Profit Maximization vs Maxing Shareholders Wealth Essay
Shareholder wealth is defined as the present value of the expected forecasting of returns to the owners which are the shareholders of one’s company. These returns can take the form of recurring dividend payments and or proceeds from the sale of the stock. Shareholder wealth is measured by the market value which is the price that the stock trades in the marketplace of a firm’s common stock. (James, Charles & Frederick, 2008) Profit maximization is defined as a more fixed concept than shareholder wealth maximization.
The profit maximization objective from economic theory does not normally consider the time dimension or the risk dimension in the measurement of profits. In contrast, the shareholder wealth maximization objective provides a convenient framework for evaluating both the timing and the risks associated with various investment and financing strategies. Some marginal decision rules derived from economic theory are extremely useful to a wealth maximizing firm. Any decision, regardless of the duration short or long inevitably results in marginal revenues exceeding the marginal costs of the decision will be consistent with wealth maximization.
When a decision has penalties extending beyond a year in time, the marginal benefits and marginal costs of that decision must be evaluated in a present value framework. The goal of shareholder wealth maximization is a long term goal. Shareholder wealth is a function of all the future returns to the shareholders. Therefore, in making decisions that maximize shareholder wealth, management must consider the lasting impact on the firm and not just focus on immediate ramifications be it negative or positive.
For instance, a firm could increase short run earnings and dividends by eliminating all research and development expenses. However, this decision would reduce long run earnings and dividends, and also reduce shareholder wealth, because the firm would be unable to develop new products to produce and sell. (James, Charles & Frederick, 2008) The separation of ownership and control in corporations may result in management pursuing goals other than shareholder wealth maximization, such as maximization of their own personal significance.
Concern for their own self-interests may lead management to make decisions that promote their long run survival such as job security, also minimizing and limiting the amount of risk incurred by ones firm. A narrow-minded person lacking such vision or a business solely concerned about short term benefits can be detrimental to the overall goals. A short term run can fulfil objective of earning profit but may not help in creating wealth. It is because wealth creation needs a longer duration to accumulate. 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 which will support profitability. (James, Charles & Frederick, 2008) Furthermore, one may think that profit maximization is a compartment of wealth and being a compartment, it will facilitate wealth creation. The better and more accurate evaluation of business as it relates to wealth maximization, focuses more on the importance of cash flows rather than profitability.
It is often stated that profit is a relative term and it can be a figure in some currency, while it is a percentage in others. For example, a profit of $20,000 cannot be considered good or bad for a business, until it is compared with investments, sales and other performance measures. Similarly, extent of earning profits is important whether it is earned in short term or long term. In wealth maximization, there is a major emphasis on cash flows rather than profit. That being said, to evaluate various alternatives for decision making, cash flows are taken under consideration.
For example to measure the worth of a project, present value of its cash inflow and present value of cash outflows which is the net present value is equated. This approach considers cash flows rather than profits into consideration to find out worth of a project. (James, Charles & Frederick, 2008) Thus, maximization of wealth approach believes that money has time value. In conclusion, profit maximization is directly correlated to profits only, while shareholder wealth encompasses total company equity, debt ratios and many other financial performance measure ratios.
One’s company could focus on profit maximization over a longer period of time, while the shareholder would rather see stock values and corporate total value increase immediately also known as getting in and get out. If ones management focused on short-term profit maximization, at the expense of long term sales revenues, then shareholder wealth/stock price could actually decrease because of the loss of market share. What are the differences between the goals of profit driven organizations and not for profit organizations?
Both for profit and not for profit entities in general have enterprising owners who open bank accounts, own assets and employ staff. They also try to maximize the income, rationalize expenses and establish and achieve the business objectives of the organization. However, founders of the enterprises start their ventures with different objectives in mind. For instance, the focus of a technology start up may involve manufacturing and marketing an innovative product with the goal of attracting angel investors.
The owners may have vision of a multimillion-dollar stock offering at some point in the future. Alternatively, a community minded person might have the goal of starting a not for profit business with the aim of starting a technologically driven Community Center with state of the art computers and other state of the art technology that provides new resources for disenfranchised urban city students. Both types of organizations, when formed as corporation, have board of directors that oversee the business of the organizations and ensure the continuity of the enterprise over time.
The board members also may have the responsibilities of approving a chief executive to manage the day to day affairs of the organization. Not for profit board members play a significant role in the development of the enterprise and fundraising activities. For profit business owners and shareholders own the assets of the companies. If the business dissolves for any reason, the property gets distributed among the individuals based on their ownership in the business. Individuals involved with not for profit enterprises cannot have ownership in the assets of the organization.
If the entity ceases operation, the law requires distribution of the property to another not for profit with a similar mission. A major difference between for profit and not for profit involves the payment of federal and state taxes. Not for profit corporations have some tax-exempt statuses, which the entity must apply for with the Internal Revenue Service and the state. (“non profits,”) For profit businesses must pay taxes on the net earnings of the business or the excess income earned over the expenses. In addition not for profits have to report the salaries of the five highest paid employees and contracts more than $50,000.
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