Do Shareholders Really Prefer Their Executives to Maximize the Equity Value? A Newsvendor Case

In this article, we study how the operational decisions of a firm manager depend on her own incentives, the capital structure, and financial decisions in the context of the newsvendor framework. We establish a relationship between the firm’s cost of raising funds and the riskiness of the inventory decisions of the manager. We consider four types of managers, namely, profit, equity, firm value, and profit-equity maximizers, and initially assume that they may raise funds to increase the inventory level only by issuing debt. We show that the shareholders are indifferent between the different types of managers when the coefficient of variation (CV) of demand is low. However, this is not the case when the CV of demand is high. Based on the demand and the firm’s specific characteristics such as profitability, leverage, and bankruptcy costs, the shareholders might be better off with the manager whose compensation package is tied to the firm value as opposed to the equity value. We, then, extend our model by allowing the manager to raise the required funds by issuing both debt and equity. For this case we focus on the equity and firm value maximizer managers and show that our earlier results (for the debt only case) still hold subject to the cost of issuing equity. However the benefit of the firm value maximizer manager over the equity maximizer manager for shareholders is considerably less in this case compared to the case where the manager can only issue debt. The Board of Directors can take these factors into consideration when establishing/modifying the right incentive package for the managers. We also incorporate the notion of the asymmetric information to capture its impact on the board of directors’ decision about the managers’ incentive package.