profit maximization and wealth maximization
Who owns a business firm? The shareholders. Those individuals who have bought shares of stock, which indicate ownership in the firm. Even if your business is a one-person shop, you are the shareholder. If the business is a huge conglomerate, then it has a Board of Directors made up of the shareholders who own shares of the firm based on how much money they have invested. Because the shareholders own the firm, they are entitled to the profits of the firm.
Shareholder wealth is the appropriate goal of a business firm in a capitalist society. In a capitalist society, there is private ownership of goods and services by individuals. Those individuals own the means of production to make money. The profits from the businesses in the economy accrue to the individuals.
What is Shareholder Wealth Maximization?
When business managers try to maximize the wealth of their firm, they are actually trying to increase their stock price. As the stock price increases, the individual who holds the stock wealth increases. As the stock price goes up, the value of the firm increases and the net worth of the individual who owns the stock increases.
Profit maximization is basically is a single-period or, at most, a short-term goal, to be achieved within one year; it is usually interpreted to mean the maximization of profits within a given period of time. A corporation may maximize its short-term profits at the expense of its long-term profitability. In contrast, stockholder wealth maximization is a long-term goal, since stockholders are interested in future as well as present profits.
Wealth maximization is generally preferred because it considers (1) wealth for the long term, (2) risk or uncertainty, (3) the timing of returns, and (4) the stockholders` return. Timing of returns is important; the earlier the return is received, the better, since a quick return reduces the uncertainty about receiving the return, and the money received can be reinvested sooner. Table 1-1 summarizes the advantages and disadvantages of these two often conflicting
PROFIT MAXIMIZATION VERSUS STOCKHOLDER WEALTH MAXIMIZATION
PROFIT MAXIMIZATION VERSUS STOCKHOLDER WEALTH MAXIMIZATION Goal
Objective
Advantages
Dis advantages
Profit maximi zation
Large profits
Easy to calculate profits. 1.
Easy to determine the link between financial decisions and profits. 2.
Emphasizes the short-term. 1.
Ignores risk or uncertainty. 2.
Ignores the timing of returns. 3.
Requires immediate resources. 4.
Stock holder wealth maximi zation
Highest share price of common stock
Emphasizes the long term. 1.
Recognizes risk or uncertainty. 2.
Recognizes the timing of returns. 3.
Considers stockholders` return. 4.
Offers no clear relationship between financial decisions and stock price. 1.
Can lead to management anxiety and frustration. 2.
Can promote aggressive and 3. creative accounting practices.
Note: The policy decisions that by themselves are likely to affect the value of the firm (maximize stockholder wealth) include the:
· Investment in a project with a large net present value.
· Sale of a risky division that will now increase the credit rating of the entire company.
· Use of a more highly leveraged capital structure that resulted in lower cost of capita
Who owns a business firm? The shareholders. Those individuals who have bought shares of stock, which indicate ownership in the firm. Even if your business is a one-person shop, you are the shareholder. If the business is a huge conglomerate, then it has a Board of Directors made up of the shareholders who own shares of the firm based on how much money they have invested. Because the shareholders own the firm, they are entitled to the profits of the firm.
Shareholder wealth is the appropriate goal of a business firm in a capitalist society. In a capitalist society, there is private ownership of goods and services by individuals. Those individuals own the means of production to make money. The profits from the businesses in the economy accrue to the individuals.
What is Shareholder Wealth Maximization?
When business managers try to maximize the wealth of their firm, they are actually trying to increase their stock price. As the stock price increases, the individual who holds the stock wealth increases. As the stock price goes up, the value of the firm increases and the net worth of the individual who owns the stock increases.
Profit maximization is basically is a single-period or, at most, a short-term goal, to be achieved within one year; it is usually interpreted to mean the maximization of profits within a given period of time. A corporation may maximize its short-term profits at the expense of its long-term profitability. In contrast, stockholder wealth maximization is a long-term goal, since stockholders are interested in future as well as present profits.
Wealth maximization is generally preferred because it considers (1) wealth for the long term, (2) risk or uncertainty, (3) the timing of returns, and (4) the stockholders` return. Timing of returns is important; the earlier the return is received, the better, since a quick return reduces the uncertainty about receiving the return, and the money received can be reinvested sooner. Table 1-1 summarizes the advantages and disadvantages of these two often conflicting
PROFIT MAXIMIZATION VERSUS STOCKHOLDER WEALTH MAXIMIZATION
PROFIT MAXIMIZATION VERSUS STOCKHOLDER WEALTH MAXIMIZATION Goal
Objective
Advantages
Dis advantages
Profit maximi zation
Large profits
Easy to calculate profits. 1.
Easy to determine the link between financial decisions and profits. 2.
Emphasizes the short-term. 1.
Ignores risk or uncertainty. 2.
Ignores the timing of returns. 3.
Requires immediate resources. 4.
Stock holder wealth maximi zation
Highest share price of common stock
Emphasizes the long term. 1.
Recognizes risk or uncertainty. 2.
Recognizes the timing of returns. 3.
Considers stockholders` return. 4.
Offers no clear relationship between financial decisions and stock price. 1.
Can lead to management anxiety and frustration. 2.
Can promote aggressive and 3. creative accounting practices.
Note: The policy decisions that by themselves are likely to affect the value of the firm (maximize stockholder wealth) include the:
· Investment in a project with a large net present value.
· Sale of a risky division that will now increase the credit rating of the entire company.
· Use of a more highly leveraged capital structure that resulted in lower cost of capita
