The Goal of the Firm

For the reasons just given, an objective of maximizing earnings per share may not be the same as maximizing market price per share. The market price of a firm's stock represents the focal judgment of all market participants as to the value of the particular firm. it takes into account present and expected future earnings per share; the timing, duration, and risk ofthese earnings; the dividend policy of the firm; and other factors that bear on the market price of the stock. The market price serves as a barometer for business performance; it indicaies how well management is doing on behalf of its shareholders.

Management is under continuous review. Shareholders who are dissatisfied with management performance may sell their shares and invest in another company. This action, if taken by other dissatisfied shareholders, will put downward pressure on market price per share.

Thus management must focus on creating value for shareholders. This requires management to judge alternative investment, financing, and asset management strategies in terms of th.i. effect on shareholder value (share price). In addition, management should pursue productmarket strategies, such as building market share or increasing customer satisfaction, only if they too will increase shareholder value.

Agency Problems

It has long been recognized that the separation of ownership and control in the modern corporation results in potential conflicts between owners and managers. In particular, the objectives of management may differ from those of the firm's shareholders. In a large corporation, stock may be so widely held that shareholders cannot even make known their objectives, much less control or influence management. Thus this separation of ownership from management creates a situation in which management may act in its or,rm best interests rather than those ofthe shareholders.

We may think of management as the agents of the owners. Shareholders, hoping that the agents will act in the shareholders'best interests, delegate decision-making authority to them.

Jensen and Meckling were the first to develop a comprehensive theory of the firm under agenry arrangements. They showed that the principals, in our case the shareholders, can assure themselves that the agents (management) will make optimal decisions only if appropriate incentives are given and only if the agents are monitored. Incentives include stock options, bonuses, and perquisites ("perks," such as company automobiles and expensive offices), and these must be directly related to how close management decisions come to the interests of the shareholders. Monitoring is done by bonding the agent, systematically reviewing management perquisites, auditing financial statements, and limiting management decisions. These monitoring activities necessarily involve costs, an inevitable result of the separation of ownership and control of a corporation. The less the ownership percentage of the managers, the less the likelihood that they will behave in a manner consistent with maximizing shareholder wealth and the greater the need for outside shareholders to monitor their activities.