Dr. Michael M. Kisembo
Department of Management
50 Goddard Ave.
The source of conflict between the business community’s objective of shareholders wealth maximization and the wider community’s objective of maximizing of common good for all stakeholders is examined. Effects of government imposed regulations on both production and operational costs in form of both direct and indirect costs with their eventual adverse effects on the market equity value for shareholders are surveyed and analyzed. Also examined are the objectivity, realism and relevance of shareholders’ wealth maximization as opposed to the balancing of interests for the both provider of knowledge, and risk capital and other stakeholders, who can substantially affect or be affected by the welfare of a firm. In the view of the difficulty of being able to maximize interests of all stakeholders simultaneously, prioritization of these interests is recommended. The recommended sequence is the maximization of the shareholders’ wealth first followed by that of the rest of stakeholders. This is because of shareholders’ wealth inclusiveness and spread effect to all other stakeholders in the long run
No business, large or small can operate without obeying myriads of rules and restrictions, usually referred to as government regulations, administered by sixty one (61) federal regulatory agencies (Hopkins, 1999). Regulations imposed on business by the federal government, which became so pervasive and comprehensive in American Society during the 1970s, their number and scope has grown dramatically during the last three decades.
These regulations, whose major objective is to make it mandatory for all firms to equally exercise social responsibility, while conducting their business, fall into four major types. These are regulations of competitive behavior like Federal Trade Commission (FTC), Industrial regulations such as Finance and Securities (SEC), Social regulations a good example of which is Occupation Safety and Health (OSHA), and regulations of Labor Management and Relations, a case in point being the National Labor Relations Board (NLRB). Such regulations though imposed on business to protect the public good and all stakeholders (shareholders included), have had and continue to have huge direct and indirect costs to both business and consumers.
Management and shareholders, the provider of knowledge and risk capital, generally view these regulations as business burden and a hidden tax, which create problems, limitations and hindrance on the management main and “official” objective of the maximization of shareholders’ wealth, represented by the market value of equity. This market value of equity, sometimes referred to as capitalization, being a present value of all expected future cash flows (dividend) to owners, is just the value of all owners’ interest in the corporation, calculated as a product of the share price and the number of shares outstanding. The maximization of this market value of shareholders’ equity depends on a number of factors like projected earning per share, timing of the earning stream, risk of projected earnings, dividend policy and manner of financing the firm, (Brigham, 1988 and Peterson, 2001). These are what management ought to maximize and what government regulations threaten not to, at least in a short-run. There is another school of thought whose empirical studies have demonstrated that when regulations are carefully conceived, and objectively enforced they would have a positive impact on business economic performance and enhance shareholder value in the long run. Schiebel and Pochtrager (2000) assert that over the long term corporation which implement regulations that enforce social responsibility generate more profit and growth and hence increase shareholder wealth.
Conflict created by imposition of government regulations on the management objective of shareholder wealth maximization.
Conflict created by the imposition of government regulations is in the way these regulations are conceived, created and in the resultant huge costs they burden business with, which conflicts with management main objective of maximization of shareholders wealth, achieved by maximization of market value of shareholders’ equity, as determined by factors outlined above.
Looked at from the business and economic perspective, the manner in which government regulations are created leaves a lot to be desired. More often than not these regulations are politically motivated and created without quantitively considering their economic or negative business consequences. When government regulates, un elected federal employees tell business and public to spend money to do something they have decided (Federal) that is good for the society even when the costs of that rule might far exceed its benefits. There is nothing to stop regulators from regulating as if it costs nothing, because these costs are usually hidden. Business community sees this as unfair to their primary objective of maximizing their economic profit, but just one of politically convenient ways to carry out public policy without first taking into account of possible adverse consequences to business and the well-being of the community. In fact according to Hahn (1996), half of all environmental, health and safety regulations adopted since 1990 are producing annual costs that exceed benefits. The federal government routinely through regulation mandates inefficient uses of resources (Hopkins 1999).
