In this report, purposes of corporations are investigated under two different approaches on corporate value maximization: shareholder approach and Stakeholder Approach. So, firstly both approaches are defined briefly. Secondly, compare and contrast of shareholder and stakeholder approaches is made. Keywords: Purpose, Corporation, Value Maximization, Shareholder Approach, Stakeholder Approach. Shareholder Approach on Value Maximization.
Shareholder approach on value maximization focuses the corporation’s purpose on maximizing the wealth of owners by maximizing the profit while minimizing the importance of the other roles of corporation in the society. The origins of the ideas shaping shareholder theory are more than 200 years old, with roots in Adam Smith’s (1776) The Wealth of Nations. Smith’s three ideas are followed by modern supporters of shareholder approach, 1. The importance of ‘free’ markets;
The ‘invisible hand of self-regulation’ and 3. The importance of ‘enlightened self-interest’ Shareholder approach supporters defend the idea that excessive oversight and regulation of industry is unnecessary. Members of the ‘Austrian School’ of economics were early supporters of the shareholder approach. They advocated the idea of ‘leave alone’ capitalism, which focuses on the importance of self-regulation among firms, with limited government intervention.
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Shareholder theory in its current form is linked most directly to the ‘Chicago School’ of economics, most notably to Milton Friedman and his colleagues, who have argued for nearly four decades that the overriding purpose of the firm is to maximize shareholder wealth. They believe solving social problems is the responsibility of the state. Friedman believed, in short, that the business of business is business. When firms become involved in social or public policy issues, wealth is diverted to issues outside the core expertise of their managers.
This inefficient use of wealth will affect society in the long run. Friedman never argued that firms can act unethically, immorally, or illegally. Today, two influential schools of thought of shareholder approach are ‘transaction cost economics’ (TCE) and ‘agency theory’. TCE focuses on the importance of corporate hierarchies and monitoring employee behavior to minimize self-interested behavior. TCE focuses primarily on the principal vs. Agent (shareowner vs. Manager) relationship in publicly traded firms, and how to best align the competing interests of two parties to maximize firm value.
Both TCE and agency theory assume that human beings are opportunistic, and, thus, will put their own interests before the firm’s. Stakeholder Approach on Value Maximization: The idea that a company should have an expanded role and responsibilities to other stakeholders besides its owners is much newer than shareholders theory. Both shareholder and stakeholder approaches are concerned with the purpose of the firm and strategies to improve its competitive position.
Stakeholder approach does not view maximization of shareholder wealth as the most efficient way to generate competitive advantage for the firm. Approach holds that firms can best generate competitive advantage and wealth by taking more than just shareholders into account. In the late 1970s and early 1980s, researchers with backgrounds in philosophy, psychology, sociology, and management began putting foth a new theory of the firm that challenged some of the basic assumptions of classic economics and shareholder approach.
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In particular, Archie Carroll and Ed Freeman theorized that by taking the interests of all the firm’s stakeholders into account, the firm could do ‘better’ than by simply focusing on shareholder interests. Carroll noted that corporations have four major responsibilities: economic (to generate shareholder wealth), legal (to obey laws and regulations), ethical (to recognize that the firm is part of community, and thushas obligations to, and an impact on, others), and discretionary (to engage in philanthropy).
Both Carroll and Freeman believe that if a firm creates value for its stake holders, it will create value for its shareholders, as well. Thus, unlike the assumptions of classical economics and shareholder theory (that a firm can only maximize value on one dimension), stakeholder theorists believe that taking all constituent groups into account is the better way to maximize oveerall firm performance.
The stakeholder theorists smell blood. Scandals at Enron, Global Crossing, ImClone, Tyco International and WorldCom, concerns about the independence of accountants who are charged with auditing financial statements, and questions about the incentive schema and investor recommendations at Credit Suisse First Boston and Merrill Lynch have all provided rich fodder for those who question the premise of shareholder supremacy.
Many observers have claimed that these scandals serve as evidence of the failure of the shareholder theory — that managers primarily have a duty to maximize shareholder returns — and the victory of stakeholder theory, which says that a manager’s duty is to balance the shareholders’ financial interests against the interests of other stakeholders such as employees, customers and the local community, even if it reduces shareholder returns.
Before attempting to declare a victor, however, it is helpful to consider what the two theories actually say and what they do not say. Comparison of ShareholderApproach and Stakeholder Approach on Value Maximization: Both the shareholder and stakeholder theories are normative theories of corporate social responsibility, dictating what a corporation’s role ought to be. By extension, they can also be seen as normative theories of business ethics, since executives and managers of a corporation should make decisions according to the “right” theory.
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Unfortunately, the two theories are very much at odds regarding what is “right. ” Shareholder theory asserts that shareholders advance capital to a company’s managers, who are supposed to spend corporate funds only in ways that have been authorized by the shareholders. As Milton Friedman wrote, “There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it and engages in open and free competition, without deception or fraud.
” On the other hand, stakeholder theory asserts that managers have a duty to both the corporation’s shareholders and “individuals and constituencies that contribute, either voluntarily or involuntarily, to [a company’s] wealth-creating capacity and activities, and who are therefore its potential beneficiaries and/or risk bearers. ” Although there is some debate regarding which stakeholders deserve consideration, a widely accepted interpretation refers to shareholders, customers, employees, suppliers and the local community.
According to the stakeholder theory, managers are agents of all stakeholders and have two responsibilities: to ensure that the ethical rights of no stakeholder are violated and to balance the legitimate interests of the stakeholders when making decisions. The objective is to balance profit maximization with the long-term ability of the corporation to remain a going concern. The fundamental distinction is that the stakeholder theory demands that interests of all stakeholders be considered even if it reduces company profitability.
In other words, under the shareholder theory, nonshareholders can be viewed as “means” to the “ends” of profitability; under the stakeholder theory, the interests of many nonshareholders are also viewed as “ends. ” Unfortunately, shareholder theory is often misrepresented in several ways. First, it is sometimes misstated as urging managers to “do anything you can to make a profit,” even though the shareholder theory obligates managers to increase profits only through legal, nondeceptive means.
Second, some criticize the shareholder theory as geared toward short-term profit maximization at the expense of the long run. However, more thoughtful shareholder theorists often refer to a need for “enlightened self-interest,” which — if embraced — would lead a corporation’s managers to take a long-term orientation. Third, it is sometimes claimed that the shareholder theory prohibits giving corporate funds to things such as charitable projects or investing in improved employee morale.
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In fact, however, the shareholder theory supports those efforts — insofar as those initiatives are, in the end, the best investments of capital that are available. Similarly, the stakeholder theory is sometimes misunderstood. It is sometimes claimed that the stakeholder theory does not demand that a company focus on profitability. Even though the stakeholder theory’s ultimate objective is the concern’s continued existence, it must be achieved by balancing the interests of all stakeholders, including the shareholders, whose interests are usually addressed through profits.
Also, because many stakeholder theory descriptions provide no formula for adjudicating among the stakeholders’ disparate interests, some have claimed that the theory cannot be implemented. While it is true that some versions of the theory provide no guidance in this regard, many stakeholder theorists have provided algorithms for trade-offs among stakeholders’ interests. For example, one might assess the level of risk that each stakeholder has embraced and rank their interests accordingly, or one might simply assert that one stakeholder group’s interests should always prevail, as Richard Ellsworth has recently argued.