The Goal of Management There are basic differences in corporate and investor philosophies globally. In this context,the universal truths of finance become culturally determined norms. Copyright 2007 Pearson Addison-Wesley.All rights reserved. 1-6
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-6 The Goal of Management • There are basic differences in corporate and investor philosophies globally. • In this context, the universal truths of finance become culturally determined norms
Shareholder Wealth Maximization In a Shareholder Wealth Maximization model (SWM),a firm should strive to maximize the return to shareholders,as measured by the sum of capital gains and dividends,for a given level of risk. Alternatively,the firm should minimize the level of risk to shareholders for a given rate of return Copyright 2007 Pearson Addison-Wesley.All rights reserved. 1-7
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-7 Shareholder Wealth Maximization • In a Shareholder Wealth Maximization model (SWM), a firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk. • Alternatively, the firm should minimize the level of risk to shareholders for a given rate of return
Shareholder Wealth Maximization The SWM model assumes as a universal truth that the stock market is efficient. An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors,quickly incorporating new information into the share price. Share prices are,in turn,the best allocators of capital in the macro economy. Copyright 2007 Pearson Addison-Wesley.All rights reserved. 1-8
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-8 Shareholder Wealth Maximization • The SWM model assumes as a universal truth that the stock market is efficient. • An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors, quickly incorporating new information into the share price. • Share prices are, in turn, the best allocators of capital in the macro economy
Shareholder Wealth Maximization The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that a firm's shares bring to a diversified portfolio. o Therefore the unsystematic,or operational risk, should not be of concern to investors (unless bankruptcy becomes a concern)because it can be diversified Systematic,or market,risk cannot however be eliminated. Copyright 2007 Pearson Addison-Wesley.All rights reserved. 1-9
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-9 Shareholder Wealth Maximization • The SWM model also treats its definition of risk as a universal truth. • Risk is defined as the added risk that a firm’s shares bring to a diversified portfolio. • Therefore the unsystematic, or operational risk, should not be of concern to investors (unless bankruptcy becomes a concern) because it can be diversified. • Systematic, or market, risk cannot however be eliminated
Shareholder Wealth Maximization Agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model Liberal use of stock options should encourage management to think more like shareholders. If management deviates too extensively from SWM objectives,the board of directors should replace them. If the board of directors is too weak (or not at "arms- length')the discipline of the capital markets could effect the same outcome through a takeover. This outcome is made more possible in Anglo- American markets due to the one-share one-vote rule. Copyright 2007 Pearson Addison-Wesley.All rights reserved. 1-10
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-10 Shareholder Wealth Maximization • Agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model. • Liberal use of stock options should encourage management to think more like shareholders. • If management deviates too extensively from SWM objectives, the board of directors should replace them. • If the board of directors is too weak (or not at “armslength”) the discipline of the capital markets could effect the same outcome through a takeover. • This outcome is made more possible in Anglo- American markets due to the one-share one-vote rule