A good example of failure to take account of consequences first is the foot- and- mouth disease in Britain. The foot- and- mouth disease was a result of regulatory changes that forced the shutdown of local abattoirs. It was the shipping of cattle hundreds of miles for slaughter that increased the chances of infection spreading which caused huge losses to many farms and livestock business, inflicting a blow to shareholders wealth. At the time of the rules implementation such regulation’s consequential dangers were ignored. Another example is the America’s ergonomics story during the Clinton Administration in which new rules strengthened workers’ legal standing and promised compensation for employees suffering back pain and other work place injuries amounting to ninety percent of their old pay. Regulators ignored the fact that regulations gave workers an incentive to excessively claim injury exponentatially increasing business operation costs. Had it not been repealed the new legal right would have made the already America’s litigious work place even more litigious – putting management and shareholders into a tight corner. It is sad to note that even the supporters of ergonomics regulations conceded that there were costs, which were too tough to calculate. For instance, the Occupational Safety and Health Administration estimated that rules would cost business $4.5 billion a year, while the Small Business Administration put the price at $100 billion, the budgetary equivalent of some of components of Bush Administration tax cut plan (Shlaes, 2001).
Furthermore, government regulations when imposed on businesses substantially increase production and operating costs of the business which could result in reduced operating and economic profit, earning per share, earning stream, dividend and eventually market equity value for shareholders. In fact the United States regulatory stringency has contributed to loss of U.S. manufacturing firms’ competitiveness in the international markets. This loss of competitiveness is believed to be reflected in declining exports, increasing imports and a long-term movement of manufacturing capacity from United States to other countries, particularly in pollution intensive industries like chemical, paper steel, and metal (Jaffe et al, 2000). The company usually strives to produce its products and services efficiently and at the possible lowest cost per unit and if possible below the industrial average. The government regulations on contrary result in the increment of both direct and indirect costs.
Direct costs arising from mandated regulatory compliance are huge amount. Hopkins (1999) puts the direct annual cost of compliance with federal regulations, incurred by various businesses at a conservative figure of $ 700 billion or 9 percent of United States Gross Domestic Product (GDP) in 1998. This figure does not take into consideration the direct effect of regulations on the labor and productivity. Johnson and Moller (2001) conservative estimates put the cost to business for complying to only six work place regulatory categories to $ 91 billion annually. The details of these costs are summarized in the table 1.
These costs are usually hidden from public view, though they are twenty times the amount of money federal government spends to administer its federal program each year (Buchholz, 1989). These costs constitute paper worker, recording and documentation, office space, equipment, litigation, work training and permits. It is worthy to note that though the benefits of regulations may be shared by a significant segment of the society including the business itself, the costs of implementing these regulations are largely borne by business organizations-draining them of profits and shareholder wealth. It is indeed sad to note that despite of keeping increasing production costs for business, many of regulations fail to do what they are supposed to do!
Table 1. Best estimates of total cost of workplace regulations. Source: Johnson and Moller (2001).
|Regulatory Category||Direct Cost (US$ Billion)|
|Labor Management Relations||4.0|
|Occupational Safety & Health||48.6|
|Employment Decision Laws||12.2|
These are costs, which are sometimes referred to as second- order effects, economic costs, opportunity costs or efficiency costs. Like the direct costs, they too, as a result of regulations, adversely affect company’s earnings in terms of the amount, earning stream and regularity, which in turn may reduce the shareholder equity market value, which is in conflict with management objective of maximizing shareholder wealth.
The most serious of these costs is losses in the productivity. Denison of Brookings Institute estimated that in 1975 business productivity was 1.4 percent lower than it would have been if business had operated under regulatory conditions existing in 1967. A 1995 study by the Employment Policy Foundation found that 19 percent of the productivity slowdown during 1970s was directly attributable to regulations published by OSHA and nearly a half of slowdown in long – term productivity can be explained by rising government regulatory activity. Also Vedder in his recent study for the center for the Study of American Business agrees that in addition to the costs of complying with regulations, the long – term costs of reduced productivity are high. When business are forced to devote resources to implement regulatory mandates, those resources are used inefficiently because firms are forced to use more costly and less productive method of production and this significant drag on productivity, denies workers higher wages and hence motivation to work more efficiently and productively for the company.
