Firm Value Maximization Research Articles

Successfully reshaping the ownership relationship by reducing ‘moral debt’ and justly distributing residual claims: The cases from Scott Bader Commonwealth and the John Lewis Partnership

This paper examines the issues relating to the most appropriate form of corporation ownership including organizational and cultural systems that will maximize the firm's value to society whilst maintaining a more sustainable market value. The paper argues that the maximization of firm value to society may be more readily achieved through a closed corporation type formation with better rights protection for all internal stakeholders, such as an employee-owned corporation or a limited liability partnership similar to Scott Bader Commonwealth and John Lewis Partnership, rather than a publicly-owned open corporation with large ‘moral debt’ claims, conflicts of interest, and agency costs. The four main perceived theoretical arguments against a closed corporation are: The horizon problem; the common-property problem; the non-transferability problem; and the control problem. Our analysis demonstrates how the Scott Bader Commonwealth and the John Lewis Partnership with support from the capital markets evolved successful solutions to the above theoretical issues. In other words, closed corporations such as Scott Bader Commonwealth and John Lewis Partnership with their better organizational and cultural systems can be considered to be more just at distributing residual and ‘moral debt’ claims than open corporations and thus are better at maximizing their value to society.

Voluntary Corporate Environmental Initiatives and Shareholder Wealth

Researchers debate whether environmental investments reduce firm value or actually improve financial performance. We provide some compelling evidence on shareholder wealth effects of membership in voluntary environmental programs (VEPs). Companies announcing membership in EPA’s Climate Leaders, a program targeting reductions in greenhouse gas emissions, experience significantly negative abnormal stock returns. The price decline is larger in firms with poor corporate governance structures, and for high market-to-book (i.e., high growth) firms. However, firms joining Ceres, a program involving more general environmental commitments, have insignificant announcement returns, as do portfolios of industry rivals. Overall, corporate commitments to reduce greenhouse gas emissions appear to conflict with firm value-maximization. This has important implications for policies that rely on voluntary initiatives to address climate change. Further, we find that firms tend to join Climate Leaders either in response to climate-related shareholder resolutions or due to weak corporate governance standards which give managers the discretion to make such voluntary environmentally responsible investment decisions — decisions that may result in lower firm value.

CEOs

This article starts with an overview of the characteristics of chief executive officers (CEOs). I discuss the rising importance of general skills over firm-specific skills and the growing share of externally recruited CEOs. I also discuss possible reasons for the underrepresentation of women and the overrepresentation of family members in the corporate suite. I then review the three main explanations that have been put forward to explain the surge in CEO compensation over the past 30 years: principal-agent view, rent extraction view, and market-based view. I assess the strengths and weaknesses of each of these explanations in light of the existing empirical research. Finally, I review work on how entrenched CEOs or cognitively biased CEOs may cause corporate practices to deviate from the maximization of firm value.

Brealey, Myers, and Allen on Valuation, Capital Structure, and Agency Issues*

In these “extracts” from the world's best‐selling graduate textbook, the authors offer a number of suggestions for practitioners, including: When valuing a company or an investment project, managers should start whenever possible with the asset's market price as the best initial estimate and then make adjustments that reflect their own private information. One obvious example of this process is when companies are evaluating possible acquisitions. When valuing a company or an asset, don't worry about risks that you can hedge separately. For example, foreign exchange risk can be hedged using forwards or futures, and there is no need to form an opinion on the future path of exchange rates. A positive NPV for a project is credible only if the company has some special advantage that competitors cannot match. That requires an understanding of the sources of the competitive advantage and how long they are likely to last. Although market inefficiencies may offer economic rents from “convergence trades,” as a general rule nonfinancial corporations gain nothing, on average, by speculating in financial markets. Since corporate managers know more about their company than outside investors, investors are likely to infer from corporate decisions to issue equity that the firm is overvalued (otherwise, why not issue debt instead?). And issuing overpriced stock to invest in projects that offer below‐normal rates of return is a sure way to destroy value. To make the most of their growth opportunities and create value for outside investors, most public companies require a co‐investment of insiders' human capital with outsiders' financial capital. Such co‐investment in turn implies a larger return to managers' and employees' human capital than that suggested by either the conventional prescription of shareholder value maximization (or even the financial economist's model of firm value maximization).

