Value Maximization and the Corporate Objective …

1 00-058 Copyright 2000 Michael C. papers are in draft form. This working paper is distributed for purposes of comment anddiscussion only. It may not be reproduced without permission of the copyright holder. Copies of workingpapers are available from the Maximizationand the CorporateObjective FunctionMichael C. JensenHarvard business SchoolValue Maximization and the Corporate Objective FunctionMichael C. JensenHarvard business SchoolNegotiations, Organizations, and Markets paper examines the role of the Corporate Objective function in Corporate productivity andefficiency, social welfare, and the accountability of managers and directors. I argue that since it islogically impossible to maximize in more than one dimension, purposeful behavior requires a singlevalued Objective function. Two hundred years of work in economics and finance implies that in theabsence of externalities (and when all goods are priced) social welfare is maximized when each firmin an economy maximizes its total market Value .

2 Total Value is not just the Value of the equity butalso includes the market values of all other financial claims including debt, preferred stock, theory, argues that managers should make decisions so as to take account of theinterests of all stakeholders in a firm (including not only financial claimants, but also employees,customers, communities, governmental officials, and under some interpretations the environment,terrorists, blackmailers, and thieves). Because the advocates of stakeholder theory refuse tospecify how to make the necessary tradeoffs among these competing interests they leave managerswith a theory that makes it impossible for them to make purposeful decisions. With no way to keepscore, stakeholder theory makes managers unaccountable for their actions. Yet stakeholder theoryis widely accepted by managers and directors.

3 It seems clear that such a theory can be attractive tothe self interest of managers and takes more than acceptance of Value Maximization as the organizational Objective to createvalue. As a statement of Corporate purpose or vision Value Maximization is not likely to tap into theenergy and enthusiasm of employees and managers to create Value . Since a firm cannot maximizevalue if it ignores the interest of it s stakeholders enlightened Value Maximization can utilize muchof the structure of stakeholder theory by accepting long run Maximization of the Value of the firm asthe criterion for making the requisite tradeoffs among its : Value Maximization , Stakeholder Theory, Balanced Scorecard, Multiple objectives ,Social Welfare, Corporate Purpose, Tradeoffs, Special Interest in Breaking the Code of Change, Michael Beer andNithan Norhia, eds, harvard business school Press, 2, 2000 Value Maximization and the Corporate Objective FunctionByMichael C.

4 Jensen1 Proposition: "This house believes that change efforts should be guided by the sole purpose ofincreasing shareholder Value ."IntroductionLying behind the statement that I have been asked to address, is a complex set of controversieson which economists, management scholars, managers, policy makers and special interest groups exhibitwide disagreement. Political, economic, social, evolutionary, and emotional forces play important rolesin this disagreement as do ignorance, complexity and conflicting self-interests. I shall discuss the organizational level the issue is the following. Every organization attempting to accomplishsomething has to ask and answer the following question: What are we trying to accomplish? Or, puteven more simply: When all is said and done how do we measure better versus worse?

5 Even moresimply, How do we keep score?At the economy-wide or social level the issue is the following: If we could dictate the criterion orobjective function to be maximized by firms (that is the criterion by which executives choose amongalternative policy options) what would it be? Or even more simply, how would we want the firms in oureconomy to measure better versus worse?In this light I prefer to restate the proposition I have been asked to address as follows: This house believes that in implementing organizational change managers must have acriterion for deciding what is better, and better should be measured by the increase in longterm market Value of the firm. 1 Jesse Isidor Straus Professor of business Administration, harvard business C.

6 Jensen2 January 2, 2000I call this the Value Maximization Proposition and it has its roots in 200 years of research ineconomics and finance. Stakeholder theory , the asserted (and currently popular2) main contender tovalue Maximization for this Objective function, has its roots in sociology, organizational behavior, thepolitics of special interests, and managerial self interest. I say asserted contender because stakeholdertheory is incomplete as a specification for the Corporate purpose or Objective function, and thereforecannot logically fulfill that role. I argue below that it s incompleteness is not accidental. It serves theprivate interests of those who promote it, including many managers and directors of answer to the questions of how managers should define better vs.

7 Worse, and howmanagers in fact do define it, have important implications for the welfare of a society s , the answer provides the business equivalent of the Hippocratic Oath to the medical is an indication of the infancy of the science of management that so many in the world s businessschools, as well as professional business organizations understand so little of the fundamental issues put, Value Maximization says that managers should make all decisions so as to increasethe total long run market Value of the firm. Total Value is the sum of the Value of all financial claims on thefirm including equity, debt, preferred stock and theory, on the other hand, says that managers should make decisions so as to takeaccount of the interests of all the stakeholders in a firm.

8 And stakeholders include all individuals orgroups who can substantially affect the welfare of the firm, including not only the financial claimants, butalso employees, customers, communities, governmental officials, and under some interpretations theenvironment, terrorists, blackmailers, and this introduction of the issues let me now move to a detailed examination of valuemaximization and stakeholder theory. 2 Stakeholder theory, for example, has been endorsed by many professional organizations, special interestgroups, and governmental organizations including the current British government. See the excellent article on thetopic by Elaine Sternberg (Sternberg 1996) (and her book (Sternberg 1994)) who surveys its acceptance by theBusiness Roundtable, its recognition by law in 29 American states and even by the Financial See (Freeman 1984, p.)

9 53). The .. definition of stakeholder [is] any group or individual who can affect or isaffected by the achievement of an organization s purpose. For instance, some corporations must count terroristgroups as stakeholders. Michael C. Jensen3 January 2, 2000 The Logical Structure of the ProblemIn discussing whether firm s should maximize Value or not we must separate two distinct issues:1) Should the firm should have a single-valued Objective , and2) Should that Objective be Value Maximization or something else (for example, maintainingemployment or the improving the environment).The debate over whether corporations should maximize Value or whether it should act in theinterests of its stakeholders is generally couched in terms of issue #2, and it is often falsely framed asstockholders versus stakeholders.

10 The real conflict is actually an unjoined debate over issue #1, whetherthe firm should have a single valued Objective function or scorecard. This confusion has led towidespread is commonly known as stakeholder theory, while not totally without content, isfundamentally flawed because it violates the necessity for any organization to have a single valuedobjective as a precursor to purposeful or rational behavior. In particular, I argue that firms that adoptstakeholder theory will be handicapped in the competition for survival because, as a basis for action,stakeholder theory politicizes the It leaves its managers empowered to exercise their own preferences inspending the firm s #1: Purposeful Behavior Requires the Existence of a Single Valued Objective Simple ExampleConsider the a firm that wishes to increase current year profits, p, as well as market share , as in Fig.