shareholder wealth optimization essay
Managers are hired to act on behalf of the shareholders of any firm. Nevertheless , this is not always the case as both parties will vary objectives. The difference in passions between shareholders and managers ‘derives from the separation of ownership and control within a corporation’ (Berk and DeMarzo, 2011: 921). Whereas shareholders are interested in maximising their own riches, managers may have more personal interests which in turn differ to this of the investors.
Downs and Monsen (no date, cited in Chin, Cooley and Monsen, late 1960s: 435) claim that managers self-interest lies in increasing their life time income and this ‘such self-interest will be congruent with profit maximisation pertaining to the company only in special cases’.
This conflict between both shareholders plus the managers is termed the agency difficulty. Alongside the agency issue comes organization costs, which can be the costs received to prevent the managers coming from prioritising their interests within the shareholders. It is usually argued the fact that extent that managers will have discretion to pursue actions that are not according to shareholder riches maximization is severely limited.
Yet , this is not constantly the case.
Managers may have got discretion to pursue their objectives ahead of those of the shareholders as there is data asymmetry between the two functions. Berk and DeMarzo (2011: 533) suggest that the managers’ ‘information regarding the company and its foreseeable future cash goes is likely to be superior to that of outside investors’. This statement is reinforced simply by Aboody and Lev (2000: 2749) who assert that ‘managers may continually observe changes in expenditure productivity’. This is certainly a consequence of the responsibilities of manager being to run the business on the day-to-day basis, meaning they will have access to managing and economical accounting data. As a result, managers will be capable to make investment decisions that may maximise all their wealth, with out detection by the shareholders. On the other hand, shareholders ‘obtain only highly aggregated information concerning investment efficiency at discrete points of time’ (Aboody and Lev, 2k: 2749).
Their very own primary source of information about the functionality of the firm is from your annual reviews, whose statistics may be subject to manipulation. Healy and Palepu (2001: 406) argue that, due to information asymmetry and organization conflicts among managers and out of doors investors, there have been a demand intended for such monetary reports and disclosures. While suggested by Healy and Palepu (2001: 408), a potential solution to the information asymmetry problem is ‘regulation that will need managers to totally disclose their private information’. This appears to be a logical and solution, yet , it will not be convenient to carry out as there will be costs involved in the monitoring.
Although managers may be able to go after their own objectives due to asymmetric information between them and the investors, this may be constrained by polices such as the Sarbanes-Oxley Act of 2002. The act was passed carrying out a number of high profile scandals, such as the fall of Enron, with the overall objective of the laws being to ‘improve the accuracy of information given to the two boards and shareholders’ (Berk and DeMarzo, 2011: 931). The work strengthened the criminal fees and penalties for offering false data to shareholders and requires the CFO and CEO to declare the fact that financial transactions are exact. With the work allowing penalties of fees up to $5 million and a maximum of 20 years imprisonment for providing deceptive financial assertions, managers will be more inclined to pursue actions consistent with maximisation of shareholder wealth, as they fear the chance of legal actions being considered against these people if they just do not.
Corporate governance is, to a large extent, a couple of mechanisms by which outside buyers protect themselves against expropriation by the insiders’ (La Apertura et ‘s., 2000: 4). One mechanism that is used to address the firm issue and ensure that managers are acting on behalf of shareholders may be the close monitoring of managers’ actions. Although it may be a basic solution, there are costs included. Berk and DeMarzo (2011: 922) state that as no person shareholder has a incentive to bear these costs, as the huge benefits are in that case divided between all shareholders, they rather elect a board of directors to monitor the managers on their behalf. The directors’ duties contain hiring the executive staff, approving significant investments and acquisitions, and dismissing management if necessary (Berk and DeMarzo, 2011: 922).
The level of monitoring required varies across companies and is ‘based on the magnitude of the motivation gap between principal and agent’ (Beatty and Zajac, 1994, cited in Westphal and Zajac, 1994: 125). However , the key factor impacting on the level of monitoring provided may be the cost, otherwise ‘all logical firms would monitor maximally, irrespective of the strength of motivation compensation legal agreements or additional factors’ (Westphal and Zajac, 1994: 125). Although the board of company directors are hired to keep a detailed eye at the top management, the agency issue may continue to exist. This will occur when the director’s duties in monitoring have been completely compromised because they have cable connections with management.
