Question

PURPOSE

To describe how the goals of a corporation, agency problem and maximising the value related to the operation of a business.

REQUIREMENT

You are required to search at least five (5) journal research articles related to managerial finance goal and value maximisation. Based on these research articles, you are required to answer the following questions:

4.Explain, should managers exploit other stakeholders to pursue shareholder wealth maximization. (1000 words)

Answer 1

The financial planning profession is built on helping people accomplish goals. While investing appropriately is generally an important part of accomplishing a goal, achieving a goal often requires advice beyond selecting investments based on alpha and beta.

•Past research on the topic of goals-based financial planning has focused primarily on determining optimal portfolios to fund different types of goals. In contrast, the focus of this research is how to determine which goals should be funded, as well as how to optimally save toward goals over time.

•A utility model based on prospect theory was used to determine the optimal funding strategy for a household.

•The results suggest that using a goals-based framework to determine which goals to fund and how to fund them can lead to an increase in utility-adjusted wealth of 15.09 percent for a hypothetical household versus a naïve strategy focused only on funding retirement. This is equivalent to generating an annual alpha of 1.65 percent for the lifetime of the base scenario household.

Financial planning is a goals-based profession. Financial planners help clients determine how to accomplish their goals through advice and guidance on a variety of topics, such as saving, investing, and risk management. While investing well is generally an important part of the process of accomplishing a goal, achieving a goal often requires advice beyond building appropriate portfolios (beta) and selecting investments that are expected to outperform their peers on a risk-adjusted basis (alpha).

From a goals-based perspective, a problem with a CRRA utility function is it implies that the majority of utility achieved from accomplishing a goal (assuming that c is substituted for the percentage of the goal completed in equation 1) can be obtained from partially completing the goal. For example, if a risk aversion level (y) of 4 is assumed, approximately 80 percent of the total utility from accomplishing a goal would be obtained from only accomplishing 50 percent of the goal. Therefore, if a client is faced with multiple goals but lacks the resources to fully fund all of them, a CRRA utility approach would imply the client should partially fund each goal rather than choosing to fully pursue certain goals. Taken to the extreme, an individual would only fund a goal if all the other goals were also fully funded. This seems inconsistent with how most people would choose to allocate resources when faced with competing goals and limited resources.

To make the goals relative, especially those that occur over multiple periods, the net present value of each goal was estimated using a real discount rate of 2 percent. If an individual has a higher subjective discount rate, this preference with respect to a goal would manifest itself via the preference factor in the current model, although an alternative approach would be to incorporate it in the discount rate.

The total utility achieved from accomplishing each goal can be obtained by multiplying the net present value of the cost of the goal by the certainty-equivalent goal completion percentage. The total utility achieved across all goals would be the summation of these values—this is called the utility-adjusted completion score. The goal for each individual would be to maximize the utility-adjusted completion score.

The return assumptions are based off the 2014 Ibbotson long-term capital market assumptions.

The entire analysis is in real terms, so all monies are adjusted to today’s dollars. The base scenario assumes the 401(k) is invested in an 80 percent stock portfolio, where the equity allocation decreases by 1 percentage point per year for the entire simulation; that the 529 is invested in a 60 percent stock The

Behavioral research suggests that goal attainment can be best achieved through first establishing a concrete goal and then setting achievable short-run goals that over time produce the long-run goal. For example, a client may set a goal of reducing credit card debt or total spending by $500 a month. In addition, automatic savings techniques that do not require active saving can be used to ensure that the client does not feel the impact of the reduction. Salary deferral or scheduled electronic transfers from a liquid account into a savings account may be more effective than relying on the long-term goal to motivate clients to make active saving decisions.

Correctly conceptualize risk. When thinking about risk, it is common to focus on risk preference or how a client feels about taking risk, which is commonly proxied through a risk tolerance questionnaire. The other important component of risk is risk aversion, which is the amount of risk an individual should take given available resources.

Build smarter portfolios. It may be operationally simple to have a single allocation for each equity risk level, but in reality, different goals have different risks that should be incorporated into the portfolio optimization routine. For example, a younger individual may be interested in maximizing return per unit of risk, and an older individual may be more focused with maximizing return per unit of risk after considering inflation. These two different approaches can lead to materially different portfolio allocations.

Incorporate new technology solutions. Implementing a goals-based approach requires that a financial planner incorporate a variety of new technology solutions for things like determining how to optimally fund goals, how to build efficient portfolios over time, how to monitor progress, as well as how to communicate all this to clients. As such, an active interest in technology solutions is necessary to fully capture the benefits of goals-based planning.

A utility model based on prospect theory was presented here to help planners determine the optimal funding strategy for a household, based on the unique preferences and financial situation of that household. The optimal strategy provides guidance on which goals should be funded, as well as how to save toward those goals over time. Certain goals, like retirement, can

be decomposed where the household is assumed to have varying levels of preference with respect to replacing different amounts of income.

The results of the analysis suggest that using a goals-based framework to determine which goals to fund and how to fund them can lead to an increase in utility-adjusted wealth of 15.09 percent versus a naïve strategy. This is equivalent to generating an annual alpha of 1.65 percent for the lifetime of the base scenario household. These potential gains suggest there is a significant amount of value using a goals-based financial planning approach that extends beyond traditional asset management decisions.

The shareholder theory was originally proposed by Milton Friedman and it states that the sole responsibility of business is to increase profits. It is based on the premise that management are hired as the agent of the shareholders to run the company for their benefit, and therefore they are legally and morally obligated to serve their interests. The only qualification on the rule to make as much money as possible is “conformity to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

The shareholder theory is now seen as the historic way of doing business with companies realising that there are disadvantages to concentrating solely on the interests of shareholders. A focus on short term strategy and greater risk taking are just two of the inherent dangers involved. The role of shareholder theory can be seen in the demise of corporations such as Enron and Worldcom where continuous pressure on managers to increase returns to shareholders led them to manipulate the company accounts.

Stakeholder theory, on the other hand, states that a company owes a responsibility to a wider group of stakeholders, other than just shareholders. A stakeholder is defined as any person/group which can affect/be affected by the actions of a business. It includes employees, customers, suppliers, creditors and even the wider community and competitors.

Edward Freeman, the original proposer of the stakeholder theory, recognised it as an important element of Corporate Social Responsibility (CSR), a concept which recognises the responsibilities of corporations in the world today, whether they be economic, legal, ethical or even philanthropic. Nowadays, some of the world’s largest corporations claim to have CSR at the centre of their corporate strategy. Whilst there are many genuine cases of companies with a “conscience”, many others exploit CSR as a good means of PR to improve their image and reputation but ultimately fail to put their words into action.

Recent controversies surrounding the tax affairs of well known companies such as Starbucks, Google and Facebook in the UK have brought stakeholder theory into the spotlight. Whilst the measures adopted by the companies are legal, they are widely seen as unethical as they are utilising loopholes in the British tax system to pay less corporation tax in the UK. The public reaction to Starbucks tax dealings has led them to pledge £10m in taxes in each of the next two years in an attempt to win back customers.