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Shareholder wealth maximization is accepted by most financial economists as the appropriate objective for financial decision-making. Recently, wealth maximization has been criticized by a growing array of opponents for condoning the exploitation of employees, customers, and other stakeholders, and encouraging short-term managerial thinking. Although these critics are misguided, proponents of shareholder theory have helped to create this confusion by exhorting managers to maximize the firm's current stock price. Because a firm's stock price can be manipulated in the shortterm, incentives to increase a firm's current stock price can distort operating and investment decisions. When wealth maximization is properly defined as a long-term goal, it is not as narrowly focused as critics believe. The main prescription of shareholder theory-invest in all positive net present value projects-benefits not only shareholders, but also key stakeholders including employees and customers.
Shareholder theory defines the primary duty of a firm's managers as the maximization of shareholder wealth (Berle and Means, 1932; Friedman, 1962). The theory enjoys widespread support in the academic finance community and is a fundamental building block of corporate financial theory. However, the shareholder model has been criticized for encouraging short-term managerial thinking and condoning unethical behavior. Smith (2003) notes that critics believe shareholder theory is ". . . geared toward short-term profit maximization at the expense of the long run."1 Freeman, Wicks, and Parmar (2004) assert that shareholder theory ". . . involves using the prima facie rights claims of one group-shareholders-to excuse violating me rights of others."
This paper explains why such critiques of shareholder theory are misguided yet understandable. They are misguided because wealth maximization is inherently a long term goal-the firm must maximize the value of all future cash flows-and does not condone the exploitation of other stakeholders (Jensen, 2002; Sundaram and Inkpen, 2004a). The criticisms are understandable because many proponents of shareholder theory, in a stylized version of the model, exhort managers to maximize me firm's current stock price (Keown, Martin, and Petty, 2008; Lasher 2008; Ross, Westerfield, and Jordan, 2008; Brealey, Myers, and Marcus, 2007; Melicher and Norton, 2007). This notion underlies the formal (e.g., stock options) and informal (e.g., pressure from the investment community and corporate boards) incentives that reward managers if a firm's stock price continually increases.2 By...