Corporate Debt Maturity Choice in Transition Financial Markets

This paper investigates the determinants of liability maturity choice in transition markets. We formulate a model of firm value maximization that describes managers' choice of optimal debt structure. The theoretical predictions are tested using a unique panel of 4,300 Ukrainian firms during the period 2000-2005. Our estimates confirm the importance of liquidity, signaling, maturity matching, and agency costs for the liability term structure of firms operating in a transition economy. In addition, we find that companies do not react uniformly to determinants of debt maturity. Firms that mainly rely on external funds are sensitive to signaling and they consider the variability of firm value an important determinant of their debt maturity choice. For less constrained companies that rely more on internal funding, asset maturity is an essential determinant of debt structure.

Enterprise Risk Management, Insurer Value Maximisation, and Market Frictions

Enterprise risk management has become a major focus for insurers and reinsurers. Capitalization and pricing decisions are recognized as critical to firm value maximization. Market imperfections including frictional costs of capital such as taxes, agency costs, and financial distress costs are an important motivation for enterprise risk management. Risk management reduces the volatility of financial performance and can have a significant impact on firm value maximization by reducing the impact of frictional costs. Insurers operate in imperfect markets where demand elasticity of policyholders and preferences for financial quality of insurers are important determinants of capitalization and pricing strategies. In this paper, we analyze the optimization of enterprise or firm value in a model with market imperfections. A realistic model of an insurer is developed and calibrated.Frictional costs, imperfectly competitive demand elasticity, and preferences for financial quality are explicitly modelled and implications for enterprise risk management are quantified.

Enterprise Risk Management, Insurer Value Maximisation, and Market Frictions

Enterprise risk management has become a major focus for insurers and reinsurers. Capitalization and pricing decisions are recognized as critical to firm value maximization. Market imperfections including frictional costs of capital such as taxes, agency costs, and financial distress costs are an important motivation for enterprise risk management. Risk management reduces the volatility of financial performance and can have a significant impact on firm value maximization by reducing the impact of frictional costs. Insurers operate in imperfect markets where demand elasticity of policyholders and preferences for financial quality of insurers are important determinants of capitalization and pricing strategies. In this paper, we analyze the optimization of enterprise or firm value in a model with market imperfections. A realistic model of an insurer is developed and calibrated.Frictional costs, imperfectly competitive demand elasticity, and preferences for financial quality are explicitly modelled and implications for enterprise risk management are quantified.

Successfully Reshaping the Ownership Relationship by Reducing 'Moral Debt' and Justly Distributing Residual Claims: Evidence from the Scott Bader Commonwealth and the John Lewis Partnership

We examine the issues relating to the most appropriate form of firm ownership structure that will maximize the firm's value to society whilst maintaining a more sustainable market value. We argue that the maximization of firm value to society may be more readily achieved through a closed corporation type formation, such as employee owned corporation or partnership similar to Scott Bader Commonwealth or John Lewis Partnership, rather than an open corporation with large 'moral debt' claims, conflicts of interest, and agency costs. The four main perceived theoretical arguments against a closed corporation are: The horizon problem; the common-property problem; the non-transferability problem; and the control problem. Our analysis demonstrates how the Scott Bader Commonwealth and the John Lewis Partnership successfully overcome these theoretical issues and thus may be considered to be more efficient and more morally just than an open corporation.

