Benefits to real owners/ providers of capital and risk takers
Shareholder Wealth Maximisation
“ Our mission is to maximise share-owner value over time”.
Coca Cola Company Annual Report
Putting value creation first can bring huge benefits, not only to the company but to society as a whole. No company can survive for long unless it creates wealth. A sick company is a drag on society. It cannot sustain jobs nor adequately serve customers. It cannot give to philanthropic causes.
We believe there is no better way for us to serve all our stakeholders-not just our shareholders, but our customers, fellow employees our business partners and our community- than by creating value over time for those who employ us. It is our success in value creation that has enabled the Lloyds TSB group to become a leader in charity. The Lloyds TSB Foundations will receive some 27million pounds in 1999 for distribution to charities.
Decision Making Framework
What is the expected return
What is the risk exposure
What is the impact on value
Corporate Securities as Contingent Claims on Total Firm Value
The basic feature of debt is that it is a promise by the borrowing firm to repay a fixed amount by a certain date.
The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.
If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.
Debt and Equity as Contingent Claims $F Debt holders are promised $ F . If the value of the firm is less than $ F , they get the whatever the firm if worth. If the value of the firm is more than $ F , debt holders get a maximum of $ F . If the value of the firm is less than $ F , share holders get nothing. If the value of the firm is more than $ F , share holders get everything above $ F . Algebraically, the bondholder’s claim is: Min[$ F ,$ X ] Algebraically, the shareholder’s claim is: Max[0,$ X – $ F ] $F Payoff to debt holders Value of the firm (X) $F Payoff to shareholders Value of the firm (X)
$F Debt holders are promised $ F . If the value of the firm is less than $ F , the shareholder’s claim is: Max[0,$ X – $ F ] = $0 and the debt holder’s claim is Min[$ F ,$ X ] = $ X . The sum of these is = $ X If the value of the firm is more than $ F , the shareholder’s claim is: Max[0,$ X – $ F ] = $ X – $ F and the debt holder’s claim is: Min[$ F ,$ X ] = $ F . The sum of these is = $ X Combined Payoffs to Debt and Equity $F Combined Payoffs to debt holders and shareholders Value of the firm (X) Payoff to debt holders Payoff to shareholders
Ownership of the shareholders
Management by professionals
Separation of ownership & management
Principal – agent relationship
Conflicting interests of shareholder & management & shareholder wealth is not maximised
Resolution of the Agency Problem
Structuring appropriate incentives
Stock options, bonuses and perquisites.
Monitoring of managers (agents)
Audit. Board of Directors. Review performance
Market for takeover
Replacement of top management
Hiring of professional managers
Change in ownership without impacting company’s operations
Larger no. of owners
Shareholders rely on CEOs to adopt policies that maximise the value of their shares. Like other human beings, however, CEOs tend to engage in activities that increase their own well being. One of the most critical roles of the Board of Directors is to create incentives that make it in the CEOs best interest to do what is in the shareholders’ best interests. Conceptually, this is not a difficult challenge. Some combination of three basic policies will create the right monetary incentives for CEOs to maximise the value of their companies.
Boards can require that CEOs become substantial owners of company stock.
Salaries, bonus and stock options can be structured so as to provide big rewards for superior performance and big penalties for poor performance.
The threat of dismissal for poor performance can be made real.