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Ethics in Finance


Shareholder Wealth Maximization


Shareholder Wealth Maximization defined (SWM): immediate operating goal and the ultimate purpose of a public corporation is and should be to maximize return on equity capital Investors and managers should narrowly focus on SWM Why? SWM is expected to yield the most socially efficient allocation of capital


Ethical Issues

What is the social purpose of a corporation How are interests of shareholders, managers and society at large reconciled Can SWM and corporate social responsibility (CSR) be aligned? Can CSR trump SWM and be justified on the basis of ethics or the generation of social benefits beyond shareholders


First public corporations were joint stock companies formed in the 17th and 18th centuries relatively recent development Legal liability of shareholders limited to capital invested Private property rights are the foundation of market capitalism The stewards of private capital, the managers, are not to be liable except for gross negligence or willful misconduct. Shareholders are typically wide group with limited rights of control


SWM principle arises from agency theory separation of ownership and control SWM also justified by economic efficiency capital allocated to highest expected return. SWM principle also recognizes the public company as a nexus of contracts
Agents are in a position of trust Must safeguard assets SWM must consider both risk and return Agents/managers allowed discretion to exercise business judgment

Measures of SWM

Share Price - shareholder wealth defined as the market capitalization of a public company no. of outstanding shares multiplied by share price Market capitalization is just a market estimate
Higher EPS increases price per share Market cap reflects potential future earnings Can be used to justify additional investments

Market capitalization is an artificial construct of the subjective valuation by buyers and sellers
Artificial bubbles in valuation form Free cash flow vs. real cash flow can be manipulated Stock price may not fully reflect value of shares

Measure of SWM

Cash flow: Earnings per share EPS Profit (net income) can be accrued and subject to accounting manipulation Free cash flow shows real returns Negative cash flows could reflect investment in capital projects with future returns Economic Value Added (EVA): Is firm earning more than its cost of capital Deduct the opportunity cost of next best return i.e. risk free govt bond Economic profit only starts when capital cost is recovered

Justifications of SWM Principle

Management has strong fiduciary duties on behalf of shareholders:

Agent acts voluntarily to act in shareholders best interests Duties established and enforced by law Shareholders retain ownership of assets and revenues support for private property Utilitarianism free movement of capital promotes wealth and benefits all. Free markets outperform alternative measures.

Critiques of SWM Principle

Managers require discretion in conduct of their duties:

business judgment rule Must prioritize competing interests of stakeholders Importance stakeholder group varies over time Competition of interests conditions are fluid

Is SWM principle binding in law?:

No, but SWM has primacy Prescriptive standard for evaluating D&O conduct D&O may exercise discretion and not always implement SWM Charitable donations, legal compliance and public welfare

Shareholder primacy challenged

Not true ownership because of separation of ownership , control and influence

Critiques of SWM Principle

Management discretion to sacrifice corporate profits in the public interest is necessary, independent of law, and SWM, actually practiced, would override social and moral sanctions on corporate misconduct - Elhauge 2005

Critiques of SWM Principle

Corporation as corporate citizen philanthropy

Does this compromise the agency principle? Polluters a largest charitable contributors corporate social legitimization vs. corporate citizenship Philanthropy as long term benefit

Maximizing short term financial performance

At cost to long term benefit Not motivational to employees and managers Socially legitimate function in order to survive Must create value in order to survive

Corporation as a social institution

Licensed by state to promote general welfare Government is a stakeholder in the company on behalf of the public

Critiques of SWM Principle

Evidence suggests that the relationship between CSR and financial performance is neutral or mildly positive.
Limited SCR is no likely to harm corporate earnings Social initiatives are not markedly unprofitable May enhance or protect corporate reputation Avoidance of harm assisted by engagement in good Wrongful conduct can clearly be very costly


Management should attempt to maximize sustainable economic value for shareholders Shareholders must guard against management self interest Some purpose other than money may be a better strategy Broad stakeholder value may be strategically valuable Doing social good may be a good long term strategy.