Government regulations have also had adverse effect on innovation in some industries and especially the drug industry. Because of these regulations the volume of new products of drug and new chemicals entities has declined since 1962 amendment to the Pure Food and Drug Act. These amendments have required extensive and costly pre-market testing of new drugs. This drop in innovation has been accompanied by increases in the cost of duration and risk of new product development which has resulted in sharp reduction in rate of return on research and development investment in the drug industry and in an erosion of American firms’ technological leadership in new drug development (Schnee, 1979).
Other adverse effects and costs of government regulations include the cost of halting of new capital formation by delaying necessary permits and clearances to construct new productive facilities, the cost of diverting management from its basic function of running enterprises to devoting much of its valuable time dealing with implementation of regulations and their impact on the economy. Resulting costs for such can be seen in terms of factories that do not get built, jobs that do not get created, goods and services that do not get produced, incomes that are not generated, dividends that are not declared and eventually shareholder wealth that is not maximized.
Supporters of regulations have argued that the cost of government regulations can simply become one of the conditions under which owners’ wealth maximization can be made (Peterson, 2001). Those costs of public policy are in reality defused to the society in form of higher prices. What should be noted though is that there is a limit to what these costs can be passed to the society or consumer for that matter, without losing the market or decrease in effective demand especially with products with elastic demand and in a competitive environment like today’s global market.
Is the management objective of maximization of shareholders wealth realistic?
There has been recent publications in corporate governance, shareholder value and stakeholder management with range of opinion on the subject of maximization of shareholder wealth as a primary management objective. Some of these sources assert that the management traditional objective is not realistic and that they should be a balancing of interests of all stakeholders, where the provider of risk capital is. Others still maintain that it is impossible to balance competing interests; therefore, it is more objective, realistic and better to stick to legitimate priority of one objective and other to follow after in the long run.
To supporters of Stakeholder theory understand stakeholders not only to include shareholders, but all individuals or groups who can substantially affect the welfare of a firm; that is the financial claimants, employees, communities, customers, government officials and by extended interpretations, environment and even terrorists, blackmailers and thieves (Freeman, 1987). Schiebel in his article “Corporate Ethics as a Factor for Success” argues that “Profits are essentially not only to reward investors, but also to provide sustainable jobs, pay fair wages, pay taxes, develop new products, invest in services and contribute to prosperity of the communities in which business operates”. What he is essentially saying is that management should aim at maximizing myriads of competing interests simultaneously. To him that is the realistic objective. While explicitly endorsing the stakeholder-balancing notion, Peter (1997) in his report argued that in order to be realistic, companies must seek good balance between the interests of providers of risk capital and other stakeholders. This implied that the balancing action is a must and the resulting short – term conflicts of interests could be resolved in the long run. The Canadian report on corporate governance in Canada, goes further to suggest that it would be a much more realistic objective to balance all stakeholders interests in a short run so as to guarantee shareholders wealth maximization. “The principle objective of the corporation is enhancing shareholder value”, and “the long term interests of shareholders will not be served if the interests of other stakeholders are not served” (Dey Report, 1994). In support of balancing of interests, the American Law Institute (ALI) argues that “the principle of economic self-interest does not mean that objective of corporation must be to realize corporate profits and shareholder gain in short run, but in the long run,” and that “… corporation is a social and economic institution, and accordingly its pursuit of the economic objective must be constrained by social imperatives and may be qualified by social need” (ALI, 1994). ALI principles here seems to accept stakeholders understanding that modern corporations creates interdependencies with a variety of groups like employees, customers, suppliers, members of the community in which it operates, with whom the corporation has a legitimate concerns and on whom long term profitability of the corporation depends.
On the other hand those in support of shareholder wealth maximization as the most legitimate and primary management objective, argue that it better and most realistic for a firm to have a single- valued prioritized objective, rather than myriads of them; and the stakeholder theory is flawed and violates the proposition that an organization should have a single – valued objective as a precursor to a purposeful and rational behavior. It is argued that a firm that adopts stakeholder theory will be handicapped in competition for survival, because as a basis for action stakeholder theory politicizes the corporation and leaves its managers empowered to exercise their own preferences in spending the firm’s resources as they become in reality accountable to no one.
