Dr. P.V. Viswanath

 

pviswanath@pace.edu

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The Objective Function in Corporate Finance
Prof. P.V. Viswanath, 1997, 2001, 2003

 
 

 

Why do we need to have an objective function? So that we can use it to make decisions.

The classical objective of maximizing firm value runs into problems when we move away from an owner-manager who provides his own financing. In other words, the separation of owners from managers, stockholders from bondholders and suppliers of labor from suppliers of capital creates difficulties.

Often, we end up with a stock price maximization objective as a way of compromising between the interests of the different forces that are brought under the umbrella of the corporation. The main reason for this is that stockholders are the residual claimants of wealth in the firm. As residual claimants, they also have more of an incentive to maximize the value of the entire firm than any of the other claimants to the value generated by the operations of the firm. And from a societal point of view, maximizing the value of the firm, i.e. making optimal use of society's resources is the correct objective. This is why it is optimal for stockholders to have control rights to the firm.

Of course, there can be conflicts between stockholders and the other stakeholders in the firm. This can lead to suboptimal use of social resources. Under the right conditions, however, maximizing the stock price is equivalent to maximizing firm value. This makes the manager's job easier, because maximizing stockholder wealth is less ambiguous than maximizing the value of the firm, and easier to justify to the parties that control the firm, i.e. stockholders, and easier for the manager to justify to himself. What are these conditions?

  • Stockholders can design managerial compensation contracts so that managers find it in their interest to maximize stockholder wealth. (So that managerial actions also maximize stockholder wealth.)
  • Bondholders can design bond contracts so that stockholders do not take actions to transfer wealth from bondholders to themselves, and injure firm value in the process. (So that stockholder actions also maximize bondholder wealth, at least ex ante.)
  • Financial Markets obtain all the information required to price securities correctly. (So that maximizing stock price also maximizes stockholder wealth.)

The objective function of maximing stockholder wealth is consistent with maximizing social value as well, provided social costs are internalized by the firm, explicitly or implicitly.

Source of conflict Solution Difficulties
Between stockholders and managers Optimal contracts and takeovers; the annual meeting, board of directors Collective action problems, greenmail, anti-takeover devices such as golden parachutes and poison pills; imperfect information problems, leading to the Winner's Curse.
Between stockholders and bondholders Covenants in Bond indentures and market discipline Imperfect monitoring
Between the firm and financial markets Action by concerned investor groups, market discipline and governmental action Difficulty of entering into and enforcing implicit multiperiod agreements (who acts on behalf of the market?)
Between the firm and society Governmental regulation, and boycotts by consumers and investors Who controls the controllers?

My interest in this note is to try and explain why firms tend to exhibit certain organizational structures and not others.  This will also cast some light on the definition of a firm.

To begin with, let us go to an example of natural selection, taken from Introduction to Evolutionary Biology by Chris Colby (http://www.talkorigins.org/faqs/faq-intro-to-biology.html). The species under consideration is a particular kind of finch, called Geospiza fortis.  "Geospiza fortis lives on the Galapagos islands along with fourteen other finch species. It feeds on the seeds of the plant Tribulus cistoides, specializing on the smaller seeds. Another species, G. Magnirostris, has a larger beak and specializes on the larger seeds. The health of these bird populations depends on seed production. Seed production, in turn, depends on the arrival of wet season. In 1977, there was a drought. Rainfall was well below normal and fewer seeds were produced. As the season progressed, the G. fortis population depleted the supply of small seeds. Eventually, only larger seeds remained. Most of the finches starved; the population plummeted from about twelve hundred birds to less than two hundred. Peter Grant, who had been studying these finches, noted that larger beaked birds fared better than smaller beaked ones. These larger birds had offspring with correspondingly large beaks. Thus, there was an increase in the proportion of large beaked birds in the population the next generation. To prove that the change in bill size in Geospiza fortis was an evolutionary change, Grant had to show that differences in bill size were at least partially genetically based. He did so by crossing finches of various beak sizes and showing that a finch's beak size was influenced by its parent's genes. Large beaked birds had large beaked offspring; beak size was not due to environmental differences (in parental care, for example)."

