Case: Assessing the Goal of Sports Products, Inc.

Managerial Finance-

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:

a. What should the management of Sports Products Inc. pursue as its overriding goal? Why?

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

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?

d. Does the firm appear to have an effective corporate governance structure? Explain any shortcomings.

e. On the basis of the information provided, what specific recommendations would you offer the firm?

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 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.

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.