FOR A PUBLICLY TRADED CORPORATION, THE GOAL SHOULD BE TO
MAXIMIZE SHAREHOLDER WEALTH BY MAXIMIZING SHARE PRICE.
WHY? BECAUSE THE SHAREHOLDERS, AS RESIDUAL OWNERS, TAKE THE
GREATEST AMOUNT OF RISK AMONG ALL THE STAKEHOLDERS. THEIR
DIVIDENDS ARE PAID FROM AFTER-TAX EARNINGS, AFTER ALL OTHER
EXPENSES HAVE BEEN ACCOUNTED FOR. ALSO, IN THE EVENT OF
BANKRUPTCY AND LIQUIDATION, THE SHAREHOLDERS ARE THE LAST TO
BE PAID AFTER ALL OTHER CLAIMS HAVE BEEN MET.
IS THIS GOAL INCONSISTENT WITH THE WELFARE OF OTHER
STAKEHOLDERS SUCH AS
CREDITORS? NO. IF THE FIRM MISCHANNELS THE BORROWED FUNDS
AND/OR FAILS TO GENERATE THE CASH FLOWS TO PAY INTEREST AND
PRINCIPAL, LENDERS WILL RAISE INTEREST RATES FOR FUTURE
BORROWINGS OR TAKE OTHER APPROPRIATE ACTIONS NOT EXCLUDING
FORCING THE FIRM TO BANKRUPTCY
EMPLOYEES?
NO. IF THE FIRM FAILS TO TAKE CARE OF ITS EMPLOYEES
BY PAYING COMPETITIVE WAGES AND BENEFITS, PROVIDING
APPROPRIATE TRAINING AND CREATING A SAFE AND HARASSMENT-FREE
WORKING ENVIRONMENT, EMPLOYEE- PRODUCTIVITY MAY DECLINE AND
TURN-OVER WILL BE HIGH, AFFECTING REVENUES, PROFITS AND
SHAREHOLDERS’ WELFARE
CUSTOMERS?
NO. IF THE FIRM FAILS TO TAKE CARE OF ITS CUSTOMERS
BY PROVIDING QUALITY PRODUCTS AND SERVICES AT COMPETITIVE
PRICES OR FAILS TO FULFILL WARRANTIES, THEY WILL GO TO
COMPETITITION, THERE MAY BE LAWSUITS AND SALES WILL FALL AND
COSTS WILL INCREASE, AFFECTING SHAREHOLDERS’ WELFARE
SOCIETY? NO. IF THE FIRM FAILS TO FOLLOW THE LAWS OF THE SOCIETY
AND/OR ENGAGES IN ETHICAL VIOLATIONS, IT MAY FACE LITIGATION,
FINES AND SOCIAL OSTRAZIATION, RESULTING IN REVENUE DECLINES,
COST INCREASES, PROFIT DECLINES, ALL AFFECTING SHAREHOLDERS’
WELFARE.
THUS, SHAREHOLDERS’ WEALTH MAXIMIZATION IS A CONSTRAINED
OPTIMIZATION PROBLEM.

GIVEN THE GOAL OF SHAREHOLDERS’ WELFARE MAXIMIZATION, WHAT
IS THE GUARANTEE THAT MANAGERS WILL PURSUE THIS GOAL
DILIGENTLY? THE PROBLEM WHEN MANAGERS FAIL TO PURSUE THE
GOAL OF OWNERS’ WELFARE MAXIMIZATION IS REFERRED TO AS
AGENCY PROBLEM . AGENCY PROBLEM INVOLVING MANAGERS MAY BE
OF TWO KINDS:
A.
MAMGAERS VS SHAREHOLDERS MANAGERS
MAY SQUANDER RESOURCES
MAY NOT TAKE APPROPRIATE RISK
MAY STRIVE TO DEPRESS STOCK PRICES FOR LEVERAGED BUYOUT
MAY ENGAGE IN OTHER SIMILAR ACTIVITIES
RESOLVED BY
THREAT OF FIRING BY STOCKHOLDERS
THREAT OF OUSTER AFTER A HOSTILE TAKEOVER
COMPENSATION STRUCTURED TO REWARD GOOD PERFORMANCE
INCLUDING INCENTIVES LIKE BONUS SHARES, STOCK OPTIONS
B.
STOCKHOLDERS VS CREDITORS: MANAGERS
MAY BE PREVAILED ON BY STOCKHOLDERS TO TAKE MORE RISK
THAN ANTICIPATED BY CREDITORS
MAY INCREASE DEBT LEVEL DRIVING DOWN THE VALUE OF
OUTSTANDING DEBT
RESOLVED BY
STRICT OVERSIGHT BY TRUSTEES
STRINGENT DEBT COVENANTS, ETC

Capital market (securities market) equilibrium/efficiency refers to the way in which relevant information about capital assets are accessed, processed and impounded in asset prices.
For capital markets to be efficient, the following are necessary:
1.
Easy and ready access to relevant information about assets
2.
Proper and accurate processing of the relevant information
3.
Rapid impounding of the processed information in asset prices
The stronger the above requirements are met, the greater the efficiency. Thus, efficiency is a matter of degree rather than an absolute. Three levels of efficiency are recognized in finance literature:
Weak-Form Efficiency: when current security prices reflect historical information. The prevalence of such an efficiency strikes a blow to
“technical analysis”
Semi-strong form efficiency: when current prices reflect all publicly available information such as management’s forecasts, analysts’ reports etc. The prevalence of such an efficiency strikes a blow to
“fundamental analysis”
Strong-form efficiency: when current prices reflect all information, public and private.
Capital markets in developed nations such as the U.S. are considered to be generally “semi-strong” efficient, i.e., they are efficient most of the times, reflecting all publicly available information, even though they may be inefficient sometimes.

