5BUS1157 Corporate Finance For the Efficiency Market Hypothesis

Introduction:

The objective with which a corporation or a particular organization is established is the most important practical and theoretical issue that is being confronted by the regulatory authorities today. Though, there have been various debates revolving this topic, the determination of a particular objective is necessary in order to ensure the corporate behavior as different objectives can lead to different outcomes in regards to a single corporate governance problem.

This study focuses on reflecting an overview into the Shareholder Wealth Maximization (SWM) theory and why it had been deemed superior, earlier. The study delves into the reasons as to why the current conditions in the economy and the social affairs have resulted in a shift from the company objective being the SWM theory to the stakeholder theories.

Supremacy of the SWM theory and how agency

theory shapes this

The Shareholder Wealth Maximization theory leads to the theory that refers to the fact that primary motive of a corporate is to maximize the wealth of a firm and earn subsequent profit to its shareholders. A shareholder is essentially a person who owns the shares of a company, which indicate ownership in a firm. Shareholder Wealth Maximization theory is adopted by the management of various organizations for earning more profits, which will in turn increase the stock, price of the firms. This is because with the increase in the stock price the wealth of the shareholders who own these stocks also increase (Harrison and Wicks 2013). The increase in the stock price also increases the net worth of the shareholders holding such stocks.

The preference or the supremacy of the SWM theory in respect to other theories as a corporate objective has been precisely due to the following factors:

• The firm strives to ensure the maximum rate of return to its shareholders
• The firm minimizes the level of risk to its shareholders for a respective rate of return
• The universal truth in regards to the stock market being always efficient is assumed by the SWM model
• The equity share price that is fixed depending upon the profits earned by a firm always forecasts the correct information in regards to the risks and returns that has been expected by an investor
• It is stated by many experts that the share or stock prices are the best possible allocators of capital especially in a macro economy

Thus, the primacy or the supremacy of the SWM theory refers to the theory in the field of corporate governance that essentially states that the interests of the shareholders should be given the first priority in regards to the other stakeholders (Mansell 2015).

The agency theory fundamentally refers to the situation when one individual or entity (principal) hires another individual or entity (agent). The primacy agency relationships that exist in a organization are that between the managers of the firm with the shareholders and the relationship that exists between the stakeholders and the shareholders. The agency theory particularly revolves around the conflicts of interest that arise between the principals and the agents of the firms. Thus, the agency theory shapes the SWM theory in such a way that the conflicts of interests arising due to the adoption of such a theory by the firm are minimized. It also ensures minimizing the agency costs that arise due to these conflicts.

Contrast between the stakeholder theories and the SWM theory

The Shareholder Wealth Maximization theory is the theory that had been proposed by Milton Friedman. The essentiality on which the SWM theory is based upon is that the managers of an organization are the agents that have been hired by the shareholders of the firm (principals) in order to the run the company only for the purpose of their interests. There have been certain disadvantages that the shareholder theory suffers from. These are particularly related with the conflicts of interest that the agents have with their principals. The agent who is acting as a representative of another party might as well disagree in regards to the best possible course of action. He may also act in his own interest instead of the interest of the principal. Thus, the SWM theory is particularly featured by the agency problem (Harrison, Freeman and de Abreu 2015).

The stakeholder theory on the other hand refers to the prioritizing the interests of the different stakeholders of business that are customers, financiers, suppliers, employees, government bodies and trade associations. Thus, the stakeholder theory fundamentally includes all the individuals or entities that are affected by the company and its workings. These are the entities without whom a particular organization may cease to exist. The stakeholder theories suggest that the stakeholders are the life support system of a business therefore, their interests should be first catered to (Strand and Freeman 2015).

The primary distinction between the SWM theory and the stakeholder theory is that the former theory focuses on only profit earning as the only corporate objective in order to increase the wealth of the shareholders. While the later primarily focuses on the stakeholders of the business and forms a foundation for serving the interests of the stakeholders at first, as they are the building blocks of the organization (Tantalo and Priem 2016).

Why has there been a shift from the SWM to the stakeholder theory?

In the recent times, there has been a shift in regards to the corporate objective that is adopted by the various organizations, from SWM theory to the stakeholder theory. This is majorly due to the fact that the current global economy asks the corporate bodies to have been built upon the foundations of equal rights and shares. Moreover, the theory aims to create a framework that connects the well-being of the stakeholders with the improvement in the performance of the organization. Secondly, the theory also clearly defines the behavior of the corporation and its elements. Thirdly, the aspect of the theory, which interprets the purpose of the company, is known as the normative validity. The stakeholder theory also strengthens the social corporate duties that are expected out of an organization thus, further strengthens the ethical foundations of the company.

However, a particular disadvantage pertaining to this theory is that the identification of the stakeholders is not clear enough. This means that a proper basis has not been provided in order to identify the potential stakeholders. In spite of such a disadvantage more and more organization are adopting the stakeholder theory because of the emergence of a socialist economy that has potentially added to the importance of the stakeholders of a particular business (Strand and Freeman 2015).

Examples of two listed companies

Dunbia, being a leading company in the food industry of the United Kingdom has adopted the stakeholder theory as its corporate objective. Thus, this further validates that the stakeholder theory is much more advantageous than the SWM theory (Dunbia.com 2017).

Greenergy, another leading company in the fuel market of United Kingdom reveals in its annual report that the corporate objective that it follows is the Shareholder Wealth Maximization theory (Greenergy.com 2017).

Conclusion:

As it can be concluded from the above discussion, in spite of the supremacy or the primacy of the shareholder theory, the stakeholder theory is increasingly adopted by the business organizations worldwide due to the advantages and the wholesome view that this theory provides. The stakeholder theory not only focuses on the social aspect of a company but also on the link that connects the corporate performance with such an aspect.

References:

Dunbia.com (2017) Available at: https://www.dunbia.com/discover-dunbia/corporate-responsibility [Accessed 26 Dec. 2017].

Greenergy.com. (2017). Available at: https://www.greenergy.com/uploads/S7dozxZ3fm6a_annual_report_2012.pdf [Accessed 26 Dec. 2017].

Harrison, J.S. and Wicks, A.C., 2013. Stakeholder theory, value, and firm performance. Business ethics quarterly, 23(1), pp.97-124.

Harrison, J.S., Freeman, R.E. and de Abreu, M.C.S., 2015. Stakeholder theory as an ethical approach to effective management: Applying the theory to multiple contexts. Revista Brasileira de Gestão de Negócios, 17(55), p.858.

Mansell, S., 2015. Book Review: Rejoinder to Veldman’s review of Capitalism, Corporations and the Social Contract: A Critique of Stakeholder Theory (Vol. 22, No. 2, pp. 271-275). Sage UK: London, England: Sage Publications.

Strand, R. and Freeman, R.E., 2015. Scandinavian cooperative advantage: The theory and practice of stakeholder engagement in Scandinavia. Journal of business ethics, 127(1), pp.65-85.

Tantalo, C. and Priem, R.L., 2016. Value creation through stakeholder synergy. Strategic Management Journal, 37(2), pp.314-329.