Why Shareholder Wealth Maximization Despite Other Objectives

S.P. Kothari is the Gordon Y. Billard Professor of Accounting and Finance at MIT Sloan School of Management. This post is based on a recent paper authored by Professor Kothari; Richard Frankel, Beverly & James Hance Professor of Accounting at Washington University in Saint Louis Olin Business School; and Luo Zuo, Associate Professor of Accounting at Cornell University SC Johnson College of Business.

The view that firms (managers) behave as if their goal is to increase shareholder wealth is the shareholder-wealth-maximization principle. While many might agree this principle governs managerial behavior, it continues to arouse intense scrutiny, adoration, and condemnation. We begin by summarizing the economic rationale behind and the welfare consequences of managers pursuing this principle. Numerous writings articulate the principle, including the influential Friedman (1970) and Jensen (2001). Friedman (1970) encapsulates the principle by imploring managers as shareholders’ agents to “conduct the business in accordance with their desires, which will generally be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

The argument that managers should seek to increase shareholder wealth begins with the premise that the society’s resources are scarce. Judicious use of scarce resources implies that resources should be directed toward higher net-value activities. If prices measure opportunity costs and benefits, the net value of an activity can be determined by subtracting the price of resources devoted to an activity from the sales revenues generated by the activity. Because a given activity might involve a multi-period commitment, employing resources that can be used for multiple periods (e.g., plant, property, and equipment), a net present value calculation is often necessary to compare cash inflows and outflows occurring in different periods. This net present value corresponds to the effect of the project on its owner’s wealth. These arguments render the following proposition: Judicious use of society’s resources implies each project’s owners maximize the value of their projects.

Many individuals with wealth do not have attractive projects of their own. These individuals will seek projects that promise higher returns, placing their wealth in the hands of project managers. In doing so, the wealth owner must add the cost of the project managers’ effort and expertise to the calculation. Manager effort and expertise are simply another of the society’s scarce resources. Thus, separating the owner of wealth from the wealth managers does not alter the conclusion that judicious use of society’s resources requires wealth owners to seek higher value projects. If we view firm managers as the project managers and shareholders as the wealth owners, our logic implies that firm managers judiciously employ a society’s resources when they seek to increase shareholder wealth.

Notwithstanding this argument, the shareholder-wealth-maximization principle has been the subject of criticism from many economists, social activists, prominent business executives, and politicians. We divide this objection into four more specific criticisms:

  1. Shareholders might wish to pursue objectives other than or in addition to wealth maximization, e.g., concern for the environment. This is a two-part criticism: (a) Managers are reluctant to pursue other objectives because those run afoul of wealth maximization; and (b) Pursuit of the other objectives is a means to increase shareholder wealth, but managers do not fully appreciate it. We explain that the political realm might be a better path to the pursuit of the objectives contrary to wealth maximization, because competition undermines firms seeking other, unrelated objectives and managers face an intractable problem when trying to consolidate competing objectives into a distinct target. As for the objectives consistent with maximization of shareholder wealth (e.g., sensitivity to worker happiness), managers would and should gladly embrace these subject to the constraints of competition, law and ethical custom.
  2. Firms might plunder other stakeholders. This idea, perhaps originating in the theory that labor creates all value, was given graphic voice by Marx, e.g., “Capital is dead labor which, vampire-like, lives only by sucking living labor, and lives the more, the more labor it sucks.” We explain that competition and constraints imposed by law and ethical standards minimize, if not eliminate, the exploitation of (or theft from) other stakeholders as a means to increase shareholder wealth. Competitive product, labor, and capital markets counter the pull of incentives to maximize shareholder wealth at the expense of other stakeholders.
  3. Managers are shareholders’ agents and they will pursue their own objectives. This well-known incentive (agency) conflict is hardly unique to shareholder-wealth-maximizing organizations. Any organization, regardless of the objective one wishes its managers to pursue, encounters incentive conflicts. For example, incentive problems exist in non-profits and government.
  4. Managers and shareholders might suffer from behavioral biases. We explain that such biases would also hamper organizations seeking alternative goals.

Before we delve into each of the aforementioned four criticisms, we begin by assuming that investors in corporate organizations seek to maximize the value of their investment. Therefore, we expect to observe firms and management teams adopt the goal of shareholder wealth maximization and expect them to compete to devise the most efficient means of achieving this goal. We describe the economic consequences of pursuing the objective of wealth creation and implications for social welfare under a set of assumptions (a “positive” approach). The merits of pursuing other objectives is a normative question. All we can argue is that societies are (predicted to be) poorer as a result.