It is further argued that it is impossible to maximize more than one dimension simultaneously unless such dimensions are monotone transformation of one another. “It is not logically possible to speak of maximizing both market share and profit. At one point increases in the market share comes at a reduced current year profit… because increased expenditure on R&D and advertising or price reductions to increase market share reduce the year profits”( Jensen, 2001). Asking manager to maximize profits, market share, future growth in profits and anything one pleases leave him/her without decision objective. The result would be confusion and fundamentally handicap the firm in its competition for survival (Jensen, Wruck and Barry.1991). In order for a firm to resolve this ambiguity firm’s management must specify tradeoffs among various dimensions.
It is also argued that social welfare is maximized when all firms in the economy maximize their firm value. This is because social value is created when a firm produces an output that is valued by its customers at more than the cost /value of the inputs it consumes in production, the firm value being the long term market value of stream of benefits. When affirm acquires an additional unit of any input to produce an additional unit of any output, it increases social welfare at least by the mount of its profit. What can be deduced from argument and counter- argument for and against the reality of management objective of maximization of shareholder wealth is that we cannot maximize the long-term market value of shareholders equity or wealth for that matter, if we completely ignored or mistreated any of important constituencies of the firm. We cannot create value without good relations with customers, employees, suppliers, regulators, community, risk capital providers and so on. Nevertheless we may not achieve these objectives simultaneously. There must be tradeoffs or opportunity cost. Hence we need to priotized these interests so as to pick the best priority of the objective whose first fulfillment would lead to best results and chances to maximizing the rest of interests for the rest of the constituency. It is the maximization of shareholder wealth that would be realistically and reliably enough to result in total maximization of all stakeholder wealth or value. This is because it is the maximization of shareholders wealth that is a total market value of equity, debt, and any other contingent claims outstanding on the firm, which is one objective function that will resolve the tradeoff problem among multiple constituencies. This tells the firm to spend an additional dollar of resources to satisfy the desires of each constituency as long as the constituency values the result at more than a dollar. Although there are other many single- valued objective functions that could guide firm’s managers in their decision, value maximization is the most realistic one because it leads under some reasonable conditions to the maximization of social welfare.
Furthermore, with the objective of maximization of shareholders wealth, the firm will always strive to be more efficient, minimize costs, enjoy economies of scale, offer best services to customers at the lowest price possible and at the same time continue to expand purchases of input and sell the resulting output at a much reduced price, all things being equal, in effect maximizing benefits of community and all stakeholders. Thus the management objective function that maximizes shareholder wealth, maximizes social welfare, and then further maximizes the total market value for the benefit of all stakeholders.
Lastly, the reality of shareholder wealth maximization as the management objective lies in the fact that unlike other financial measures like profit and earning per share, shareholder wealth maximization is more inclusive. Though maximization of earnings per share (EPS) is more important than profit maximization, is not a full appropriate objective. This is because EPS does not specify the timing or duration of expected returns, does not consider the Financial Risk of prospective earning stream or the firm’s Dividends Policy. To extent that the payment of dividends can affect the value of stock, the maximization of earning per share will not be a satisfactory objective by itself, Van Horne (1980) observed. As already alluded to above, the firm’s stock market value, is the focal judgment of all market participants as to what value is of a particular firm. It takes into account present and prospective future earning per share, the timing, duration and the risk of these earnings, the dividend policy of the firm and other factors that bear upon the market price of the stock.
The imposition of government regulations on business in many cases has resulted in the substantial increase in the firms’ total cost both directly and indirectly. These costs have taken the form of increased cost of material, labor, and equipment on one hand and lost productivity and market competition on the other. These adverse effects on business have been in direct conflict with the cardinal management objective of maximization of shareholder wealth realistically measured in terms of market value of shareholder equity. Proponent for government regulations to business have argued that shareholder wealth maximization is not realistic and that there should be a balanced attention to all what they call stakeholders interest in which also the providers of risk capital are part. Nevertheless it is true that one cannot maximize interests of all stakeholders simultaneously. There is a need of prioritizing, and it would be in the best interest of all stakeholders to start with maximization of shareholder wealth since it is all-inclusive with positive spread effects to the society as a whole.
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