What Is The Grossman-Stiglitz Paradox?

1. Discuss the nature of stock as an investment. Do most stockholders play large roles in the management of the firms in which they invest? Why or Why not?

Managers and shareholders are the utmost contributors of these conflicts, hence affecting the entire structural organization of a company, its managerial system and eventually to the company's societal responsibility. A corporation is well organized with stipulated division of responsibilities among the arms of the organizational structure, shareholders, directors, managers and corporate officers. However, conflicts between managers in most firms and shareholders have brought about agency problems. Shares and their trade have seen many companies rise to big investments. Shareholders keep the companies running

According to Gitman, the goal of the firm, and therefore of all managers and employees, is to maximize the wealth of the owners for whom it is being operated (2009). The financial manager is responsible for acquiring sources of financing and allocate amongst competitive investment alternatives. The ultimate goal is to invest in projects yielding higher returns than amount of financing used to invest, so profits can be used satisfy claims and increase shareholder wealth. The issues facing financial managers are therefore to 1) increase sources of financing from investors and 2) increase shareholder wealth while maintaining a

Aside from the two aforementioned proposals the company can raise its leverage in other ways. By conducting DuPont analysis and understanding operating leverage we see that purchasing fixed assets and decreasing stockholder’s equity will raise the equity multiplier and the firm’s operating leverage. In this instance we recommend against this approach as the firm already has a large amount of excess cash above what they require to fund new positive NPV projects and purchase new assets. Investors would rather see their capital returned to them in the form of share repurchases and dividends as it is evident by the company’s cash stockpile that they can

Financial management is a work plan that details the revenue and expenses of a company. Financial decisions are strategies that achieve the financial objectives of a company that include capital budgeting, capital structure, and working capital management. Modigliani and Miller (1958) received the Nobel Prize in economics for their study of the relationship between capital structure and corporate value, with and without corporate tax. Whether financial management decisions influence firm value is still debated daily because there are plenty of uncertain factors. In this paper, I intend

To put it simply, in financial terms, to maximize shareholders wealth means to maximize purchasing power. Throughout the years, we have learned that markets are most efficient when the company is able to maximize at the current share price. Every company’s main goal should be to strive to maximize its value to every single one of their shareholders. Common stock represents the value of the market price, and it also gives the shareholder an idea of the different investment, financing, and dividend decisions made by that particular firm.

Another concern relates of insider trading of market efficiency of stock market. In his classical study Fama (1970) proposes efficient market Hypothesis, which suggests that stock price reflects all available information (historical price, public and private) in

Traditionally, conflict was ignored, avoided or overlooked by management. However, over the past few years, it has come about that some conflict can help the production of the organization if that conflict is cultivated properly. It is important to remember that “managers must be able to handle conflict in a functional manner.” (Satterlee, 2013, p. 173).

Last but not least important, an efficient capital market is one in which stock prices fully reflect all available information. However, the paradox is that since information is reflected in security prices quickly, knowing information when it is released does an investor little good. Furthermore, it is impossible to create a portfolio which would earn extraordinary risk adjusted return. As a consequence, all the technical and fundamental analysis are useless, no one can consistently outperform the market, and new

Conflicts between stockholders and creditors Conflict between shareholders and creditors is common for the company which use debt capital to form an optimum capital structure. As mentioned earlier, agency relation exist when one party works as an agent of the principal. In an organization management

Gittman (2004, pp. 312) divided stock into two types, such as common stock and preferred stock. He also showed that dividends are the outcome of investment. So, common stocks are an ownership claim against primarily real or productive asset (Higgins, 1995), but he also said that if the company prospers, stockholders are the chief beneficiaries, if it falters, they are the chief losers. Smith (1988) presented that stocks are one of the most popular forms of investment. People buy stocks for various reasons: some are interested in the long-term growth of their investment by buying low priced stock of a new company in the hope of substantially growth of share price over the next few years. Another reason he suggested that in a well established firm stockholders expect the stock growth will be stable over the long run. (Smith,1988).

From this set of problems, we can see that leverage is good for the firm. Leverage has increased the value of the firm as a whole and increased the price per share. Although the cost of debt increases the firm's risk because it increases the probability of default and bankruptcy, therefore shareholders will require higher rates of return on the equity they provide, debt also provides tax savings. And we can see that in table 4, where we calculated the total value of the firm as the pure business cash flows plus the tax savings. Another reason why debt increases firm value is the fact that it reduces WACC, because the cost of debt is generally lower than the cost of equity. Another option that shareholders can do is using homemade leverage. Shareholders should pay a premium for the shares of a levered firm when the addition of debt increases value.

Economic science teaches us that due to their subjective needs, individuals have subjective preferences, and hence different interest. Occasionally different subjective interests give rise to conflicts of interest between contracting partners. These conflicts of interest may result in turn, in one or both parties undertaking actions that may be against the interest of the other contracting partner. The primary reason for the divergence of objectives between managers and shareholders has been attributed to separation of ownership (shareholders) and control (management) in corporations. As a consequence, agency problems

Nevertheless if companies operate in weak markets and fail to create growth and profit the concept of maximization of shareholder wealth is also an opportunity for self-regulation and security against threats for a company. This approach is in particular useful for safeguarding against difficulties arising from wrong or misguided leadership within a corporation. Shareholders of a company have the strongest interest in a company’s success because they often invest a lot of capital in the business and require revenues for their deposit (Moore, 2002). As a matter of fact, they become more

Harris and Reviv (1990) gave one more reason of using debt in capital structure. They say that management will hide information from shareholders about the liquidation of the firm even if the liquidation will be in the best interest of shareholders because managers want the perpetuation of their service. Similarly, Amihud and Lev (1981) suggest that mangers have incentives to pursue strategies that reduce their employment risk. This conflict can be solved by increasing the use of debt financing since bondholders will take control of the firm in case of default as they are powered to do so by the debt indentures. Stulz (1990) said when shareholders cannot observe either the investing decisions of management or the cash flow position in the firm, they will use debt financing. Managers, to maintain credibility, will over-invest if it has extra cash and under-invest if it has limited cash. Stulz (1990) argued that to reduce the cost of underinvestment and overinvestment, the amount of free cash flow should be reduced to