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“If you do not know where you are going, it does not matter how you get there”
Corporate finance™s greatest strength and its greatest weaknesses is its focus on
value maximization. By maintaining that focus, corporate finance preserves internal
consistency and coherence, and develops powerful models and theory about the “right”
way to make investment, financing and dividend decisions. It can be argued, however,
that all of these conclusions are conditional on the acceptance of value maximization as
the only objective in decision-making.
In this chapter, we consider why we focus so strongly on value maximization and
why, in practice, the focus shifts to stock price maximization. We also look at the
assumptions needed for stock price maximization to be the right objective, the things that
can go wrong with firms that focus on it and at least partial fixes to some of these
problems. We will argue strongly that, even though stock price maximization is a flawed
objective, it offers far more promise than alternative objectives because it is self-

Choosing the Right Objective
Let us start with a description of what an objective is, and the purpose it serves in
developing theory. An objective specifies what a decision maker is trying to accomplish
and by so doing, provides measures that can be used to choose between alternatives. In
most firms, it is the managers of the firm, rather than the owners, who make the decisions
about where to invest or how to raise funds for an investment. Thus, if stock price
maximization is the objective, a manager choosing between two alternatives will choose
the one that increases stock price more. In most cases, the objective is stated in terms of
maximizing some function or variable, such as profits or growth, or minimizing some
function or variable, such as risk or costs.
So why do we need an objective, and if we do need one, why cannot we have
several? Let us start with the first question. If an objective is not chosen, there is no

systematic way to make the decisions that every business will be confronted with at some
point in time. For instance, without an objective, how can Disney's managers decide
whether the investment in a new theme park is a good one? There would be a menu of
approaches for picking projects, ranging from reasonable ones like maximizing return on
investment to obscure ones like maximizing the size of the firm, and no statements could
be made about their relative value. Consequently, three managers looking at the same
project may come to three separate conclusions about it.
If we choose multiple objectives, we are faced with a different problem. A theory
developed around multiple objectives of equal weight will create quandaries when it
comes to making decisions. To illustrate, assume that a firm chooses as its objectives
maximizing market share and maximizing current earnings. If a project increases market
share and current earnings, the firm will face no problems, but what if the project being
analyzed increases market share while reducing current earnings? The firm should not
invest in the project if the current earnings objective is considered, but it should invest in
it based upon the market share objective. If objectives are prioritized, we are faced with
the same stark choices as in the choice of a single objective. Should the top priority be the
maximization of current earnings or should it be maximizing market share? Since there is
no gain, therefore, from having multiple objectives, and developing theory becomes
much more difficult, we would argue that there should be only one objective.
There are a number of different objectives that a firm can choose between, when
it comes to decision making. How will we know whether the objective that we have
chosen is the 'right' objective? A good objective should have the following
characteristics --
(a) It is clear and unambiguous. An objective that is ambiguous will lead to decision
rules that vary from case to case and from decision-maker to decision-maker. Consider,
for instance, a firm that specifies its objective to be increasing growth in the long term.
This is an ambiguous objective since it does not answer at least two questions. The first is
growth in what variable - Is it in revenue, operating earnings, net income or earnings per
share? The second is in the definition of the long term: Is it 3 years, 5 years or a longer

(b) It comes with a clear and timely measure that can be used to evaluate the success or
failure of decisions. Objectives that sound good but that do not come with a measurement
mechanism are likely to fail. For instance, consider a retail firm that defines its objective
as “maximizing customer satisfaction”. How exactly is customer satisfaction defined and
how is it to be measured? If no good mechanism exists for measuring how satisfied
customers are with their purchases, not only will managers be unable to make decisions
based upon this objective, but stockholders will also have no way of holding them
accountable for any decisions that they do make.
(c) It does not create costs for other entities or groups that erase firm-specific benefits
and leave society worse off overall. As an example, assume that a tobacco company
defines its objective to be revenue growth. Managers of this firm would then be inclined
to increase advertising to teenagers, since it will increase sales. Doing so may create
significant costs for society that overwhelm any benefits arising from the objective.
Some may disagree with the inclusion of social costs and benefits and argue that a
business only has a responsibility to its stockholders and not to society. This strikes us as
short sighted because the people who own and operate businesses are part of society.