A way of defeating this problem is always to hire owners who will be independent for the company, because they are deemed being better monitors of bureaucratic effort. Since Mehran (1995: 166) states, outside administrators are ‘more independent of top management and thus better represent the interests of shareholders than do inside directors’. Research has also proved this, exhibiting that firms with panels made up of outside the house directors help to make less value-destroying acquisitions and therefore are more likely to take action in the interest of investors (Byrd and Hickman, 1992, cited in Berk and DeMarzo, 2011: 922).
Monitoring may be a powerful measure intended for ensuring managers’ act in the shareholders’ hobbies, however , Jensen and Meckling (1976, offered in Westphal and Zajac, 1994: 125) ‘stress the primacy of incentive contracting as a first best solution to the agency problem’. Berk and DeMarzo (2011: 921) suggest that the significance of the conflict of interest depends upon how tightly aligned the managers and shareholders’ interests are, which therefore suggests that aligning all their interests will mitigate the conflict. Tries can be built to align these interests by giving incentives intended for acting in the right and punishment to get acting in the wrong. These incentives have to be designed smartly to ensure that they achieve their very own intended objective and may differ for different managers in different companies.
Mehran (1995: 165) suggests that ‘tying managers’ compensation to firm efficiency motivates those to make more value-maximising decisions’. An example of this would be to include commodity to business owners. This would give managers a motivation to increase the stock price, as bureaucratic wealth is actually tied to the wealth of investors. Using these types of incentives works in excuse the company problem as it effectively gives manager’s control in the firm. In the case of Enron, ‘management was heavily paid using inventory options’ (Healy and Palepu, 2003: 13). However , just read was only based on short-term accounting performance. Because of this, Hall and Knox (2002, cited in Healey and Palepu, 2003: 14), through looking at Enron alongside additional firms, enhance the possibility that ‘stock compensation programs as currently designed can encourage managers making decisions that increase short-term stock performance, although fail to create medium- or long-term value’.
Westphal and Zajac (1994: 123) propose that using reimbursement to align supervisor and shareholder interests is definitely ‘potentially a double-edged sword’ as, although it may stimulate managers’ to work in the shareholders’ fascination, ‘linking a manager’s compensation too carefully to firm wealth might lead to risk-avoiding behaviour’ on the manager’s part. This seems rational, as by giving managers title in the firm, their risk exposure boosts. This is because they are now exposed to the firm’s risk, since a firm might not succeed for factors unrelated to the managers’ performance.
References
Aboody, D. and Lev, B., (2000) ‘Information Asymmetry, R&D, and Insider Gains’, The Record of Financing, 55 (6), pp. 2747-2766.
Berk, L. and DeMarzo, P., (2011) ‘Corporate Governance’, In Battista, D. (ed. ) Company Finance, Harrlow: Pearson, pp. 927-931.
Chin, J. S., Cooley, Deb. E. and Monsen, T., (1968) ‘The Effect of Parting of Control and Control on the Overall performance of the Large Firm’, The Quarterly Journal of Economics, 82 (3), pp. 435-451.
Healy, G. M. and Palepu, E. G., (2001) ‘Information Asymmetry, Corporate Disclosure, and the Capital Markets: An assessment the Empirical Disclosure Literature’, Journal of Accounting and Economics, thirty-one, pp. 405-440.
Healy, L. M. and Palepu, K. G., (2003) ‘The Fall of Enron’, Journal of Economic Perspectives, 17 (2), pp. 3-26.
La Apertura, R. et al., (2000) ‘Investor Security and Corporate Governance’, Journal of Financial Economics, fifty eight, pp. 3-27.
Mehran, They would., (1995) ‘Executive Compensation Structure, Ownership and Firm Performance’, Journal of economic Econometrics, 38 (2), pp. 163-184.
Westphal, D. and Zajac, Electronic. J., (1994) ‘The Costs and Advantages of Managerial Offers and Monitoring in Significant U. H. Corporations: When Is more Not really Better? ‘, Strategic Managing Journal, 12-15, pp. 121-142.
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