Custom Search

DO MANAGERS REALLY MAXIMIZE FIRM VALUE?

Owner-managers have no conflicts of interest in their management of the business. They work for themselves, reaping the rewards of good work and suffering the penalties of bad work. Their personal well-being is tied to the value of the firm.

In most large companies the managers are not the owners and they might be tempted to act in ways that are not in the best interests of the owners. For example, they might buy luxurious corporate jets for their travel, or overindulge in expense-account dinners. They might shy away from attractive but risky projects because they are worried more about the safety of their jobs than the potential for superior profits. They might engage in empire building, adding unnecessary capacity or employees. Such problems can arise because the managers of the firm, who are hired as agents of the owners, may have their own axes to grind. Therefore they are called agency problems.

Think of the company`s net revenue as a pie that is divided among a number of claimants. These include the management and the work force as well as the lenders and shareholders who put up the money to establish and maintain the business. The government is a claimant, too, since it gets to tax the profits of the enterprise. It is common to hear these claimants called stakeholders in the firm. Each has a stake in the firm and

their interests may not coincide.

All these stakeholders are bound together in a complex web of contracts and understandings. For example, when banks lend money to the firm, they insist on a formal contract stating the rate of interest and repayment dates, perhaps placing restrictions on dividends or additional borrowing. Similarly, large companies have carefully worked out personnel policies that establish employees` rights and responsibilities. But you can`t devise written rules to cover every possible future event. So the written contracts are supplemented by understandings. For example, managers understand that in return for a fat salary they are expected to work hard and not spend the firm`s money on unwarranted personal luxuries.

What enforces these understandings? Is it realistic to expect managers always to act on behalf of the shareholders? The shareholders can`t spend their lives watching through binoculars to check that managers are not shirking or dissipating company funds on the latest executive jet.

A closer look reveals several arrangements that help to ensure that the shareholders and managers are working toward common goals.

Compensation Plans. Managers are spurred on by incentive schemes that provide big returns if shareholders gain but are valueless if they do not. For example, when Michael Eisner was hired as chief executive officer (CEO) by the Walt Disney Company, his compensation package had three main components: a base annual salary of $750,000; an annual bonus of 2 percent of Disney`s net income above a threshold of ¬normal ­ profitability; and a 10-year option that allowed him to purchase 2 million shares of stock for $14 per share, which was about the price of Disney stock at the time. Those options would be worthless if Disney`s shares were selling for below $14 but highly valuable if the shares were worth more. This gave Eisner a huge personal stake in the success of the firm.

As it turned out, by the end of Eisner`s 6-year contract the value of Disney shares had increased by $12 billion, more than sixfold. Eisner`s compensation over the period was $190 million.13 Was he overpaid? We don`t know (and we suspect nobody else knows) how much Disney`s success was due to Michael Eisner or how hard Eisner would have worked with a different compensation scheme. Our point is that managers often have a strong financial interest in increasing firm value. Table 1.4 lists the top-earning CEOs in 1998. Notice the importance of stock options in the total compensation package.

The Board of Directors. Boards of directors are sometimes portrayed as passive supporters of top management. But when company performance starts to slide, and managers don`t offer a credible recovery plan, boards do act. In recent years, the chief executives of IBM, Eastman Kodak, General Motors, and Apple Computer all were forced out. The nearby box points out that boards recently have become more aggressive in their willingness to replace underperforming managers. If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding the managers to task, they can try to replace the board in the next election. The dissident shareholders will attempt to convince other shareholders to vote for their slate of candidates to the board. If they succeed, a new board will be elected and it can replace the current management team. Takeovers. Poorly performing companies are also more likely to be taken over by another firm. After the takeover, the old management team may find itself out on the street.

Specialist Monitoring. Finally, managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts who advise investors to buy, hold, or sell the company`s shares. They are also reviewed by banks, which keep an eagle eye on the progress of firms receiving their loans. We do not want to leave the impression that corporate life is a series of squabbles and endless micromanagement. It isn`t, because practical corporate finance has evolved to reconcile personal and corporate interests to keep everyone working together to increase

the value of the whole pie, not merely the size of each person`s slice.

The agency problem is mitigated in practice through several devices: compensation plans that tie the fortune of the manager to the fortunes of the firm; monitoring by lenders, stock market analysts, and investors; and ultimately the threat that poor performance will result in the removal of the manager.

AGENCY PROBLEMS

Conflict of interest between the firm`s owners and managers.

STAKEHOLDER Anyone

with a financial interest in the firm.