A postscript The limits of corporate finance

Corporate finance has come in for more than its share of criticism in the last decade. There are many who argue that the failures of corporate America can be traced to its dependence on stock price maximization. Some of the criticism is justified and based upon the limitations of a single-minded pursuit of stockholder wealth. Some of it, however, is based upon a misunderstanding of what corporate finance is about.

Economics was once branded the gospel of Mammon, because of its emphasis on money. The descendants of those critics have labeled corporate finance as unethical, because of its emphasis on the 'bottom line' and market prices, even if this focus implies that workers lose their jobs and take cuts in pay. In restructuring and liquidations, it is true that value maximization for stockholders may mean that other stakeholders, such as customers and employees, lose out. In most cases, however, decisions that increase market value also make customers and employees better off. Furthermore, if the firm is really in trouble, either because it is being undersold by competitors or because its products are technologically obsolete, the choice is not between liquidation and survival, but between a speedy resolution, which is what corporate financial theory would recommend, and a slow death, while the firm declines over time, and costs society considerably more in the process.

The conflict between wealth maximization for the firm and social welfare is the genesis for the attention paid to ethics in business schools. There will never be an objective and therefore decision rules that perfectly factor in societal concerns, simply because many of these concerns are difficult to quantify and are subjective. Thus, corporate financial theory, in some sense, assumes that decision makers will not make decisions that create large social costs. This assumption that decision makers are, for the most part, ethical and will not create unreasonable costs for society or for other stakeholders, is unstated but underlies corporate financial theory. When it is violated, it exposes corporate financial theory to ethical and moral criticism, though the criticism may be better directed at the violators.

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