Corporate Finance: Problems associated with the Shareholder Theory,

Today,  as part of my trial blog I will be discussing the problems associated with the Shareholder Theory. I will begin by introducing the shareholder theory before moving on to an analysis of the issues surrounding this theory. 

The Anglo-American viewpoint argues that the ultimate objective of corporate finance should be to make investment and financing decisions that maximise the wealth of its shareholders.  Therefore, investment decisions will be based on those projects that deliver the highest return.  There are many academics who support this view by emphasising the importance of shareholders. Two examples can be seen with Hayek and Friedman. Hayek argues the “only specific purpose corporations ought to serve is to secure the highest long term return.”  Friedman also supports this view stating that companies do not have any moral obligations or social responsibilities other than maximise their own profit. Both acaedemics make it clear that wealth maximisation is the main priority.

Firstly, it is argued that the shareholder theory allows management to ignore the interests of other stakeholders, as its focus remains on delivering the highest return to its shareholders. The stakeholder theory can be used to support this view. The main problem is seen with the fact that stakeholders can have a significant impact on a companies’ performance. Freeman argues that the legitimate interests of these groups and individuals who are affected by the company need to be taken into account. Freedman stresses the importance of these groups; corporation's who opt to place a strong emphasis on wealth maximisation risk upsetting stakeholders such as employees or customers. Stemberg, takes this argument even further by stating that the business should be run to serve all of their stakeholders.  It is therefore clear that neglecting the needs of other stakeholders can have a negative impact on wealth maximisation; the Enron failure is a perfect example. The failure of this corporation strengthens the argument of a stakeholder theory and exposes the failures of the shareholder theory.

Furthermore, John Kay identifies another issue, where he argues that those directing focus on shareholder value may do worse for the shareholders in the long term. This mentality can be referred to as short-termism and has caused many problems. The 2008 recession is an example of the devastating effects that short-termism has on shareholder wealth maximisation.

Finally, Jensen & Meckling's Agency Theory highlights another problem. This theory identifies the gap between ownership and control. The theory argues that the agents (managers) may pursue objectives attractive to them at the expense of shareholders.  It shows the importance of employees in a company and how their actions can have a detrimental effect on shareholders wealth. Examples of this include the recent Tesco accounting scandal, where the £250m black hole in their accounts has resulted in a dramatic decrease in its share price, reducing its shareholders value.  Other examples can be seen with the former CEO of Merrill Lynch and the Directors at General Motors who would treat themselves with expensive perks at the cost of the shareholders.  These examples demonstrate the importance of employees in a corporation. Understanding this can help reduce the problems mentioned above and enable the company to generate long term value. 

In conclusion, the problems highlighted above give a clear indication of the effects this can have on shareholders wealth in the long term. It should be highlighted that shareholders are influential and can have an impact on the company, but solely focusing on the owners can cause many problems. In my next blog, I will be looking to discuss the problems associated with the stakeholder view and how companies can generate the long-term value in the most efficient manner.

Sources 

Hayek

Friedman 

Freenan 

John Kay

Jensen & Meckling 

Arnold