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The information that firms convey to financial markets is often erroneous, and
sometimes misleading. The market price that emerges from financial markets can be
wrong, partly because of inefficiencies in markets and partly because of the errors in the
information. There are no easy or quick fix solutions to these problems. In the long term,
however, there are actions that will improve information quality and reduce deviations
between price and value.

Improving the Quality of Information
While regulatory bodies like the Securities and Exchange Commission can require
firms to reveal more information and penalize firms that provide misleading and
fraudulent information, the quality of information cannot be improved with information
disclosure laws alone. In particular, firms will always have a vested interest in when and
what information they reveal to markets. To provide balance, therefore, an active market
for information, where analysts, who are not hired and fired by the firms that they follow,
collect and disseminate information, has to exist. While these analysts are just as likely to
make mistakes as the firm, they presumably should have a greater incentive to unearth
bad news about the firm and to disseminate that information to their clients. For this
system to work, analysts have to be given free rein to search for good as well as bad news
and to make positive or negative judgments about a firm.

Making Markets more efficient
Just as better information cannot be legislated into existence, markets cannot be
made more efficient by edict. In fact, there is widespread disagreement on what is
required to make markets more efficient. At the minimum, these are necessary (though
not sufficient) conditions for more efficient markets --
a. Trading should be both inexpensive and easy. The higher transactions
costs are, and the more difficult it is to execute a trade, the more likely it is
that markets will be inefficient.
b. There should be free and wide access to information about firms.
c. Investors should be allowed to benefit when they pick the right stocks to
invest in and to pay the price when they make mistakes.

Restrictions imposed on trading, while well intentioned, often lead to market
inefficiencies. For instance, restricting short sales, where investors who don™t own a stock
can borrow and sell it if they feel it is overpriced, may seem like good public policy, but
it can create a scenario where negative information about stocks cannot be reflected
adequately in prices.

Firms and Society
There will always be social costs associated with actions taken by firms, operating
in their own best interests. The basic conundrum is as follows; social costs cannot be
ignored in making decisions, but they are also too nebulous to be factored explicitly into
analyses. One solution is for firms to maximize firm or stockholder value, subject to a
'good citizen' constraint, where attempts are made to minimize or alleviate social costs,
even though the firm may not be under any legal obligation to do so. The problem with
this approach, of course, is that the definition of a 'good citizen' is likely to vary from
firm to firm and from manager to manager.
Ultimately, the most effective way to make companies more socially responsible
is to make it in their best economic interests to behave well. This can occur in two ways.
First, firms that are construed as socially irresponsible could lose customers and profits.
This was the galvanizing factor behind a number of specialty retailers in the United States
disavowing the use of sweatshops and underage labor in other countries in making their
products. Second, investors might avoid buying stock in these companies. As an example,
many college and state pension plans in the United States have started reducing or
eliminating their holding of tobacco stocks to reflect their concerns about the health
effects of tobacco. In fact, investors now have access to “ethical mutual funds” which
invest only in companies that meet a social consciousness threshold. 32 Figure 2.3
summarizes the ways in which we can reduce potential side costs from stock price

32 Studies of these funds indicate that they earn returns comparable to conventional mutual funds.

Figure 2.3: Maximize Stock Prices but minimize side costs

1. Stock-based Managers think like
compensation stockholders
2. Hostile takeovers
3. Activist investors

Reduced Social Costs
Lend Money
1. Laws and Restrictions
Protect themselves with
2. Investor/ Customer Backlash
covenants and new bonds
More liquid markets
More external
with lower
transactions costs
Active analysts


In Practice: Can you add value while doing good?
Does doing social good hurt or help firms? On the one side of this argument stand
those who believe that firms that expend considerable resources to generate social good
are misguided and are doing their stockholders a disservice. On the other side, there are
those who believe that socially conscious firms are rewarded by consumers and investors.
The evidence is mixed and will undoubtedly disappoint both sides:
Studies indicate that the returns earned by stockholders in socially conscious

firms are no different than the returns earned by stockholders in the rest o the
market. Studies of ethical mutual funds find that they neither lag nor lead other
mutual funds.
There is clearly a substantial economic cost borne by companies that are viewed

by society as beyond the pale when it comes to creating social costs. Tobacco
firms, for instance, have seen stock prices slide as investors avoid their shares and
profits hurt by legal costs.

When firms are profitable and doing well, stockholders are usually willing to give

managers the flexibility to use company money to do social good. Few investors
in Microsoft begrudged its decision in 1998 to give free computers to public
libraries around the country. In firms that are doing badly, stockholders tend to be
much more resistant to meeting society™s ills.
Summarizing this evidence, we can draw some conclusions. First, a firm™s foremost
obligation is to stay financially healthy and to increase value; firms that are losing money
cannot afford to be charitable. Second, firms that create large social costs pay a high price
in the long term. Finally, managers should not keep stockholders in the dark about the
company™s charitable giving; after all, it is the stockholder™s money that is being used for
the purpose.

