verything that remains after the company has This type of residual claim is usually referred to as equity, and its owners are sometimes referred to as shareholders.

A more complex contract would give investors the same rights as a debtholder until a certain date, combined with an option at some date in the future to exchange these rights for those of an equity-holder: this type of contract is known as a convertible bond. Clearly, the nature of investors’ claims is limited only by the imagination of the corporate fl nancier: the corporate objective above states that the company should maximise the ombined value of all of its investors claims. Since a detailed appreciation of the generalised Company Customers Suppliers Workforce Investors Investors 1 Wal-Mart mission statement. May Kay Cosmetics mission statement. JUSTIFYING SHAREHOLDER WEALTH MAXIMISATION ‘claim’ requires a degree of abstract thinking, the objective is frequently expressed in terms of shareholder wealth. Recall from the previous paragraph that shares are residual claims: that is, they pay out whatever is left after every other investor has been satisfi ed. So if the shareholders are doing well you might argue that veryone else must be doing so, too. For this reason many people state the corporate objective as the maximisation of shareholder wealth. Indeed, in many companies this objective is enshrined in corporate law.

However, in the real world maximising shareholder wealth is not the same as maximising the combined value of investors’ claims. For example, we will see in the fl nance course that corporations can increase shareholder wealth at the expense of their debtholders by taking value-reducing risks. Doing so maximises shareholder wealth, but it also reduces the sum of shareholder and bondholder wealth. Justifying Investor Wealth Maximisation maximise the wealth of their investors strikes some people as an ignorant statement of crude capitalistic sensibilities. They argue that this argument ignores wider social issues.

For example, don’t companies have an obligation to provide Jobs? Shouldn’t they worry about their impact upon their surroundings, and upon the communities within which they operate? These questions are too big fully to do Justice to here, but we will take a moment to consider them. The statement that corporations should maximise investor wealth is founded upon notions of property rights and contract. Loosely speaking, a person’s ‘property rights’ over an asset specify the ways in which he can use it, and include the ways in which he can alienate his rights: that is, the ways in which he can pass his rights on to another person. When two people exchange property rights they do so via a contract. This might be a simple agreement to sell something, but fl nancial contracts are usually more complex. For example, in addition to transferring rights over the cash that a company produces, debt contracts frequently stipulate the company’s Board of Directors, detailed procedures for altering the terms of the ebt, and may also limit the company’s freedom to borrow additional money in the future.

The world in which it is easiest to Justify an investor wealth-maximisation role for corporations is one in which property rights are well-defi ned and contracts are easy to write and to enforce. In such a world, people with property rights will transfer them to another person only if he is prepared to pay them suffi ciently. As a result, property will tend to move to the place where it can generate the highest value. Furthermore, property-holders will anticipate a return on any investments that they make o increase the value to other people of their possessions, and hence they will be more inclined to make such investments.

In short, a system of well-defi ned and freely transferrable property rights tends to ensure that goods are incentives for investments that increase the value of the goods. These observations apply broadly to nonphysical goods. For example, if a person believes that she can sell her abilities in a liquid labour market then she will be more inclined to work hard to acquire fresh skills which are of value to other people. 4 Moreover, the likelihood that someone will employ her, and hence her ncentive to learn, is greater when property rights are easily formed and transferred to their most effi cient use.

Institutions that support property rights also underpin skill acquisition, and hence enhance economic growth. 5 Companies that maximise investor value ensure that their capital is employed in the most productive fashion possible. Ultimately, this means that they produce something that other people value highly, and that they do so in the cheapest possible way. If they cannot outperform their competitors then they should return the capital to investors, so that they can re-deploy it. Their employment decisions refl ect the value that potential employees can add.

Negotiations between a corporation and an employee are simple: the corporation buys some of the employee’s time and expertise and in return the corporation promises her a salary, and possibly other forms of compensation such as stock options, dress-down Fridays and a subsidised employee restaurant. Of course, value-maximising fl rms wish to get their staff as cheaply as possible, but they are forced to compete for employees, who will take their skills wherever they are most valued. If necessary, employees may invest in additional knowledge nd skills, possibly by doing some executive education.

This system is effi cient: employees earn a wage that is commensurate with the value that other people place upon them, they deploy their skills in the place where they are of most value to other people, and their training decisions refl ect the things that other people most value. 6 wind up writing contracts with the suppliers who most effi ciently fulfi I their requirements and suppliers will work to maximise the value of their property by enhancing their value. Opponents of this type of reasoning argue that companies have a wider obligation to ‘society. They promulgate a notion of ‘Corporate Social Responsibility,’ or CSR, under which companies balance the needs of their shareholders with those of other interested parties, who are generally referred to in this context as ‘stakeholders. ‘ For example, some advocates of this position argue that companies should invest in cultural activities, because these have positive social consequences. 7 The subtext here appears to be that companies have negative social consequences which they should pay for by investing in things that enhance our quality of life.

CSR is in many respects a beguiling concept. Financial economists raise a number of bjections to it. First, it arguably undermines the effectiveness of the price system. Suppose that companies started to guarantee employment to their workforce. While this would surely prevent some cases of hardship, it would also imply that employee incomes less accurately refl ected the value that others8 placed upon their skills; they would have less incentive to acquire new skills, and their productivity would fall.

