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Managerial Finance- case study 1 July 2010

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Case: Assessing the Goal of Sports Products, Inc.

Loren Seguara and Dale Johnson both work for Sports Products, Inc., a major producer of

boating equipment and accessories. Loren works as a clerical assistant in the Accounting

Department, and Dale works as a packager in the Shipping Department. During their lunch

break one day, they began talking about the company. Dale complained that he had always

worked hard trying not to waste packing materials and efficiently and cost-effectively

performing his job. In spite of his efforts and those of his co-workers in the department, the

firm’s stock price had declined nearly $2 per share over the past 9 months. Loren indicated

that she shared Dale’s frustration, particularly because the firm’s profits had been rising.

Neither could understand why the firm’s stock price was falling as profits rose. Loren

indicated that she had seen documents describing the firm’s profit sharing plan under which

all managers were partially compensated on the basis of the firm’s profits. She suggested

that maybe it was profit that was important to management, because it directly affected

their pay. Dale said, “That doesn’t make sense, because the stockholders own the firm.

Shouldn’t management do what’s best for stockholders? Something’s wrong!” Loren

responded, “Well, maybe that explains why the company hasn’t concerned itself with the

stock price. Look, the only profits that stockholders receive are in the form of cash

dividends, and this firm has never paid dividends during its 20-year history. We as

stockholders therefore don’t directly benefit from profits. The only way we benefit is for the

stock price to rise.” Dale chimed in, “That probably explains why the firm is being sued by

state and federal environmental officials for dumping pollutants in the adjacent stream. Why

spend money for pollution control? It increases costs, lowers profits, and therefore lowers

management’s earnings!”

Loren and Dale realized that the lunch break had ended and they must quickly return to

work. Before leaving, they decided to meet the next day to continue their discussion.

Questions and Answers!

a. What should the management of Sports Products Inc. pursue as

its overriding goal? Why?

Current theory asserts that the firms’ proper goal is to maximize shareholders’ wealth, as

measured by the market price of the firm’s stock. A firm’s stock price reflects the timing, size

and risk of the cash flow that investors expect a firm to generate over time. So financial

managers should undertake only those actions that they expect will increase the value of the

firm’s future cash flow. Theorical and empirical arguments support the assertion that

managers should focus on maximization shareholder wealth. Shareholders of a firm are

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sometimes called residual claimants, meaning that they have claims only on any of the firm’s

cash flows that remain after employees, suppliers, creditors, governments and other

stakeholders are paid in full. As you see, shareholders stand at the end of this line so if the

firm cannot pay the stakeholders first, shareholders receive nothing! Shareholders also bear

most of the risk of running the firm. So if firms did not manage to maximize shareholders

wealth, investors would have little incentive to accept the risks necessary for a business to

succeed.

b. Does the firm appear to have an agency problem? Explain.

Yes. In this case," the firm's stock price had declined nearly $2 per share over the past 9

months" and at the same time "the firm's profits had been rising". What the

shareholders receive are in the form of cash dividends, and this firm has never paid

dividends during its 20-year history. Based on what I wrote before, shareholders wealth is

reducing during this period and it shows that there is an agency problem.

In addition, management's actions in case of pollution controls show a profit maximization

try, which means they are trying to maximize their salary, rather than an attempt to

maximize shareholders’ wealth(stock price).

c. Evaluate the firm’s approach to pollution control. Does it seem

to be ethical? Why might incurring the expense to control

pollution be in the best interests of the firm’s owners despite its

negative effect on profits?

It possibly has two sides! We don’t know whether their acts were planned or accidental. It is

clear that they are violating the law with dumping pollutants in the adjacent stream and

damaging the environment. Clearly, Sports Products has not only done against the law but

also established poor standards of conduct and moral judgment. So at both situations, the

company's manner does not seem to be ethical. Incurring the expense to control pollution

be in the best interests of the firm’s owners because guarantees the firm's long term profits

in case of social responsibility.

d. Does the firm appear to have an effective corporate governance

structure? Explain any shortcomings.

It seems not! The most important shortcoming is the management team who don’t

make good decisions for maximizing shareholders’ wealth.

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e. On the basis of the information provided, what specific

recommendations would you offer the firm?

Comply with all laws as well as accepted standards of conduct or moral judgment.

Establish a corporate ethics policy, to be read and signed by all employees

Designing a payment system that ties management team and employees' salary to

share price or a performance based scale.