Implications of Executive Hedge Markets for Firm Value Maximization

This paper analyzes the incentive implications of executive hedge markets. The manager can promise the return from his shares to third parties in exchange for a fixed payment—swap contracts—and/or he can trade a customized security correlated with his firm‐specific risk. The customized security improves incentives by diversifying the manager's firm‐specific risk. However, unless they are exclusive, swap contracts lead to a complete unraveling of incentives. When security customization is sufficiently high, the manager only trades the customized security—but not any nonexclusive swap contracts, and incentives improve. Access to highly customized hedge securities and/or exclusive swap contracts increases the manager's pay‐performance sensitivity.

Investment under Uncertainty with Strategic Debt Service

The presence of a well designed bankruptcy code is an important part of the financialarchitecture in developed economies. By allowing the creditors to seize the assets of theborrowers who fail to make contractual payments, the code generates beneficial ex ante effectson debt capacity and firm value. By giving the borrowers options to renegotiate their debtobligations and seek bankruptcy protection, the code increases the likelihood that borrowersmay avoid inefficient ex post liquidation. As Hart (1999) notes, the code should balanceex ante firm value maximization with ex post efficiency. The bankruptcy codes in differentcountries weight this tradeoff differently and hence vary in terms of the distribution of rightsand powers between borrowers and lenders.In this paper, we provide an inter-temporal framework to examine how the creditors’liquidation rights and the distribution of ex post bargaining powers influence the firm’s in-vestment and financing decisions, and affect ex ante firm value. We show that strongerequityholders’ bargaining power lowers debt capacity, reduces firm value, and discouragesgrowth option exercising. Our calibration suggests that the quantitative effects of ex poststrategic renegotiation on ex ante firm value may be large.Our paper provides an attempt to integrate financial architecture into the theory of in-vestment (growth option exercising), by building on two strands of literature: investment anddebt pricing. We extend the real options approach to investment, pioneered by McDonaldand Siegel (1986) and Brennan and Schwartz (1985), to allow for capital structure decisionsunder strategic debt service. We also draw insights from corporate debt pricing/capital struc-ture literature, which focuses on leverage and security pricing after investment has alreadybeen made (Merton (1974), Black and Cox (1976), and Leland (1994)). Our paper bridgesthe gap between these two strands of literature by characterizing the optimal investment andfinancing decisions, and the option value of waiting in closed form. We show that the inter-action between financing and investment decisions in the presence of strategic debt servicegenerates new insights and also quantitatively important effects on ex ante firm value.

Hedge Markets for Executives and Corporate Agency

This paper analyzes the implications of executive hedge markets for firm value maximization in an optimal contracting framework. The main results are as follows: Without any hedging ability, the manager underinvests in risk at the firm level to diversify his own compensation risk. If the manager can trade a security correlated with firm specific risk, the underinvestment in risk is reduced, optimal managerial share ownership and equilibrium effort increase. If the manager can hedge by simulating the sale of his shares, however, he can completely undo any incentive scheme. The model predicts that a higher degree of financial market development implies higher managerial share ownership and more efficient risk taking at the firm level.

The determinants of Norwegian exporters’ foreign exchange risk management

This paper examines foreign exchange (FX) hedging by Norwegian exporting firms to provide empirical evidence on the determinants of the hedging decision. The paper contributes to prior studies by, first, focusing on exporters to ensure that the companies in the sample have FX exposure, thereby allowing a more rigorous test of the theoretical determinants of hedging, and, secondly, in contrast to most previous studies that have focused on FX external hedging instruments, the use of both internal and external instruments is examined. Univariate, multivariate and multinominal analyses all provide evidence consistent with the firm value maximization hypotheses of underinvestment and risk aversion. Also, the following characteristics of firms—size, extent of internationalization and liquidity—are found to be related to the decision to hedge FX risk. However, the evidence on the links between the firm characteristics and the decision to hedge is not consistent across internal and external FX hedgers, and also varies for individual hedging instruments. Therefore it is argued that the empirical evidence on the theoretical determinants cannot be generalized to cover the full range of FX hedging strategies (which includes internal hedging instruments). Unlike empirical studies for other countries the evidence for Norwegian firms does not support the hypothesis that the avoidance of financial distress and the need to resort to external capital markets is a significant determinant of the hedging decision. Whilst the evidence suggests that country-specific factors may play a role in determining the use of FX hedging, it does not imply that the different policies adopted are necessarily inconsistent with the firm value maximization hypothesis.