In the long run this would be unlikely to serve anyone’s best interests. Second, CSR would undermine the property rights of investors. An investor who expects some of the returns from a successful nvestment to be ploughed into social projects many be less likely to invest in the fl rst place; she may equally elect to invest in less productive technologies where she believes that she will hang onto a greater proportion of the returns. Once again, the resultant drop in investment productivity reduces the size of the social pie and hence cannot be good for anyone.

Third, when managers have a poorly-defi ned objective function it is harder to prove that they are dismissal. A fourth and related point is that CSR effectively allows managers to select their own objective functions: social policy is then ecided on a rather ad-hoc basis in accordance with managerial whims. It would be better to leave this to an elected and democraticallyaccountable legislature. 9 Notwithstanding the extreme and frequently knee-Jerk hostility which some CSR advocates exhibittowards business, we should not dismiss their arguments out of hand.

Everything that we have said so far is predicated upon the existence of a well-functioning set of legal institutions that can support a comprehensive set of property rights. In some countries the legal institutions are broken or non-existent. If the state provides no guarantee that an employment contract ill be honoured, an employee is not able to auction her skills to the highest bidder as above because, as soon as she is locked in to a single company, it can break its promises and exploit her.

This reduces her incentives to acquire skills, and makes it unlikely that she will be effectively employed. A country with a corrupt 3 Property rights are at the heart of any discussion of corporate governance, and I have argued in recent work with Bill Wilhelm (Morrison and Wilhelm, 2007) that they are central to an understanding of investment banking. 4 In line with the reasoning in this section, economists often refer to her skill set as er human capital: see ?. 5 An enormous literature supports this assertion.

You can fl nd a simple discussion in De Soto (2000). Two of the highlights of the serious academic work in this fl eld are North and Thomas (1973) and Acemoglu, Johnson, and Robinson (2005). 6 Presumably, “other people” is what we mean when we talk about ‘society. ‘ 7 Many of these advocates work for orchestras, and art galleries. 8 i. e. , ‘society. ‘ 9 A polemical expression of the fourth point in this paragraph is ?. A slightly more sympathetic treatment of the topic is due to ? who discusses the problems of an ill- efi ned objective function and suggests that it can be resolved through a concentration upon ‘long-run value maximisation’ is the right way to implement stakeholder theory. JUSTIFYING SHAREHOLDER WEALTH MAXIMISATION justice system cannot guarantee property rights to investors, and it cannot prevent corporations from exploiting their counterparties (‘stakeholders’) without adequately undermine economic activity: in this situation, companies that behave socially responsibly may also be acting socially effl ciently.

Even in developed economies where the Rule of Law obtains property rights are sometimes ll-defl ned. If my company pollutes the air, whose property rights are affected? The answer in general is ‘no-one’s. ‘ Nobody owns the air. If they did they would have the right incentives to keep it clean, and polluters would have to pay for their actions. But, because there is no forum for contracting over pollutants, companies may be able to pollute in pursuit of investor wealth, without any concern for the costs that they impose upon others, which could far exceed the benefi ts their investors derive.

Activities like polluting that are unpriced because we cannot establish property rights over hem are referred to by economists as externalities. The model in fl gure 1 is incomplete: we need to include unpriced externalities. When companies can take advantage of these their classical wealthmaximising objective may not be socially effi cient. What should we do about this? One possibility would be arbitrarily to assign property rights to goods that are currently unpriced.

If the courts could accomplish this then, provided it was easy to negotiate over price and to transfer the rights, the mechanisms that we have already discussed would again ensure that assets were effi ciently allocated. 10 In practice, though, roperty right allocation and transfer may be very hard. If this is the case then we might hope that the government could step in to pass laws that either constrained the activities of corporations, or to ensure that externalities were adequately priced. In short, fl gure 1 had some missing components.

Figure 2 shows a more complete picture. As in fl gure 1, the corporation receives fl nancial capital from investors, and it contracts with employees and suppliers to make goods, its actions have social consequences which are not priced: that is, they have consequences for important assets over which property rights have ot been defl ned. These are indicated in the picture by the dotted box labeled ‘Society. ‘ When property rights are ill-defi ned or undefi nable the government steps in. It does so in two ways.

First, it affects the environment within which the company operates, both by providing a legal infrastructure and by creating a physical infrastructure. These actions are taken in response to the social cost problems of unpriced goodsll and hence appear as a dotted box in fl gure 2. The second government action is to tax: this may be to force companies to pay the social costs of their actions, or for purely political reasons. Both reasons have the same immediate effect upon the corporation: they force it to give some of the cash that would otherwise have gone to investors to the government.

The tax fl ow is indicated in the fi gure as a double arrow from the corporation to the government. How does this discussion leave our investor wealth-maximisation objective function? If governments are not corrupt and they are competent then the effect of their legislation and their taxation will be to force the internalisation of social costs that the company would otherwise ignore. In this case, investor wealth-maximisation by the corporation will be onsonant with social effi ciency, for the reasons discussed above.

I can therefore teach you how to maximise investor wealth with a clear conscience. When governments are corrupt or incompetent, property rights will be insecure, and both legislation and taxation decisions are likely to refl ect the concerns of either the legislators or of their paymasters. In either case, investor wealth maximisation may result in outcomes that diverge signifi cantly from effi ciency. In this case their may be a social argument for some type of stakeholder approach to company management.

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