What then to make of the alternative objectives that are the passion of many individuals, who might also be shareholders? Forming a consensus might be impossible (Arrow, 1951; Gibbard, 1973; Satterthwait, 1975). Still, competing objectives espoused by shareholders and members of society, in our opinion, become the purview of politics. We recognize that politics and law are imperfect avenues to convert these competing shareholder objectives into restraints on firm actions. Politics is fraught with challenges encountered in getting the electorate energized about an issue, acting on it either directly or through elected representatives, and thus bringing about a change that reflects the collective (majority) objective. However, we explain below that the political route dominates the alternative of expecting managers to embrace a multiplicity of objectives.

While we champion shareholder wealth maximization, to be clear, our position is not that society’s goal should be unconstrained shareholder-wealth maximization. Hyman Roth is one Hollywood avatar of this position. When discussing the murder of Moe Green with Michael Corleone, he says, “This is the business we’ve chosen. I didn’t ask who gave the order, because it had nothing to do with business.” (The Godfather Part II, 1974). Rule of law is necessary to prevent coercion and fraud. Laws and ethics, as well as competition, constrain the scope of actions of a corporation. Examples of legal constraints include laws against bribery, child labor, and forced labor. Ethical principles, such as honesty, keeping firmly to one’s word, and the sanctity of human beings, constrain individual behavior in situations ill-suited for the state’s heavy hand. Still shareholder wealth maximization remains the objective subject to these constraints and future constraints as the society’s objectives evolve and morph into new laws and ethical customs.

Perhaps, criticism of shareholder wealth maximization arises because of a distaste for the concept as a normative proposition despite the fact that the proposition predicts firm behavior. That is, we face a disagreement about values masquerading as a disagreement about facts. We explain shareholder wealth maximization is an efficient means to maximize societal wealth. We do not argue that society’s goal should be to maximize wealth. The end of a kinder, finer, freer, more just and peaceful society is unlikely to be reached solely by increasing a society’s wealth. Advocates of other objectives for social ends and the means to achieve those ends have worthy arguments.

We maintain that managers seeking to increase wealth are not acting immorally, per se. Therefore, we take issue with those demonizing managers for taking steps to increase shareholder wealth while staying within law and operating in a competitive economy. We observe that a competitive environment reduces the chances that the firm will flourish if it pursues other objectives. In addition, managers do not have the means to distill the varied preferences of present and future shareholders into an objective function that could feasibly serve as guide for decision making. Other objectives then become the purview of the political realm, cultural norms, and ethical outlook. Individuals advocating other objectives must persuade other citizens to adopt their opinions and passions. Of course, demonizing managers, companies, and industries solely because they pursue shareholder wealth maximization might be an effective (though groundless) means of persuasion.

The possibility that CEOs might engage in mercenary behavior is real and therefore checks and balances are essential to ensure competition in markets and legal (and ethical) behavior on the part of managers. Adam Smith’s dim view of businessmen suggests, one must distinguish between defending capitalism and apologizing for capitalists. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices” (Smith, 1776, p. 105). Likewise, we recognize the necessity of a moral code and law to set bounds on permissible wealth-increasing actions. However, the necessity of moral boundaries is not a distinguishing demerit of shareholder wealth maximization. Any alternative goal is similarly incomplete without these constraints. Moreover, we are tempted to give our needs the patina of “morality” to forestall consideration of trade-offs necessary to meet them. After all, the prohibition against the murder of an innocent man is not subject to a cost-benefit analysis. Moral arguments must be countered with moral arguments. They cannot be refuted by efficiency (or even practical) arguments. Stakeholders will be inclined to make moral claims to stymie counter arguments.

Mindful of this dubious pull, we seek a method to guide managers in choosing among legally and ethically permissible actions. Moreover, shareholder wealth maximization is not incompatible with strategies that, for example, take into account sustainability, the firm’s local community, or, customer and employee satisfaction. If paying attention to sustainability increases firm value, that is what managers will (and should) do. Shareholder wealth maximization would be the criterion managers apply in deciding how much to invest in “socially responsible activities” similar to any other corporate investment decision they make.

The complete paper is available for download here.

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