Reading: Lesson 2 - Value Maximization

1.2.A - Understanding Corporate Value Maximization

1. Value Maximization

1. Shareholders are the owners of a corporation, and they purchase stocks because they want to earn a good return on their investment without undue risk exposure. In most cases, shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis. Because managers are supposed to be working on behalf of shareholders, they should pursue policies that enhance shareholder value. Consequently, throughout this book we operate on the assumption that management’s primary objective should be stockholder wealth maximization
   
2. The market price is the stock price that we observe in the financial markets. We later explain in detail how stock prices are determined, but for now it is enough to say that a company’s market price incorporates the information available to investors. If the market price reflects all relevant information, then the observed price is the intrinsic price, also called the fundamental price.
   
3. Investors rarely have all relevant information. Companies report most major decisions, but they may withhold selected information to prevent competitors from gaining strategic advantages. In addition, managers may take actions that boost bonuses linked to higher current earnings yet actually decrease future cash flows, such as reducing scheduled maintenance. Short-term focus can reduce the intrinsic price but might actually increase the market price if such actions are difficult for investors to discern immediately. Thus, the market price can deviate from the intrinsic price.
   
4. When we say management’s objective should be to maximize stockholder wealth, we really mean it is to maximize the fundamental price of the firm’s common stock, not just the current market price. Firms do, of course, have other objectives; in particular, the managers who make the actual decisions are interested in their own personal satisfaction, in their employees’ welfare, and in the good of their communities and society at large. Still, for the reasons set forth in the following sections, maximizing intrinsic stock value should be the most important objective for most corporations.
   

• Ethical Dilemmas - When conflicts arise between profits and ethics, sometimes legal and ethical considerations make the choice obvious. At other times the right choice isn’t clear. For example, suppose Norfolk Southern’s managers know that its trains are polluting the air, but the amount of pollution is within legal limits and further reduction would be costly, causing harm to their shareholders. Are the managers ethically bound to reduce pollution? Aren’t they also ethically bound to act in their shareholders’ best interests? This is clearly a dilemma.
  
  
• Ethical Responsibility - Over the past few years, illegal ethical lapses have led to a number of bankruptcies, which have raised this question: Were the companies unethical, or was it just a few of their employees? Arthur Andersen, an accounting firm, audited Enron, WorldCom, and several other companies that committed accounting fraud. The U.S. Justice Department concluded that Andersen itself was guilty because it fostered a climate in which unethical behavior was permitted, and it built an incentive system that made such behavior profitable to both the perpetrators and the firm itself. As a result, Andersen went out of business. Andersen was later judged to be not guilty, but by the time the judgment was rendered the company was already out of business. People simply did not want to deal with a tainted accounting firm.
  
  
• Protecting Ethical Employees - If employees discover questionable activities or are given questionable orders, should they obey their bosses’ orders, refuse to obey those orders, or report the situation to a higher authority, such as the company’s board of directors, its auditors, or a federal prosecutor? In 2002 Congress passed the Sarbanes Oxley Act, with a provision designed to protect “whistle-blowers.” If an employee reports corporate wrongdoing and later is penalized, he or she can ask the Occupational Safety and Health Administration to investigate the situation. If the employee was improperly penalized, the company can be required to reinstate the person, along with providing back pay and a sizable penalty award. Several big awards have been handed out since the act was passed.

2. Intrinsic Stock Value Maximization and Social Welfare

1. If a firm attempts to maximize its intrinsic stock value, is this good or bad for society? In general, it is good. Aside from such illegal actions as fraudulent accounting, exploiting monopoly power, violating safety codes, and failing to meet environmental standards, the same actions that maximize intrinsic stock values also benefit society.
   
2. Most individuals have a stake in the stock market. Seventy-five years ago this was not true, because most stock ownership was concentrated in the hands of a relatively small segment of society consisting of the wealthiest individuals. More than 44% of all U.S. households now own mutual funds, as compared with only 4.6% in 1980. When direct stock ownership and indirect ownership through pension funds are also considered, many members of society now have an important stake in the stock market, either directly or indirectly. Therefore, when a manager takes actions to maximize the stock price, this improves the quality of life for millions of ordinary citizens.
   
3. Consumers benefit. Stock price maximization requires efficient, low-cost businesses that produce high-quality goods and services at the lowest possible cost. This means that companies must develop products and services that consumers want and need, which leads to new technology and new products. Also, companies that maximize their stock price must generate growth in sales by creating value for customers in the form of efficient and courteous service, adequate stocks of merchandise, and well located business establishments.
   
4. Employees benefit. In some situations a stock increases when a company announces plans to lay off employees, but viewed over time this is the exception rather than the rule. In general, companies that successfully increase stock prices also grow and add more employees, thus benefiting society. Note, too, that many governments across the world, including U.S. federal and state governments, are privatizing some of their state-owned activities by selling these operations to investors. Perhaps not surprisingly, the sales and cash flows of recently privatized companies generally improve. Moreover, studies show that newly privatized companies tend to grow and thus require more employees when they are managed with the goal of stock price maximization.
   

3. Managerial Actions to Maximize Shareholder Wealth

1. What determines a firms value? A company's ability to generate cash flows now and in the future. (1) Any financial asset, including a company’s stock, is valuable only to the extent that it generates cash flows. (2) The timing of cash flows matters—cash received sooner is better. (3) Investors are averse to risk, so all else equal, they will pay more for a stock whose cash flows are relatively certain than for one whose cash flows are more risky. Therefore, managers can increase their firm’s value by increasing the size of the expected cash flows, by speeding up their receipt, and by reducing their risk.
2. The cash flows that matter are called free cash flows (FCF), not because they are free, but because they are available (or free) for distribution to all of the company’s investors, including creditors and stockholders.
3. Brand managers and marketing managers can increase sales (and prices) by truly understanding their customers and then designing goods and services that customers want. Human resource managers can improve productivity through training and employee retention. Production and logistics managers can improve profit margins, reduce inventory, and improve throughput at factories by implementing supply chain management, just-in-time inventory management, and lean manufacturing. In fact, all managers make decisions that can increase free cash flows.
4. One of the financial manager’s roles is to help others see how their actions affect the company’s ability to generate cash flow and, hence, its intrinsic value. Financial managers also must decide how to finance the firm. In particular, they must choose the mix of debt and equity to use and the specific types of debt and equity securities to issue. They also must decide what percentage of current earnings to retain and reinvest rather than pay out as dividends. Along with these financing decisions, the general level of interest rates in the economy, the risk of the firm’s operations, and stock market investors’ overall attitude toward risk determine the rate of return required to satisfy a firm’s investors. This rate of return from an investor’s perspective is a cost from the company’s point of view. Therefore, the rate of return required by investors is called the weighted average cost of capital (WACC).