How Do Information Ambiguity and Timing of Contextual Information Affect Managers’ Goal Congruence in Making Investment Decisions in Good Times vs. Bad Times?

Information ambiguity is prevalent in organizations and may influence management decisions. This study draws upon research on information bias and ambiguity research to empirically test how information ambiguity and non-financial factors (e.g., interpersonal information) affect managers’ capital budgeting decisions when in good vs. bad times. Ninety-two managers completed two experiments. In Experiment One, the information was presented sequentially. Our results show that without the presence of non-financial factors, managers tend to maximize the firm value. After receiving non-financial factors, a significant number of managers switched to the self-serving option in good times (the gain condition) but stayed with firm-value maximization in bad times (the loss condition). In Experiment Two, the information was presented simultaneously in the presence and absence of ambiguity. We found that in the presence of ambiguity, the information presentation has no impact on managers’ self-serving bias in good times or their firm-value maximization tendency in bad times. Interestingly, we also observed managers’ use of interpersonal information even in the absence of ambiguity.

Corporate Social Responsibility as a Conflict Between Shareholders

In recent years firms have greatly increased the amount of resources allocated to activities classified as Corporate Social Responsibility (CSR). While an increase in CSR expenditure may be consistent with firm value maximization if it is a response to changes in stakeholders' preferences, we argue that a firm's insiders (managers and large blockholders) may seek to over-invest in CSR for their private benefit to the extent that doing so improves their reputations as good global citizens. We test this hypothesis by investigating the relation between firms' CSR ratings and their ownership and capital structures. Employing a unique data set that categorizes the largest 3,000 U.S. corporations as either socially responsible or socially irresponsible, we find that on average, insiders' ownership and leverage are negatively related to the firm's social rating, while institutional ownership is uncorrelated with it. These results support our hypothesis that insiders induce firms to over-invest in CSR when they bear little of the cost of doing so.

Macroeconomic Uncertainty and Firm Leverage

This paper investigates the link between the optimal level of nonfinancial firms' leverage and macroeconomic uncertainty. We develop a structural model of a firm's value maximization problem that predicts that as macroeconomic uncertainty increases the firm will decrease its optimal level of borrowing. We test this proposition using a panel of non-financial US firms drawn from the COMPUSTAT quarterly database covering the period 1991-2001. The estimates confirm that as macroeconomic uncertainty increases, firms decrease their levels of leverage. Furthermore, we demonstrate that our results are robust with respect to the inclusion of the index of leading indicators.

CORPORATE GOVERNANCE, EVA, AND SHAREHOLDER VALUE

Together with corporate governance expert Stuart Gillan, the managing partner of Stern Stewart discusses important issues of corporate financial management, including the fundamental objective of the public corporation and how boards of directors can achieve it. Whereas financial economists have long argued that the corporate goal is the maximization of firm value, Stern advocates a variation of the concept known as “Market Value Added”–one that is designed to discourage corporate growth and capital raising that does not end up adding value for shareholders. To accomplish this goal, he emphasizes the importance of incentive compensation systems tied not to accounting earnings, but to a measure of economic profit like EVA. And, as Stern argues in closing, EVA‐based incentive systems are likely to be effective not only in the private sector, but in increasing the efficiency and value of state‐owned enterprises. Indeed, such systems could bring about a new kind of employee capitalism that ESOPs promised, but have largely failed, to deliver.