The Classical Objective
There is general agreement, at least among corporate finance theorists that the
objective when making decisions in a business is to maximize value. There is some
disagreement on whether the objective is to maximize the value of the stockholder™s stake
in the business or the value of the entire business (firm), which includes besides
stockholders, the other financial claim holders (debt holders, preferred stockholders etc.).
Furthermore, even among those who argue for stockholder wealth maximization, there is
a question about whether this translates into maximizing the stock price. As we will see
in this chapter, these objectives vary in terms of the assumptions that are needed to justify
them. The least restrictive of the three objectives, in terms of assumptions needed, is to
maximize the firm value and the most restrictive is to maximize the stock price.

Multiple Stakeholders and Conflicts of Interest
In the modern corporation, stockholders hire managers to run the firm for them;
these managers then borrow from banks and bondholders to finance the firm™s operations.

Investors in financial markets respond to information about the firm revealed to them by
the managers and firms have to operate in the context of a larger society. By focusing on
maximizing stock price, corporate finance exposes itself to several risks. First, the
managers who are hired to operate the firm for stockholders may have their own interests
that deviate from those of stockholders. Second, stockholders can sometimes be made
wealthier by decisions that transfer wealth from those who have lent money to the firm.
Third, the information that investors respond to in financial markets may be misleading,
incorrect or even fraudulent, and the market response may be out of proportion to the
information. Finally, firms that focus on maximizing wealth may create significant costs
for society that do not get reflected in the firm™s bottom line.
These conflicts of interests are exacerbated further when we bring in two
additional stakeholders in the firm. First, the employees of the firm may have little or no
interest in stockholder wealth maximization and may have a much larger stake in
improving wages, benefits and job security. In some cases, these interests may be in
direct conflict with stockholder wealth maximization. Second, the customers of the
business will probably prefer that products and services be priced lower to maximize
their utility, but this again may conflict with what stockholders would prefer.

Potential Side Costs of Value Maximization
If the objective when making decisions is to maximize firm value, there is a
possibility that what is good for the firm may not be good for society. In other words,
decisions that are good for the firm, insofar as they increase value, may create social
costs. If these costs are large, we can see society paying a high price for value
maximization and the objective will have to be modified to allow for these costs. To be
fair, however, this is a problem that is likely to persist in any system of private enterprise
and is not peculiar to value maximization. The objective of value maximization may also
face obstacles when there is separation of ownership and management, as there is in most
large public corporations. When managers act as agents for the owners (stockholders),
there is the potential for a conflict of interest between stockholder and managerial
interests, which in turn can lead to decisions that make managers better off at the expense
of stockholders.

When the objective is stated in terms of stockholder wealth, the conflicting
interests of stockholders and bondholders have to be reconciled. Since stockholders are
the decision-makers, and bondholders are often not completely protected from the side
effects of these decisions, one way of maximizing stockholder wealth is to take actions
that expropriate wealth from the bondholders, even though such actions may reduce the
wealth of the firm.
Finally, when the objective is narrowed further to one of maximizing stock price,
inefficiencies in the financial markets may lead to misallocation of resources and bad
decisions. For instance, if stock prices do not reflect the long term consequences of
decisions, but respond, as some critics say, to short term earnings effects, a decision that
increases stockholder wealth (which reflects long term earnings potential) may reduce the
stock price. Conversely, a decision that reduces stockholder wealth, but increases
earnings in the near term, may increase the stock price.

