Business Standard

Objective function of firms and sustainability

Value of a firm depends on its ability to generate free cash flows over a long period of time

Asish K Bhattacharyya 

Asish K Bhattacharyya

What are a corporation's "social responsibilities?" Milton Friedman's well-known response is: a corporation's responsibility is to make as much money for the stockholders as possible. He observes, "In [a free economy] there is one and only one social responsibility of business·to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game." (Capitalism and Freedom, University of Chicago Press, 2002 Fortieth Anniversary Edition, p 133).

According to Friedman, it is the responsibility of the rest of us to establish a framework of law such that an individual in pursuing his own interest promotes an end, which was no part of his intention.

When we debate on changing laws relating to land acquisition or environment protection or labour engagement, we debate on whether to change the 'rules of the game'. In an article published in The New York Times (September 17, 1970) Friedman stated that firms should maximise profit conforming to 'the basic rules of the society, both those embodied by law and those embodied in ethical custom'. Framework of law, social and ethical norms, and social expectations and concerns set the 'rules of the game'.

Has anything changed today? Should firms strive to create social value rather than shareholder value?

Business firms' core objective function is to create 'shareholder value' while conforming to the 'rules of the game'. Entrepreneurs identify business opportunities and invite investors to invest money. Investors invest in the business with the expectation that the investment will grow at a rate higher than the rate at which it will grow if invested in risk-free securities. The value of a firm depends on its ability to generate free cash flows (cash flows available for distribution to investors) over a long period of time. Therefore, firms select business models that will generate adequate FCF over a long period of time.

They build resilience in business models to enable them to respond quickly to changes in the business environment to enable them to generate adequate FCF to perpetuity. This is logical.

Some experts who champion corporate social responsibility (CSR) and 'sustainability' often argue that the core objective function of a firm is to create 'social value' and not 'shareholder value'. When we argue in favour of creating 'social value' we propose that business firms should not take advantage of some business opportunities that are available in the market place. For example, a business firm that pursues the objective of creating 'social value' will not engage in tobacco business because it creates huge health hazard even though manufacturing, selling and consumption of tobacco products is not prohibited by law or consumption of tobacco products is not prohibited by social norms. In a free economy, all business opportunities are exploited to create 'shareholder value'. Moreover, quantification of 'social value' is very subjective and difficult.

Therefore, the management's accountability towards investors gets diluted when it is asked to pursue the objective of creating 'social value'. It is utopian to ask business firms to pursue the objective of creating 'social value'. When business leaders talk about 'triple bottom line' (people, planet and profit), it is only rhetoric. However, it does not mean that 'sustainability' and 'CSR' are fads.

One thing has changed over the years. Advocacy groups and international organisations articulate societal concerns and expectations very clearly create awareness about the same. Business firms need not have to research for developing an understanding of those concerns and expectations. As a result, understanding the 'rules of the game' has become much easier now than what it was in the past. This helps business firms to design a sustainable business model. Generally speaking, a business model is sustainable if it creates value for shareholders with minimum negative consequences on the community and the environment.

Therefore, building a sustainable business model requires consideration of all the social and environmental issues, for example, they may range from the health problems of the local community to the global climate change concerns.

Enlightened business firms embed 'sustainability' and CSR in their business model and strategy without diluting the core objective function of creating 'shareholder value'. A business model that fails to generate sufficient profit is not sustainable. Similarly, a business model that fails to conform to the 'rules of the game' is not sustainable. Therefore, business firms that have adopted 'sustainability' principles innovate continuously to reduce the negative impact of its business model on the society and environment. On May 5, 2015 Reuters reported "Consumer goods maker Unilever says its brands that most fully embrace its CEO's passion for sustainability perform the best, adding fuel to its oft-repeated argument that social responsibility is good for business."

It further reported "On the cost side, Unilever said, it has saved over 400 million euros through eco-friendly measures taken at its factories since 2008. In addition, it made over 200 million euros of savings last year through manufacturing, logistics and other areas related to its 'Sustainable Living Plan". Unilever has not shifted its focus from the core objective function of creating 'shareholder value'; rather it has designed a business plan that responds to societal expectations and concerns.

Professor and Head, School of Corporate Governance and Public Policy, Indian Institute of Corporate Affairs; Advisor (Advanced Studies), Institute of Cost Accountants of India; Chairman, Riverside Management Academy Private Limited

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First Published: Sun, May 10 2015. 21:34 IST