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Corporate Objectives Article

Corporate Objectives Article



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Published by theshahzad
This Article challenges the traditional view of Corporate Finance Objective by Simon Kean a Professor at University of Glasgow
This Article challenges the traditional view of Corporate Finance Objective by Simon Kean a Professor at University of Glasgow

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Categories:Business/Law, Finance
Published by: theshahzad on Apr 28, 2009
Copyright:Attribution Non-commercial


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Simon Keane
This chapter challenges a fundamental assumption of financetextbooks - that a company’s goal should be to increase its share price and thatmanagement should be judged by their success in doing so. The assumption hasbecome so entrenched in finance theory that it seems unassailable, but it will beargued here that it is based on a simple error, so simple that, once understood, it isdifficult to understand how the idea of share price maximisation has persisted for solong. To understand how the error has arisen it is necessary to have regard foranother fundamental assumption of finance, that the securities market is reasonablyefficient in pricing a company’s future growth potential. The chapter will concludethat it is possible to believe either that share price maximisation is a credibleobjective or that the securities market is rational, but not both.
The purpose of this chapter is to present a case for concluding that theconventional share-price maximising rule is fundamentally flawed. It will be argued that:
After a company’s shares have been floated in the market, even the mostsuccessful companies cannot expect to increase their share price beyondthe normal rate of growth,
The appropriate goal for companies is to “maximise the value of the firmsubject to maximising the share price”, where the share price acts as aconstraint on management behaviour rather than as the target of management activity.
Managerial performance should not primarily be assessed or rewarded byreference to the company’s share price performance.
The share-price maximising rule has fostered an attitude of indifferenceto zero-NPV projects, which creates a propensity to underinvest.
Emphasis on abnormal share price growth as the benchmark of managerial performance creates a potential bias in financial reporting.
The goal of corporate enterprises is generally stated to be the maximisationof shareholder wealth, and this in practice is usually equated with share pricemaximisation (
). The logic underlying the practice of equating wealth-maximisation with share price growth is that, if a company undertakes asuccession of positive-NPV decisions throughout its life, thus generatingadded wealth for shareholders, the share price should follow suit and riseaccordingly. The share price in effect will respond to the firm’s capitalinvestment decisions. The greater the number and value of the positive NPVs the greater the rise in the share price. The standard assumption,therefore, is that more efficient managers will tend to generate greater share price growth than less efficient managers. Hence management should beencouraged to maximise share price growth and should be judged andrewarded accordingly. The conventional view is illustrated in Figure 1.Growth in the per share value of the underlying productive assets of thecompany is approximately matched by growth in the share price.We are now going to show that this logic can be valid only if themarket is exceedingly inefficient. Before doing so, however, we need toemphasise that there are two markets involved in the process of shareholder-wealth creation, the
product market
(in which firms undertake realinvestments such as the manufacture of cars or computers), and the
securities market
(in which the shareholders finance and trade their claimsto the companies that own the productive assets). The conventional view is based on the assumption that asset values in these two markets move intandem, and we are going to show shortly why this cannot be so.
The second point to be emphasised is that there are two kinds of share price growth,
results from inflation and the retention of earnings,and possibly from general market growth caused by say systematic declinesin the risk premium. Inflation is outside the control of management andretained earnings are simply the residual of the dividend payout. Likewise,the market price for risk is determined by factors outside the control of individual companies. The combination of normal growth in the share priceand dividends provide the normal rate of return to investors. In an efficientmarket all shares are priced to give an expectation of the normal rate of return and, therefore, an expectation of normal growth.
arises when shareholders receive added valueabove the normal rate of return. Thus, if a positive NPV project undertaken by the firm feeds through to the share price this is abnormal growth. It isabnormal growth that is at issue here. When the textbooks suggest thatmanagement should seek SPM they mean they should seek to achieveabnormal growth. Otherwise managers would be motivated to retain allearnings and keep dividends to a minimum.It might seem that defining growth in the share price resulting fromretained earnings as normal is misleading since a company may earn andretain
earnings from its investments. Does adjusting share pricegrowth for retention of abnormal earnings not conceal abnormal share pricegrowth? The answer is no, because abnormal share price growth does notresult from
abnormal earnings, but from the
abnormal earningsthemselves
. For example, assume that a new company is expected to earn15% on every pound it invests when the normal rate of return is 10%. Its £1shares will be valued at 150p, an abnormal growth rate of 50%. If, after thefirst year, the company pays out its abnormal earnings of 15p in dividends,shareholders will earn 15p/150p = 10%, the normal return for the risk class.If the company instead decided to retain its abnormal earnings of 15p, theshares would then be priced at 165p. The growth in the share price from150p to 165p is, again “normal”, being 10%. Therefore, adjusting thegrowth in the share price for retained earnings, whether normal or abnormal,to determine whether there is any abnormal growth is perfectly valid. In thisexample the abnormal growth is zero whether the company pays or retainsits abnormal earnings.

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