Why Corporate Finance Focuses on Stock Price Maximization
Much of corporate financial theory is centered on stock price maximization as the
sole objective when making decisions. This may seem surprising given the potential side
costs listed above, but there are three reasons for the focus on stock price maximization in
traditional corporate finance.
Stock prices are the most observable of all measures that can be used to judge the

performance of a publicly traded firm. Unlike earnings or sales, which are
updated once every quarter or even once every year, stock prices are updated
constantly to reflect new information coming out about the firm. Thus, managers
receive instantaneous feedback from investors on every action that they take. A
good illustration is the response of markets to a firm announcing that it plans to
acquire another firm. While managers consistently paint a rosy picture of every
acquisition that they plan, the stock price of the acquiring firm drops in roughly
half of all acquisitions, suggesting that markets are much more skeptical about
managerial claims.
If investors are rational and markets are efficient, stock prices will reflect the

long-term effects of decisions made by the firm. Unlike accounting measures like

earnings or sales measures such as market share, which look at the effects on
current operations of decisions made by a firm, the value of a stock is a function
of the long-term health and prospects of the firm. In a rational market, the stock
price is an attempt on the part of investors to measure this value. Even if they err
in their estimates, it can be argued that a noisy estimate of long-term value is
better than a precise estimate of current earnings.
Finally, choosing stock price maximization as an objective allows us to make

categorical statements about what the best way to pick projects and finance them

˜: Which of the following assumptions do you need to make for stock price
maximization to be the only objective in decision making?
a. Managers act in the best interests of stockholders
b. Lenders to the firm are fully protected from expropriation.
c. Financial markets are efficient.
d. There are no social costs.
e. All of the above

f. None of the above

In Practice: What is the objective in decision making in a private firm or a non-
profit organization?
The objective of maximizing stock prices is a relevant objective only for firms
that are publicly traded. How, then, can corporate finance principles be adapted for
private firms? For firms that are not publicly traded, the objective in decision-making is
the maximization of firm value. The investment, financing and dividend principles we
will develop in the chapters to come apply for both publicly traded firms, which focus on
stock prices, and private businesses, that maximize firm value. Since firm value is not
observable and has to be estimated, what private businesses will lack is the feedback,
sometimes unwelcome, that publicly traded firms get from financial markets, when they
make major decisions.

It is, however, much more difficult to adapt corporate finance principles to a not-
for-profit organization, since it™s objective is often to deliver a service in the most
efficient way possible, rather than to make profits. For instance, the objective of a
hospital may be stated as delivering quality health care at the least cost. The problem,
though, is that someone has to define the acceptable level of care and the friction between
cost and quality will underlie all decisions made by the hospital.

Maximize Stock Prices: The Best Case Scenario
If corporate financial theory is based on the objective of maximizing stock prices,
it is worth asking when it is reasonable to ask managers to focus on this objective to the
exclusion of all others. There is a scenario where managers can concentrate on
maximizing stock prices to the exclusion of all other considerations and not worry about
side costs. For this scenario to unfold, the following assumptions have to hold:
1. The managers of the firm put aside their own interests and focus on maximizing
stockholder wealth. This might occur either because they are terrified of the power
stockholders have to replace them (through the annual meeting or the board of
directors) or because they own enough stock in the firm that maximizing stockholder
wealth becomes their objective as well.
2. The lenders to the firm are fully protected from expropriation by stockholders. This
can occur for one of two reasons. The first is a reputation effect, i.e., that stockholders
will not take any actions that hurt lenders now if they feel that doing so might hurt
them when they try to borrow money in the future. The second is that lenders might
be able to protect themselves fully when they lend by writing in covenants
proscribing the firm from taking any actions that hurt them.
3. The managers of the firm do not attempt to mislead or lie to financial markets about
the firm™s future prospects, and there is sufficient information for markets to make
judgments about the effects of actions on long-term cash flows and value. Markets are
assumed to be reasoned and rational in their assessments of these actions and the
consequent effects on value.
4. There are no social costs or social benefits. All costs created by the firm in its pursuit
of maximizing stockholder wealth can be traced and charged to the firm.

With these assumptions, there are no side costs to stock price maximization.
Consequently, managers can concentrate on maximizing stock prices. In the process,
stockholder wealth and firm value will be maximized and society will be made better off.
The assumptions needed for the classical objective are summarized in pictorial form in
figure 2.1.
Figure 2.1: Stock Price Maximization: The Costless Scenario

Hire & fire

No Social Costs
Lend Money
Protect Costs can be

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