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Financial Management and the Agency Theory

Shareholder Wealth Maximization as an organizational goal for private firms

Essay 2013 10 Pages

Business economics - Investment and Finance

Excerpt

Table of Content:

1. Approach

2. Shareholder’ wealth maximization as an organisational goal for private firms and its link to the agency theory

3. The Concept of Cost of Capital and how it is derived

4. Critical analysis of the sources of capital

5. Conclusion

1. Approach

In Financial Management it´s generally assumed that the goal of a private firm is shareholder wealth maximization respectively maximizing shareholder value (ACCA BPP, 2012, p. 5). This assumption correspond with a recent statement of Philip Clarke (2013) - Chief Executive Officer of Tesco who declared that ‘[e]verything [they] are doing reflects [their] determination to deliver shareholder value’. The question arises if shareholder wealth maximization is an appropriate goal since there are other individuals besides the shareholders that are affected by the activities of a firm. Another point is that managers often do not act in shareholders best interest in order to maximize their own utility. This conflict of interest is described by the agency theory. Furthermore the agency relationship complicates the achievement of the goal of shareholder wealth maximization (Van Horne and Wachowicz, 2009, p.5).

Recently shareholders of the former Yellow Pages publisher Hibu blame the management not to act in their best interest because of both a lack of information provided by directors and by restructuring the company with a debt-for-equity swap that wipes shareholders out. As a consequence of Hibu’s oppressive debt mountain the debt-for-equity swap enables major lenders to take control over the company (Spanier, 2013). In this context the concept of cost of capital and its calculation provides an approach to the costs of financing decision. (McLaney, 2011,p.296). Since the debt-for-equity swap restructures Hibu´s balance sheet it is of crucial importance to examine the sources of capital that are discussed in this context in order to evaluate the reasonableness of the debt-for-equity swap from a economical perspective.

Section 1 of this assignment focuses on the characteristics of shareholders’ wealth maximization as an organizational goal of management and discusses its link with the Agency Theory. Section 2 gives an insight into the concept and the calculation of cost of capital. The 3rd section critically evaluates the different sources of capital discussed in the previous section. The last section summarizes the main points of the assignment and provides a conclusion.

2. Shareholder’ wealth maximization as an organisational goal for private firms and its link to the agency theory

Although there is no precise definition of shareholder wealth maximization the market price of shares gives a very good approach to the extent of shareholder´s wealth since it generally represents the current market value of a corporation and can therefore be put on a level with the wealth of its owners – the shareholders (Van Horne and Wachowicz, 2009, pp. 3-5). Assuming that the current share price represents shareholder’s wealth, management’s decisions should lead to rising share prices as well as dividend growth in order to create shareholder value (ACCA BPP, 2012, p. 9).

Basically the assumption that private firms try to maximize the wealth of their shareholders is very straightforward since they are actually the present owners of the company. So, at first view shareholder wealth maximization seems to be an appropriate organizational goal since it corresponds with the objective of the owners of the corporation. Furthermore since the share price reflects management´s performance of creating shareholder value the achievement of the objective can be measured easily. However, creating shareholder wealth as a primary financial objective is a very complex issue since there are other stakeholders that are affected by the firm´s activities (ACCA BPP, 2012, p. 14). Tesco’s CEO Philip Clarke defines creating shareholder value as “an appropriate balance between investing for future growth, and delivering sustainable returns for […] shareholders” (2013). Especially the future growth of every company does not only depend on its shareholders but heavily depends on all other stakeholders. For instance without clever management decisions, motivated employees, satisfied suppliers and customers hardly any firm could be successful. So it´s absolutely necessary for management to consider the stakeholders while making decisions. The question arises if it is probably more reasonable to focus on the interest of all stakeholders instead of only focusing on the shareholders (McLaney, 2011, pp.21-23). Theories such as corporate social responsibility (CSR) underline these thoughts stressing the importance of considering the interest of stakeholders in order to achieve the overall goal of shareholder wealth maximization (Van Horne and Wachowicz, 2009, pp. 5-6).

Nevertheless this leads to a conflict of interests since on the one hand management tries to maximize shareholder wealth but on the other hand they have to consider their own interests as stakeholders of the firm. In order to maximize their utility mangers may rather follow their own interest instead of trying to reach the goal of shareholder wealth maximization (ACCA BPP, 2012, p. 16). This conflict of interest is called an agency problem caused by the separation of ownership and control between shareholders and managers. The Agency Theory was introduced by Jensen and Meckling in 1976. It argues that managers as agents of the shareholders are generally supposed to act in the best interest for the owners of a company. However, since they are running the day-to-day business they can take actions that are not in the best interest of the shareholders (principals) in order to maximize their own utility (Pike and Neal, 2003, pp.13-16). To assure that managers act in the best interest of the shareholders they have to be monitored and appropriate incentives have to be given. The monitoring process includes the audit of financial statements as well as limiting management´s decision-making power and perquisites. Furthermore the Board of Directors is a proper instrument to assure that corporate management acts in shareholders’ interest (Van Horne and Wachowicz, 2009, pp. 5-8). Especially stock option plans seem to be the most appropriate method to bond the management to the goal of shareholder wealth maximization since this measure makes managers themselves to shareholders. So the managers benefit from rising share prices as well and therefore they are presumable going to be more likely to focus on the creation of shareholder value. As a result the more stocks mangers hold the higher the probability that they´re going to pursue the goal of shareholder wealth maximization (Van Horne and Wachowicz, 2009, p. 5).

As a consequence of a huge takeover in 2006 former Yellow Pages puplisher Hibu loaded its balance sheet up with debt (Armitage, 2013). Besides the rising market share of search engines such as Google and Yahoo undermined Hibu`s core business. Therefore the company recently defaulted on loan payments and the management was forced to agree on a debt-for-equity swap with Hibu´s creditors in order to avoid a bankruptcy (Kortekaas and Mance, 2013). Shareholders are upset about this agreement since it wiped shares in the company out and shareholders blame the management of Hibu not to act in their best interest. Hibu´s share price declined by almost 100% (Image1). The shareholders accuse the management to default on loan payments although there were sufficient funds available (Spanier, 2013). Furthermore they blame the mangers having paid bonuses to staff although they missed loan payments (Spanier, 2013). It seems like the shareholders could not make the management act in their interest since shareholder wealth decreased almost a 100%. Maybe the shareholders didn´t monitor the managers properly. Presumably there were too less motivation for the management – like stock option plans that encouraged them to take the right decisions. In the end debt holders benefit most since they are now in charge of the company most of them bought the debt capital cheaply (Gribben, 2013).

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Details

Pages
10
Year
2013
ISBN (eBook)
9783656614944
ISBN (Book)
9783656614920
File size
516 KB
Language
English
Catalog Number
v270125
Institution / College
University of New South Wales, Sydney
Grade
A15 bzw. 1,0
Tags
financial management agency theory shareholder wealth maximization

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Title: Financial Management and the Agency Theory