1.10 Issues Relating to the Maximization of Shareholder Value

Given the movement away from the traditional goal or objective of the firm, it might be important to recognize issues associated with the maximization of shareholder value. The first issue relating to the maximization of shareholder value is the concept of agency costsCosts that are incurred when management does not act in the best interests of shareholders; the costs that result from the principal-agent problem.. Agency costs are defined as costs that are incurred when management does not act in the best interests of shareholders. Most shareholders (or owners) have delegated the responsibility of running the day-to-day operationsThe business function responsible for the production of the good or service being sold. to the firm management. What happens when management has incentives that are different from those of the shareholder? For example, a particular manager might really want to remodel his office on the company’s dime. Does remodeling an office maximize shareholders’ value? Probably not. As a more common example, management might wish to invest capital in particular projects that may not maximize shareholders’ value. A company’s marketingThe business function responsible for generating sales. team may come up with an advertising campaign that might improve salesThe top line of the income statement. The total amount of money a business brings in (before subtracting out any costs). and might even be considered profitable. However, what if capital can be better spent on acquiring new machinery to improve efficiency and, consequently, the bottom line?

Perhaps the following is a more provocative example. Suppose a firm with a large manufacturing facility is located in a small town and employs many of the town’s citizens. However, the products produced in this facility could be sourced from an overseas vendor at a lower per-unit price. Traditionally, the profit-maximizing firm would simply shut down the facility and move on. However, the alternative goal of maximizing value for both shareholders and stakeholders of the firm might require more thought about the viability of the manufacturing facility. Agency costs are real costs, and historically, the way that most firms have mitigated some of these costs is by aligning managers’ interests with shareholders’ interests. Most commonly, management might be compensated with shares of ownership in the company. Therefore, the incentives of managers become aligned with the incentives of shareholders.

The second issue regarding profit maximization or the maximization of shareholder value is the potential effect of focusing solely on profits. Is it good for society to have corporations motivated primarily by profit? There are cases when the pursuit of profit has led to unethical behavior by some. For example, one of the most famous cases in ethics happened in 2001, when the Texas-based energy company EnronA firm that perpetrated one of the largest corporate frauds in history. misreported its financial statements, misled investors, and eventually filed for bankruptcy. Some estimate that more than $10 billion of shareholder value was destroyed because of the scandal. While Enron is an important test case for the unethical maximization of profits, greed and unethical behavior are not always synonymous and should be looked at separately. Think of the benefits that come to society from profitable corporations. Proponents of shareholder capitalism might argue that profitable businesses are efficiently providing goods or services that are demanded by the marketplace. Further, profitable businesses are employing other workers and are providing their employees the means to consume goods and services from other businesses in the economy. The employees’ consumption improves the profitability of other businesses, which leads to the hiring of more employees and so on. Arguably, the benefits that arise from this economy occur because corporations are attempting to maximize profit. However, others might suggest that the negative trade-offs associated with the strict maximization of shareholder value or the laser focus of profit maximization are greater than any potential positive trade-offs.