Now, the interesting aspect of this is how Geospiza fortis came to have larger bill sizes.  This did not occur because some finches realized that larger bills were advantageous and proceeded to somehow grow larger bills.  Rather, birds with larger bill sizes survived the drought better and transmitted larger bill sizes to their progeny.  In other words, natural selection led to the larger bill size of Geospiza fortis.  This is particularly interesting to us because in talking about organizational structures, we are not talking about entities that have volitions and objectives.  Rather, we are talking about a set of relationships between other entities that do have volitions and objectives.  These entities are suppliers of capital (bondholders and stockholders), suppliers of labor (employees), suppliers of raw materials (suppliers), etc.  However, it is difficult to argue that these groups sat down and worked out the best way of setting up their relationships; the main argument against this is that these groups, generally, have conflicting objectives, more or less, in the same way that any buyer and seller have competing objectives.  Buyers want the lowest price possible for their goods, while sellers want to sell at the highest price.  

Agency Costs

The term agency costs is often used to refer to the costs incurred by the firm due to the conflicts referred to above -- conflicts between management and shareholders, conflicts between shareholders and bondholders, etc.

These costs are of three varieties:

  • Costs that are incurred by the principal directly to monitor the activities of the agent
  • Costs that are incurred by the agent to comply with the restrictions imposed by the principal, who is attempting to ensure that the agent acts as he, the principal wishes.
  • Costs due to suboptimal actions that the agent might take because of these conflicts. These can be of two kinds:
    • suboptimal actions that the agent is able to take because the monitoring by the principal is not effective.
    • suboptimal actions that the agent is forced to take because of the restrictions imposed by the principal.

Agency costs of debt

Agency costs of outside equity

One of the agency problems that occur when managers are also not owners is that they have an incentive to take excessive perquisites.  Here are some examples of executive perks.  Of course, these perks are portrayed as necessary for employee retention and/or increased productivity, but such claims are difficult to verify.

Staff-hungry tech firms cast exotic lures Pet insurance, BMWs, day care are among perks
USA Today; Arlington; Feb 1, 2000

PALO ALTO, Calif. -- High-tech firms and recruiters are ratcheting up the outrageous and creative incentives they're dangling to fill the 346,000 highly skilled technology jobs that have gone begging.

"The market is hotter than hot, so employers are doing everything to stand out," says Lance Choy, a recruiting director at Stanford University, which graduates more than 1,000 engineering students a year.

  • Interwoven, an e-commerce software maker in Sunnyvale, Calif., hopes to lure engineers with flashy BMW Z3s. The firm will cover a two-year lease, auto insurance and other costs, worth more than $60,000. "It introduces them to the spirit of our culture," says Jack Jia, an Interwoven executive.
  • 2Wire, a Silicon Valley start-up that makes products for home networks, opened an office in the rolling foothills of Grass Valley - - just to hire 10 top engineers at a nearby 3Com facility who didn't want to move from the area. "If you want world-class people, you've got to go to great lengths," 2Wire's Roy Johnson says.
  • L.L. Bean, the big retailer in Freeport, Maine, attracts Web site engineers to its rural headquarters by selling the gorgeous New England wilds.

Techies who join the company get five "outdoor days" to borrow L.L. Bean camping gear for backpacking, kayaking and other activities. And it doesn't count against vacation.

The most desirable hires, such as e-commerce software developers, are juggling several offers. They command up to $120,000 salaries, $15,000 signing bonuses and stock options worth nearly $1 million after an IPO, says Craig Silverman of Hall Kinion, a technology staffing firm in San Francisco.

But recruitment tricks and cash only go so far, notes Dave Van De Voort, a compensation expert at William Mercer.

Firms must sell workplace culture and lifestyle perks, such as flextime, telecommuting, fitness centers, day care, even health insurance for pets. "Organizations must offer the total work experience to attract talent," Van De Voort says.

To keep talent from leaving, 1,000 high-tech firms surveyed last year by Mercer say they offer workers more challenging jobs and training, more family-related benefits and better management supervision.

The nation's high-tech regions have been hit equally hard by the talent shortage. Unemployment last year sank to record lows in Silicon Valley (2.7%); Austin, Texas (2.1%); Boston (2.6%); and Fairfax County, Va. (1.6%), according to the American Electronics Association.


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