Question

1. Identify the primary goal of the management of a publicly held corporation, and understand the relationship between stock prices and shareholder value. Briefly explain the conflicts between managers and stockholders, and explain useful motivational tools that can help to prevent these conflicts.

Answer 1

A publicly held corporation is that organisation which raises its capital for continuing & growing business operations from the share markets through an issue of Initial Public Offering. Hence, the main feature of a publicly held organisation is that it is owned by the shareholders and run by the appointed management. A corporation has a separate legal entity and thus can take business decisions and make investments on its own. However, each shareholders liability is limited to the amount of his/her shareholding.
Earlier the primary goal of the management of a company was profit/EPS maximisation. However, in the present times, it has been replaced by shareholder’s wealth maximisation, since the shareholders are the owners of the company. The main shortcomings of the profit maximisation objective as the operational decision criteria are: - 1) it doesn’t take into account the uncertainty of risk over a long period of time, 2) it ignores the time value of money, 3) its computations may sometimes become ambiguous.
The management’s primary goal is shareholder’s wealth maximisation & thus increase the company value because they invest in the company to get returns from the share price appreciation and/dividends.

Two important issues are related to the share price/value maximisation. They are:-

Economic value Added – EVA is used by most of the firms nowadays to determine whether an investment positively contributes to the shareholder’s wealth. A positive EVA increases the shareholders wealth/value. EVA is equal to after tax operating profits less the cost of funds used to finance the investments.

The focus on other stakeholders – Besides shareholders, the other stakeholders of an organisation are like employees, creditors, suppliers, customers who have direct link with an org. The shareholders wealth maximisation goal also includes taking those actions that preserve the wealth of these stakeholders also, the stakeholders are considered as a part of its corporate social responsibility and their interests must be protected by maintaining a positive stakeholder relationship which would minimise stakeholder’s turnover, litigations & conflict. Then only a firm can achieve its goal of shareholders wealth maximization with the cooperation of other stakeholders.
In corporate social responsibility another stakeholder of a public company is the society at large. Hence, the companies nowadays contribute to charity, build schools, healthcare facilities and contribute to environment conservation.

The other goals of the management of a public company include the following:-

Profit generation – when a company generates revenue through its business, it share prices appreciates in the stock market and the shareholders get dividend as well. However, the corporate losses only erode the shareholders value.

Growth of operations – as a company expands its operations that only contribute to share price maximisation.

Stability – The stable & consistent quarterly income of a company generates confidence among investors. The managers should consistently improve the quality of its products & services in order to remain competitive in the market as well as retain and attract more customers.

Relationship between stock prices and shareholder value

Increasing the shareholders value is increasing the total amount of the stockholders equity in the company’s balance sheet. The management of a company tries to increase the Earning per share which is defined as a ratio of the earning available to the equity shareholders divided by the total equity share outstanding. When the company’s earnings increases, the EPS increases, and hence its value increases in the eyes of the investors.

The shareholders value maximisation also depends upon the sound operational decision taking capability of the management. If the management can take proper investment decisions which will generate positive ROI, then over longer period of time, company’s share price will increase as well as the amount of dividend payout also. Merger & acquisitions also sometimes increases the share price hugely.
The management’s ability to increase the company’s sales turnover, revenue, total free cash flow ultimately increases the share price of the company. Hence the equity shareholders actually derive their value from the increase in the dividends & the capital gains.
The company also invests the capital provided by the shareholders in buying assets. An efficient co. management would use these assets to increase sales and to invest in projects with positive ROI, which in turn would increase the firm’s value.
Having a positive free cash flow also increases shareholders value because that means a company can run smoothly without the need of issuing more stock or raising more debt. The company can increase cash flow by quickly converting inventories & accounts receivables into cash. Hence, a high inventory turnover ratio and accounts receivables turnover ratio also increases shareholders value.

Conflicts between managers & stockholders

A key feature of a public company is the separation between ownership & management. The stockholders appointed board of directors and the management is responsible for the smooth business operations of the company. Since the ownership of a public co. is widely diffused & scattered, it is not possible for the shareholders to have a regular oversight of company business. This may entice the management to act in its own interest rather than those of the owners. This gives rise to the conflict of interest between the shareholders and the management which is also known as the agency problem. Agency problem mainly occurs when the management has its personal goals to achieve other than the goal of shareholders wealth maximisation. The management for example, may for their personal interests buy other companies to expand power, get into fraud by manipulating annual financial performance figures to optimize bonuses & other stock price related options etc.

Tools for resolving agency problem

Market Forces

Security market Participants – The security market participants mainly the equity shareholders and large institutional investors like mutual funds, insurance cos., financial institutions can but large blocks of the company shares to actively participate in the management. In the recent times to ensure competent management & minimise agency problems, the shareholders have exercised their voting rights to replace the underperforming management with a more competent one.

Hostile takeover – This is another market force that has compelled the management to perform in the best interest of the shareholders. The acquisition of a target firm by another firm (acquirer) is never supported by the management because that threatens their existence. The threat of hostile takeover arises when the target firm is undervalued due to its poor management & its acquisition is possible due to its low current market share price. The acquirer often restructures the co. in terms of its management, operations & financing.

Agency Costs: - In order to prevent agency problems, the shareholders have to incur different types of agency costs:-

Monitoring expenditures: - these expenditures are incurred to monitor the performance of the management in the form of payment to the auditors of the annual reports & other control procedures to keep corporate corruption in check.

Bonding expenditures: the firm may purchase a fidelity bond from a third party that would protect the investors from the financial consequences of the dishonest act by the company management.

Structural expenditure: they relate to structuring management compensation so as to motivate the management to work in the interest of the shareholders. The objective is to offer incentives, fair value compensations to the management for their performance. The restructured higher compensation packages would enable the company to hire the best available managers.

Incentive plans – These tie the management compensation to the share price. Example, the Employee stock option plan (ESOP) which confers the management the right to acquire the shares of the company at a concessional price on a later date. Hence, a higher future share price would increase the management compensation.

Performance plans – These compensate management on the basis of its proven performance measured by EPS, growth in EPS and an increase in the ROI. Based on these performance indicators, performance shares are given to the management for meeting the specified goals. Also cash bonuses & other perks can be paid to the managers for their positive achievements.