What are the Goals Of The Firm and explain profit maximization and shareholders' wealth maximization.

May 17th, 2008 Comments off
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From Finance’s stand-point there are two main goals:

a. Profit Maximization

b. Shareholders’ Wealth Maximization

Let’s look at what is

PROFIT MAXIMIZATION:

  • Simply a single-period or a short-term goal to be achieved within one year
  • Management mainly focus on efficient utilization of capital resources to maximize profits WITHOUT considering the consequences of its actions towards the company’s future performance.

Drawbacks/disadvantages of Profit Maximization Goal:

a. It is only a SHORT TERM concept

b. It does NOT consider the timing of returns

c. It IGNORES risk

Next, let’s look at what is

SHAREHOLDERS’ WEALTH MAXIMIZATION:

  • Shareholders’ wealth is regarding the maximizing of the total market /market price of the existing shareholders’ common stock
  • It can be achieved by considering many factors whether short or long term pertaining to decisions/actions made affecting the present and future earnings per share, timing of returns, dividend policy and other factors that can affect the market price of the company stock

Unlike profit maximization, it has the following advantages:

  • Its applies to the principle of time value of money wherein a dollar received today is worth more han it is to be received say 1 year later. By considering time value of money, this will lead to an overall increase in the company’s earning
  • To achieve shareholder’s wealth maximization, management needs to consider the uncertainty or risk factor. It accept a certain degree of risk when it is compensated with the same level of return
  • Increase in shareholders’ wealth will directly lead to increase in cash flows. It is not concern only with accounting earnings/profits but CASH FLOWS.
  • To achieve shareholders’ wealth maximization, the firm has to achieve all the short-term target like sales/earnings growth and dividend payout targets. Only when these short term targets being achieved, the firm will then be attractive to the potential investors which might raise the stock price..

Salient point to note:

  • Referring to the above two goals, we see that Profit Maximization(short-term) is actually a part of Shareholders Wealth Maximization. The ultimate or long term goal of a firm is actually to maximize shareholders’ value where we see the growth and sustainability of the market share prices of the owners’ common stock increasing from one year to another.
  • Unfortunately, in today’s world, there are still many companies who aggressively look towards immediate/short-term profit maximization as the main and ultimate goal. The major reason can be blamed to big incentives like bonus/stock options given by the shareholders to its top management when sales or earnings target being achieved.

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Financial Accounting

 
 

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