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Why is profit maximization, by itself, an inappropriate goal? What is meant the goal of maximization of shareholders wealth?

24 Jul

Traditionally, finance teaches that managers should act according to the interest of the firm’s owners or its stockholders. There are different viewpoints in this case. Some agree with pure profit maximization and some not. I personally think here the goal is the main keyword .I mean what you want determines what you have to do.

What should you as a financial manager try to maximize?

Some people believe that the manager’s main goal always should be to try to maximize profits. To do it, they should take only those actions that expected to increase revenues more than costs. It means maximizing in EPS (Earning Per Share). It seems a reasonable objective but as a goal suffers from several flows:

  • First of all, figures for EPS are always historical so reflect past performance rather than what is happening now or what will happen in the future. If you as a manager seek only to maximize profits in a limited period, you may ignore the timing of those profits. Large profits that pay off many years in the future may be less valuable than smaller profits received next year.
  • Second, Different accounting principles result differences in profit computing. It means when firms compute profits, they follow certain accounting principles which focus on accrued revenues and costs. A firm that is profitable according to accounting principles may spend more cash that it receives and an unprofitable firm may have larger cash inflows than outflows. There is a famous expression in finance saying:” you cannot pay your bills with earning, only with cash!!” In finance, we place more emphasis on cash than on profit or earning.
  • Finally, as a manager you have to include variability or risk. Focusing only on earning may ignore them. When comparing two investment opportunities, we must consider both the risk and the expected return of the investment and we face a trade-off between risk and expected return.

These three reasons reveal that profit maximization, by itself, is an unsuitable goal.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. In this theory, 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.

Take a look at overall product cycle of the firm shows that the shareholders who make risky, value-increasing investments are the most important part of this cycle. They can force the firm to take on risky, but potentially profitable, ventures.

Although the primary goal of managers should be maximizing the shareholder wealth, in recent years, many firms have focused to include the interests of other stakeholders like employees, customers, tax authorities and etc. considering other constituents’ interests in part of the firm’s “social responsibility ” and keeping other affected groups happy provides long term benefits to shareholders.  In most cases, taking care of stakeholders translates into maximizing shareholders wealth.

***

It was one of my assignments on Basic Financial management subject.  I’ve used some notes of this book:” The scope of corporate Finance” (William L. Megginson, Scott B. Smart)

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73 Comments

Posted by on July 24, 2009 in FIN, MBA

 

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  2. etramway

    January 15, 2010 at 12:34

    Well done. The goal of any firm is to maximize shareholder wealth, of course timing is everything. Cellular telephone companies had net losses and huge outflows of cash from both operations and investments for their first decade in business. Building shareholder value was done by increasing market share.

    Business like life has no absolutes. Unfortunately we try to teach our business students that there are “general rules”. You didn’t fall into this trap.

     
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