VALUE MAXIMIZATION, STAKEHOLDER THEORY, AND THE CORPORATE OBJECTIVE FUNCTION

This paper examines the role of the corporate objective function in corporate productivity and efficiency, social welfare, and the accountability of managers and directors. The author argues that because it is logically impossible to maximize in more than one dimension, purposeful behavior requires a single‐valued objective function. Two hundred years of work in economics and finance implies that, in the absence of externalities and monopoly, social welfare is maximized when each firm in an economy maximizes its total market value.The main contender to value maximization as the corporate objective is stakeholder theory, which argues that managers should make decisions so as to take account of the interests of all stakeholders in a firm, including not only financial claimants, but also employees, customers, communities, and governmental officials. Because the advocates of stakeholder theory refuse to specify how to make the necessary tradeoffs among these competing interests, they leave managers with a theory that makes it impossible for them to make purposeful decisions. With no clear way to keep score, stakeholder theory effectively makes managers unaccountable for their actions (which helps explain the theory's popularity among many managers).But if value creation is the overarching corporate goal, the process of creating value involves much more than simply holding up value maximization as the organizational objective. As a statement of corporate purpose or vision, value maximization is not likely to tap into the energy and enthusiasm of employees and managers. Thus, in addition to setting up value maximization as the corporate scorecard, top management must provide a corporate vision, strategy, and tactics that will unite all the firm's constituencies in its efforts to compete and add value for investors.In clarifying the proper relation between value maximization and stakeholder theory, the author introduces a somewhat new corporate objective called “enlightened value maximization.” Enlightened value maximization uses much of the structure of stakeholder theory—notably the need to consider the interests of all corporate stakeholders—while continuing to posit maximization of long‐run firm value as the criterion for making the necessary tradeoffs among stakeholders.The paper comes to similar conclusions about the Balanced Scorecard, which is described as the managerial equivalent of stakeholder theory. Although the Balanced Scorecard can add value by helping managers better understand the drivers of shareholder value, it should not be used as a performance measurement and incentive compensation system because it fails to provide a single valued score, a clear way of distinguishing superior from substandard performance.

Tunneling or Value Addition? Evidence from Mergers by Korean Business Groups

Business groups in emerging markets have the potential to create either value or agency problems. Using Korean mergers, we investigate the nature of business groups in emerging markets and examine whether Korean business groups (chaebols) add value to their member firms or provide the controlling shareholders with an opportunity for wealth transfer (tunneling). We show that chaebol-affiliated firms that performed well prior to the merger realize significantly negative announcement returns. We also find that chaebol bidders who acquired poorly performing targets within the same group and/or had concentrated equity ownership by owner-managers experience significantly negative abnormal returns. These types of mergers, however, have a significantly positive effect on the market value of the portfolio of other firms in the group. Our results support the tunneling view that firms belonging to business groups pay less attention to the maximization of individual firm value and make takeover decisions that are beneficial to only controlling shareholders.

The Allocation of Residual Rights

In this paper we examine the value of the right to design the method of sale of corporate assets. The question we ask is simple - who should have the right to decide how the assets of the firm should be sold? We show that this right is a valuable one and its value comes from recognizing the conflicting incentives of claimants at the time of sale. We characterize the choices of the senior and junior claimants and show that they have distinct preferences on a set of common auction procedures. More importantly, we show that the optimal allocation of the right cannot be independent of the realized values of information at the time of sale. We also show that the firm-value maximization is aided when the law mandates an ascending-bid selling mechanism for sale of indentured corporate assets. Our analysis points out that when the process of disposition of a firm's assets in bankruptcy is disassociated with that of the distribution of cash flows accruing from the sale, the incentive problems that are commonly analyzed in the bankruptcy literature show up in the choice of the selling mechanism. In particular, the choice of a selling mechanism is formally identical to the choice of a risky project.

A Multiperiod Theory of Corporate Financial Policy Under Taxation

This paper examines multiperiod corporate financial policy in a world where the only market imperfection is taxation. The optimal financial policy determines the firm's capital structure and debt maturity structure. Two implications of this policy are: (1) there can be a set of debt-asset ratios that is consistent with firm value maximization, and (2) debt maturity structure is irrelevant to firm value.