The Objectives in Corporate Finance Dr. Himanshu Joshi FORE School of Management New Delhi

Why Corporate Finance focuses on Stock Price Maximization? Stock prices are the most observable of all measures that can be used to judge the performance of a publicly traded firm. unlike earnings or sales which are updated once every quarter or year, stock price are updated constantly to reflect new information coming out about the firm. Thus managers receive instantaneous feedback on every action they take from investors in markets.

Why Corporate Finance focuses on Stock Price Maximization? Stock prices in a market with rational investors, reflect the long term effects of the firm’s decisions. Even if market err in their estimates. Erroneous estimate of long term value is better than a precise estimate of current earnings because stock price reflects future and is based on all available information.

Why Corporate Finance focuses on Stock Price Maximization? Stock price is the real measure of stock holder wealth, since stock holders can sell their stock and the receive the price now.

When is stock price maximization the only objective a firm needs? Although, this single mindedness sounds extreme and may actually be damaging to other claim holders in the firm (lenders, employees, and society) it is appropriate if the following assumptions hold:

Stock holders Managers Bond Holders Financial Markets Society Hire and fire managers Boards/Annual Meetings Maximize Stock holders Wealth Reveal information honestly and on time Markets are efficient and assess effect on value No Social Cost Costs can be Traced to the firm Lend money Protect bondholder interest

Assumptions: 1. The managers of the firm put aside their own objectives and focus on maximizing stockholder wealth measured by stock price. Managers are terrified of the power of stockholders to replace them. They own enough stock in the firm that maximizing stockholder wealth becomes their primary objectives.

Assumptions.. The lenders to the firm feel secure that their interests will be protected and the firm will live up to its contractual obligations. Stockholders might be concerned about the damage to the firm’s reputation if they take actions that hurt the lenders and about the consequences of that damage for future borrowings. The lenders might be able to protect themselves fully when they lend by writing in restrictions that proscribe the firm’s taking any actions that hurt the lenders.

Assumptions.. 3. The managers of the firm do not attempt to mislead or lie to financial markets about their future prospects. and There is sufficient information for markets to make judgments about the effects of the firm’s actions on its value.

Assumptions.. 5. There are no burdens that are created for society, in the form of health, pollution, or infrastructure costs, in the process of stockholder wealth maximization. All costs created by the firm in its pursuits of stockholders wealth maximization can be traced to and charged to firm.

Why stock price maximization works Stockholders hire managers to run their firms form them… Because stockholders have absolute power to hire and fire managers. Managers set aside their interests and maximize stock price… Because markets are efficient. Stockholders wealth is maximized.. Because lenders are fully protected from stockholders actions Firm value is maximized… Because there are no cost created for society Societal wealth is maximized…

Agency Costs The core of the problem is that stockholders, managers, bondholders, and society have different interests and incentives. Consequently, conflicts of interests may arise between these different groups. These conflicts create costs for the firm that are called agency costs, and these costs can result into stock price maximization going into awry.

Conflict Groups Stockholders and Managers Stockholders and Bondholders The firm and Financial Markets The firm and Society

Stock Price Maximization with Agency Costs Managers, given the limited powers of stockholders have over them, may not make decisions to maximize stockholder wealth but may instead choose to further their own interests. Stockholders, if not restricted contractually, may increase stock price by transferring wealth from those who lent them money.

Stock Price Maximization with Agency Costs.. Firms may increase stock prices by feeding misleading or fraudulent information to markets that do not efficiently assimilate the information in the first place. Finally, firms can create substantial costs for society while they focus on maximizing stock prices.

Stock holders Managers Bond Holders Financial Markets Society Have little control over managers Managers put their own Objectives above stockholders Delay bad news or provide misleading information Markets make mistake and can overreact Significant Social Cost Some Costs can not be traced to the firm Lend money Bondholders can be exploited

Corporate Governance??

Wealth Maximization Vs. Stakeholder’s Theory It is logically impossible to maximize in more than one direction, purposeful behaviour requires a single valued objective function. Two hundred years of work in economics literature implies that in absence of externalities, (when all goods are priced), social welfare is maximized when each firm in economy maximizes its total market value. Total value is not just the value of the equity, but also includes the market values of all other financial claims, including debt, preferred stocks, and warrants.

Wealth Maximization Vs. Stakeholder’s Theory Stakeholder’s theory, argues that managers should make decisions so as to take account of interest of all stakeholders in a firm (including not only financial claimants but also employee, customers, communities, government officials, and under some interpretations the environment, the terrorists, and thieves). Because the advocates of then stakeholder’s theory refuse to specify how to make necessary tradeoffs among these competing interests, they leave managers with a theory that make it impossible for them to make purposeful decisions. With no way to keep score, stakeholder theory makes managers unaccountable for their actions.

So Why Stakeholder’s theory is so popularly accepted by managers and directors?