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Goals of the Corporation

SHAREHOLDERS WANT MANAGERS TO MAXIMIZE MARKET VALUE

For small firms, shareholders and management may be one and the same. But for large

companies, separation of ownership and management is a practical necessity. For ex ample, AT&T has over 2 million shareholders. There is no way that these shareholders can be actively involved in management; it would be like trying to run New York City by town meetings. Authority has to be delegated.

How can shareholders decide how to delegate decision making when they all have different tastes, wealth, time horizons, and personal opportunities? Delegation can work only if the shareholders have a common objective. Fortunately there is a natural financial objective on which almost all shareholders can agree. This is to maximize the current value of their investment.

A smart and effective financial manager makes decisions which increase the current value of the company`s shares and the wealth of its stockholders. That increased wealth can then be put to whatever purposes the shareholders want. They can give their money to charity or spend it in glitzy night clubs; they can save it or spend it now. Whatever their personal tastes or objectives, they can all do more when their shares are worth more.

Sometimes you hear managers speak as if the corporation has other goals. For example, they may say that their job is to ¬maximize profits. ­ That sounds reasonable. After all, don`t shareholders want their company to be profitable? But taken literally, profit maximization is not a well- defined corporate objective. Here are three reasons:

1. ¬Maximizing profits ­ leaves open the question of ¬which year`s profits? ­ The company may be able to increase current profits by cutting back on maintenance or staff training, but shareholders may not welcome this if profits are damaged in future years.

2. A company may be able to increase future profits by cutting this year`s dividend and investing the freed-up cash in the firm. That is not in the shareholders` best interest if the company earns only a very low rate of return on the extra investment.

3. Different accountants may calculate profits in different ways. So you may find that a decision that improves profits using one set of accounting rules may reduce them using another.

In a free economy a firm is unlikely to survive if it pursues goals that reduce the firm`s value. Suppose, for example, that a firm`s only goal is to increase its market share. It aggressively reduces prices to capture new customers, even when the price discounts cause continuing losses. What would happen to such a firm? As losses mount, it will find it more and more difficult to borrow money, and it may not even have sufficient profits to repay existing debts. Sooner or later, however, outside investors would see an opportunity for easy money. They could offer to buy the firm from its current shareholders and, once they have tossed out existing management, could increase the firm`s value by changing its policies. They would profit by the difference between the price paid for the firm and the higher value it would have under new management. Managers

who pursue goals that destroy value often land in early retirement.

We conclude that managers as a general rule will act to maximize the value of the firm to its stockholders. Management teams that deviate too far from this rule are likely to be replaced.