An Argument for Stockholder Wealth Maximization
Let us start off by conceding that all of the alternatives - choosing a different
corporate governance system, picking an alternative objective and maximizing
stockholder wealth with constraints “ have their limitations and lead to problems. The
questions then become how each alternative deals with mistakes and how quickly errors
get corrected. This is where stock price maximization does better than the alternatives. It
is the only one of the three that is self-correcting, in the sense that excesses by any
stakeholder attract responses in three waves.
1. Market reaction: The first and most immediate reaction comes from financial
markets. Consider again the turmoil created when we have well publicized
failures like Enron. Not only did the market punish Enron (by knocking its stock
and bond price down) but it punished other companies that it perceived as being
exposed to the same problems as Enron “ weak corporate governance and opaque
financial statements - by discounting their values as well.
2. Group Activism: Following on the heels of the market reaction to any excess is
outrage on the part of those who feel that they have been victimized by it. In
response to management excesses in the 1980s, we saw an increase in the number
of activist investors and hostile acquisitions, reminding managers that there are
limits to their power. In the aftermath of well-publicized scandals in the late

1980s where loopholes in lending agreements were exploited by firms, banks and
bondholders began playing more active roles in management.
3. Market Innovations: Markets often come up with innovative solutions to
problems. In response to the corporate governance scandals in 2002 and 2003,
Institutional Shareholder Services began scoring corporate boards on
independence and effectiveness and selling these scores to investors. After the
accounting scandals of the same period, the demand for forensic accounting,
where accountants go over financial statements looking for clues of accounting
malfeasance, increased dramatically. The bond market debacles of the 1980s gave
birth to dozens of innovative bonds designed to protect bondholders. Even in the
area of social costs, there are markets that have developed to quantify the cost.
Note that we have not mentioned another common reaction to scandal, which is
legislation. While the motives for passing new laws to prevent future excesses may be
pure, laws are blunt instruments that are often ineffective for three reasons. First, they
are almost never timely. It takes far more time for legislation to be put together than
for markets to react, and the outrage has often subsided before the laws becomes
effective. Second, laws written to prevent past mistakes often prove ineffective at
preventing future mistakes, as circumstances change. Third, laws often have
unintended consequences, where in the process of correcting one distortion, they
create new ones.

A postscript - The limits of corporate finance
Corporate finance has come in for more than its share of criticism in the last
decade. There are many who argue that the failures of corporate America can be traced to
its dependence on stock price maximization. Some of the criticism is justified and based
upon the limitations of a single-minded pursuit of stockholder wealth. Some of it,
however, is based upon a misunderstanding of what corporate finance is about.
Economics was once branded the gospel of Mammon, because of its emphasis on
money. The descendants of those critics have labeled corporate finance as unethical,
because of its emphasis on the 'bottom line' and market prices, even if this focus implies
that workers lose their jobs and take cuts in pay. In restructuring and liquidations, it is

true that value maximization for stockholders may mean that other stakeholders, such as
customers and employees, lose out. In most cases, however, decisions that increase
market value also make customers and employees better off. Furthermore, if the firm is
really in trouble, either because it is being undersold by competitors or because its
products are technologically obsolete, the choice is not between liquidation and survival,
but between a speedy resolution, which is what corporate financial theory would
recommend, and a slow death, while the firm declines over time, and costs society
considerably more in the process.
The conflict between wealth maximization for the firm and social welfare is the
genesis for the attention paid to ethics in business schools. There will never be an
objective and therefore decision rules that perfectly factor in societal concerns, simply
because many of these concerns are difficult to quantify and are subjective. Thus,
corporate financial theory, in some sense, assumes that decision makers will not make
decisions that create large social costs. This assumption that decision makers are, for the
most part, ethical and will not create unreasonable costs for society or for other
stakeholders, is unstated but underlies corporate financial theory. When it is violated, it
exposes corporate financial theory to ethical and moral criticism, though the criticism
may be better directed at the violators.

2.10. ˜: What do you think the objective of the firm should be?
Having heard the pros and cons of the different objectives, the following statement best
describes where I stand in terms of the right objective for decision making in a business.
a. Maximize stock price or stockholder wealth, with no constraints
b. Maximize stock price or stockholder wealth, with constraints on being a good social
c. Maximize profits or profitability
d. Maximize market share
e. Maximize Revenues
f. Maximize social good

g. None of the above

While the objective in corporate finance is to maximize firm value, in practice we
often adopt the narrower objective of maximizing a firm™s stock price. As a measurable
and unambiguous measure of a firm™s success, stock price offers a clear target for
managers in the course of their decision-making.
Stock price maximization as the only objective can be problematic when the
different players in the firm “ stockholders, managers, lenders and society “ all have
different interests and work at cross purposes. These differences, which result in agency
costs can result in managers who put their interests over those of the stockholders who
hired them, stockholders who try to take advantage of lenders, firms that try to mislead
financial markets and decisions that create large costs for society. In the presence of these
agency problems, there are many who argue for an alternative to stock price
maximization. While this path is alluring, each of the alternatives, including using a
different system of corporate governance or a different objective, comes with its own
share of limitations.
Given the limitations of the alternatives, stock price maximization is the best of a
set of imperfect choices for two reasons. First, we can reduce the agency problems
between the different groups substantially by trying the align the interests of
stockholders, managers and lenders (using both rewards and punishment), and by
punishing firms that lie to financial markets or create large social costs. Second, stock
price maximization as an objective is self correcting. In other words, excesses by any one
of the groups (whether it be managers or stockholders) lead to reactions by the other
groups that reduce the likelihood of the behavior being repeated in future periods.

Problems and Questions
1. There is a conflict of interest between stockholders and managers. In theory,
stockholders are expected to exercise control over managers through the annual meeting
or the board of directors. In practice, why might these disciplinary mechanisms not work?

2. Stockholders can transfer wealth from bondholders through a variety of actions. How
would the following actions by stockholders transfer wealth from bondholders?
(a) An increase in dividends
(b) A leveraged buyout
(c) Acquiring a risky business
How would bondholders protect themselves against these actions?

3. Stock prices are much too volatile for financial markets to be efficient. Comment.

4. Maximizing stock prices does not make sense because investors focus on short term
results, and not on the long term consequences. Comment.

5. There are some corporate strategists who have suggested that firms focus on
maximizing market share rather than market prices. When might this strategy work, and
when might it fail?


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