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3. Profit maximization is not wealth maximization –
Discuss briefly by giving appropriate examples.
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Answer Posted / shaikh kader, mba
Frequently, maximization of profits is regarded as the
proper objective of the firm, but it is not as inclusive a
goal as that of maximizing shareholder wealth. For one
thing, total profits are not as important as earnings per
share. A firm could always raise total profits by issuing
stock and using the proceeds to invest in Treasury bills.
Even maximization of earnings per share, however, is not a
fully appropriate objective, partly because it does not
specify the timing or duration of expected returns. Is the
investment project that will produce $100,000 return 5
years from now more valuable than the project that will
produce annual returns of $15,000 in each of the next 5
years? An answer to this question depends upon the time
value of money to the firm and to investors at the margin.
Few existing stockholders would think favorably of a
project that promised its first return in 100 years. We
must take into account the time pattern of returns in our
analysis.
Another shortcoming of the objective of maximizing earnings
per share is that it does not consider the risk or
uncertainty of the prospective earnings stream. Some
investment projects are far more risky than others. As a
result, the prospective stream of earnings per share would
be more uncertain if these projects were undertaken. In
addition, a company will be more or less risky depending
upon the amount of debt in relation to equity in its
capital structure. This risk is known as financial risk;
and it, too, contributes to the uncertainty of the
prospective stream of earnings per share. Two companies
may have the same expected future earnings per share, but
if the earnings stream of one is subject to considerably
more uncertainty than the earnings stream of the other, the
market price per share of its stock may be less.
For the reasons above, an objective of maximizing earnings
per share may not be the same as maximizing market price
per share. The market price of a firm’s stock represents
the focal judgment of all market participants as to what
the value is of the particular firm. It takes into account
present and prospective future earnings per share, the
timing, duration, and risk of these earnings, and any other
factors that bear upon the market price of stock. The
market price serves as a performance index or report card
of the firm’s progress; it indicates how well management is
doing in behalf of its stockholders.
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