Goal of the firm
Maximize Shareholder Wealth?
What about Stakeholders?
What is Profit Maximization? Why profit max is not good enough? What are constraints of Profit Max?
Profit maximization refers to how much dollar profit the company makes. It is a short term approach and a myopic person or business is mostly concerned about short term benefits.
But a short term horizon can fulfill objective of earning profit but may not help in creating wealth. It is because wealth creation needs a longer term; therefore financial management emphasizes on wealth maximization rather than profit maximization.
For a business, it is not necessary that profit should be the only objective; it may concentrate on various other aspects like increasing sales, capturing more market share, return on capital etc, which will take care of profitability. So, we can say that profit maximization is a subset of wealth and being a subset, it will facilitate wealth creation.
Constrains of Profit Max-
It is a short term approach
It ignores the timing of returns, cash flows, and risk
Profit max method could not discuss on market share, high sales, and greater stability and so on.
It could not consider the social responsibility that is one of the most important objectives of many firms.
Wealth Maximization/ Maximize Shareholder Wealth
Why wealth max is better option than profit max?
Wealth maximization is long term process. It refers the value of the company generally expressed in the value of the stock.
Value maximization says that managers should make all decisions so as to increase the total long run market value of the firm. Total value is the sum of the value of all financial claims on the firm- including equity, debt, preferred stock and warrants.
Here, the executives undertake investing in new projects, maximizing profits from existing products and services, controlling cost, and adding value to the company through process, which reflects in the price of the stock, but always in the increase in Net Asset Value and Equity Per Share.
The wealth of corporate owners is measured by the share price of the stock, which in turn is based on the timing of returns (cash flows), their magnitude and their risk. Maximizing share price will maximize owner wealth.
Cash flow and risk are the key decision variables in maximizing owner wealth.
When investors look at a company they not only look at dollar profit but also profit margins, return on capital, and other indicators of efficiency. Profit maximization does not achieve the objectives of the firm’s owners; therefore wealth maximization is better option than profit maximization.
Profit Max vs. Wealth Max
Profit maximization is short term approach and it refers to how much money the company makes. But Wealth maximization is a long term approach and it refers the value of the company.
Profit maximization is a subset of wealth.
Profit max ignores timing, cash flows, and risk, but in wealth maximizing those are the key decisions variables.
Maximization of wealth approach believes that money has time value.
“Stakeholder theory”, the asserted main contender to value maximization for this objective function, has its root in sociology, organizational behavior, the politics of specials interests, and managerial self interest. Here “asserted contender” because stakeholder theory is incomplete as a specification for the corporate purpose or objective function. It is incompleteness in not accidental; it serves the private interests of those who promote it, including many managers and directors of corporations.
Briefly put, value maximization says that managers should make all decisions so as to increase the total long run market value for the firm. Total value is the sum of the value of all financial claims on the firm- including equity, debt, preferred stock, and warrants.
Stakeholder theory, on the other hand, says that managers should make decisions so as to take account of the interest of all the stakeholders in a firm. And stakeholders include all individuals or group who can substantially affect the welfare of the firm, including not only the financial claimants, but also employees, customers, communities, governmental officials, and under some interpretation the environment, terrorists, blackmailers, and thieves.