When markets are efficient, assets are considered be to priced efficiently (fairly) and are in equilibrium. In such cases the price of an asset is considered to reflect the asset’s intrinsic value. When the market for an asset (or assets) is not efficient, the asset is not efficiently/fairly priced. In such a case, the asset is considered to be mispriced. The asset’s price may be greater or less than its intrinsic value. If the asset’s price is greater than its intrinsic value, the asset is overpriced. If the asset’s price is less than its intrinsic value, it is under priced. Thus the following relationships can be enunciated:
IF PRICE = VALUE (VALUE = PRICE), ASSET IS FAIRLY/ EFFICIENTLY
PRICED AND AN INVESTOR WOULD BE INDIFFERENT/NEUTRAL ABOUT
INVESTING IN THAT ASSET (MAY OR MAY NOT BUY).
IF PRICE >VALUE (VALUE<PRICE), ASSET IS OVERPRICED AND AN
INVESTOR SHOULD NOT BUY THE ASSET.
IF PRICE < VALUE (VALUE>PRICE), ASSET IS UNDERPRICED AND AN
INVESTOR SHOULD BUY THE ASSET .
SINCE CAPITAL MARKETS IN DEVELOPED ECONOMIES SUCH AS THE U.S.
ARE GENERALLY “SEMI-STRONG” EFFICIENT, HOW CAN A MANAGER
INFLUENCE AND MAXIMIZE STOCK PRICE?
BY PROVIDING THE RELEVANT INFORMATION ABOUT THE FIRM AND THE
STOCK TO MARKET PARTICIPANTS ON A TIMELY BASIS. THIS CAN BE
DONE IN ONE OF TWO WAYS:
DIRECT DISSEMINATION OF RELEVANT INFORMATION VIA PUBLIC
REPORTS, REGULAR MEETINGS WITH ANALYSTS., ETC
INDIRECT DISSEMINATION OF RELEVANT TO MARKET PARTICIPANTS
THRU SIGNALLING, I.E., TAKING ACTIONS THAT ARE INTERPRETED BY
THE MARKET PARTICIPANTS AS PROVIDING CERTAIN INFORMATION.
SIGNALLING IS AN IMPORTANT CONCEPT WHICH WILL BE ADDRESSED AT
GREATER LENGTH WHEN DISCUSSING CAPITAL STRUCTURE AND
DICVIDEND POLICIES.

RISK-RETURN TRADE OFF BETWEEN DEBT AND EQUITY
SOURCE OF
CAPITAL
DEBT/BONDS
CAPITALS FOR INVESTORS AND FIRMS
PREFERRED
STOCK/
PREFERRED
EQUITY
_________________
OWNERS’EQUITY/
COMMON STOCK
FIRM/RECEIVER OF CAPITAL INVESTOR/SUPPLIER OF
CAPITAL
BORROWER/DEBTOR/SELLER CREDITOR/LENDER/BUYER
OF BONDS
SUBJECTED TO HIGHER RISK
OF BANKRUPTCY BY
OF BONDS
ASSUMES LOWER RISK
BECAUSE OF LEGAL
PROTECTIONS IN THE
EVENT OF DEFAULT/
HIGHER PRIORITY OF
CAPITAL PROVIDER
POSSIBILITY OF HIGHER
RATE OF RETURN BECAUSE
OF LOWER COST OF
BORROWING
SELLER OF PREFERRED
STOCK
CLAIMS IN THE EVENT OF
BANKRUPTCY
LOWER REQUIRED RATE OF
RETURN BECAUSE OF
LOWER RISK ASSUMED
NO RISK OF BANKRUPTCY
BY CAPITAL PROVIDER
____________________________
SELLER OF COMMON STOCK
NO RISK OF BANKRUPTCY
BY CAPITAL PROVIDER
HIGHER RISK THAN BONDS
BUT LOWER RISK THAN
COMMON STOCK
HIGHER RETURN THAN
BONDS/LOWER RETURNS
THAN COMMON STOCK
__________________________
PART OWNER / STOCK OR
SHARE HOLDER
HIGHER RISK BECAUSE OF
LOWER RATE OF RETURN
BECAUSE OF HIGHER COST
OF EQUITY CAPITAL
LACK OF LEGAL
PROTECTIONS IN THE
EVENT OF DEFAULT/
LOWER PRIORITY OF
CLAIMS IN THE EVENT OF
BANKRUPTCY
HIGHER REQUIRED RATE
OF RETURN BECAUSE OF
HIGHER RISK ASSUMED