Many people believe that the primary objective of a firm is to maximize profits. Sports Products, Inc. is a firm who has followed this practice during its 20 year history. The management of Sports Products, Inc. has concentrated on maximizing profits while ignoring other critical factors. Management’s decision to maximize profits has created issues with its overriding goal, agency problem, approach to pollution control, and corporate governance. In order for Sports Products, Inc. to resolve the issues, changes need to be made in the way it operates.
OVERRIDING GOAL
The primary goal of a firm should be to achieve the objectives of its owners, also known as shareholders; therefore, management of Sports Products, Inc. should pursue maximizing shareholder wealth as its overriding goal. The current objective of Sports Products, Inc. has been to maximize profits, but “profits do not necessarily result in cash flows available to the stockholders” (Gitman, 2006, p. 15).
Owners only receive cash flow when receiving dividends or selling their shares for a higher price than when first purchased; Sports Products, Inc. has failed to pay dividends in its 20 year history.
Although profits may increase earnings per share, higher earnings per share do not increase stock prices unless accompanied by increased future cash flows. A decrease in future cash flow may result in decreased share price. The price of Sports Products, Inc.’s stock has declined nearly $2 per share over the past nine months. Because share price has decreased and “share price represents the owners’ wealth in the firm” (Gitman, 2006, p. 15), Sports Products, Inc. is failing to achieve the objectives of its owners. Pursuing the goal of maximizing shareholder wealth can lead to increased investor confidence, investments, cash flows, share price, and ultimately profits.
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AGENCY PROBLEM
The owners of Sports Products, Inc. rely of management, as their agents, to make decisions during the course of operations that will achieve the owners’ objectives. The owners’ objectives are to maximize wealth, which is measured be the share price of stock. In maximizing profits, it appears that Sports Products, Inc. has created agency problem. The firm has a profit-sharing plan under which all managers are partially compensated on the basis of the firm’s profits. The profit-sharing plan has created an issue in which managers are placing personal goals ahead of the owners’ goals. Dumping of pollutants in the adjacent stream demonstrates that management has made decisions in their own personal interests to decrease costs and increase profits, thus increasing management earnings. Management’s decisions were based on the results that were expected to make a major contribution to the firm’s overall profits, rather than the effects on share price. The negative public image created by the litigation impaired the firm’s competitive position and its stock price likely dropped as investors sold their stock in recognition of lower future cash flows.
APPROACH TO POLLUTION CONTROL
Sports Products, Inc.’s approach to pollution control, or lack of, was unethical. Management failed to consider the following questions by noted ethicist, Robert A. Cooke, (Gitman, 2006) before taking action:
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Is the action arbitrary or capricious? Does it unfairly single out an individual or group?
Does the action violate the moral or legal rights of any individual or group?
Does the action conform to accepted moral standards?
Are there alternative courses of action that are less likely to cause actual or potential harm? (p. 18).
In failing to ensure the ethical viability of its actions, the firm has put itself in the position to be sued by state and federal environmental officials.
Incurring the expense to control pollution would have been in the best interests for the firm’s owners despite its negative effect on profits because of the effect on the share price of stock. Expenses to control pollution may have decreased profits, but Sports Products, Inc. would not have created a negative public image that impaired its competitive advantage. Stockholders would not have sold their stock in recognition of lower cash flows, and the price of shares may not have fallen. By controlling pollution the firm could have eliminated litigation, enhanced its corporate image, and shareholder confidence and loyalty could have been gained, thus enhancing cash flow and increasing price share.
CORPORATE GOVERNANCE
Sports Products, Inc. does not appear to have an effective corporate governance structure because “a well-defined and enforced corporate governance provides a structure that, at least in theory, works for the benefit of everyone concerned by ensuring that the enterprise adheres to accepted ethical standards and best practices as well as to formal laws” (SearchFinancialSecurity, 2010, para. 2).
The failure in the structure appears to begin with the board of directors. The board should have established and monitored goals, plans, and policies on behalf of the shareholders. Dividends should have been paid, a profit-sharing plan for management should have never been approved, and unethical actions should have never occurred. Monitoring by the board should have eliminated any activities not within policy.
RECOMMENDATIONS
On the basis of the information provided, the first recommendation is to replace the board of directors. It is evident that the board was not acting responsibly on behalf of the shareholders because dividends should have been paid within the 20 years of operations and policies should have specified ethical practices to prevent situations, such as the dumping, from occurring. The next recommendation is to re-develop and implement strategic goals and plans consistent with the objectives of Sports Products, Inc. owners. The following recommendation is to replace the profit-sharing plan with management compensation, such as incentive and performance plans which corresponds with share price maximization. Management incentives benefit the managers while acting in the best interest of the owners. The final recommendation is to conduct a thorough review of the firm’s accounting practices. Sports Products, Inc. is generating profits, but there may be a problem with negative cash flow due to funds being tied up and problems with collecting accounts receivables. The lack of cash flow could be the reason dividends had never been paid.
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Conclusion
The management of Sports Products, Inc. has operated in a questionable manner. The decisions have resulted in loss of confidence by the shareholders, decreasing share price of stock, and litigation by state and federal environmental officials. Sports Products, Inc. needs to make changes in the way it operates to improve its situation. Changing its current goal of maximizing profits to maximizing shareholder wealth will result in a chain reaction of positive changes that will benefit not only the shareholders, but also the company.
References
Gitman, L. (2006).
_Principles of managerial finance._ (11th ed.).
New York, NY: Pearson, Addison Wesley.
SearchFinancialSecurity. (2010).
_Corporate governance._ Retrieved from http://searchfinancialsecurity.techtarget.com/sDefinition/0,,sid185_gci1174602,00.html
