Goal Of A Firm

Topics: Stock market, Stock, Shareholder Pages: 8 (2606 words) Published: December 11, 2014
Goals of Corporation
P ROFIT M AXIMIZATION
In microeconomics courses, profit maximization is frequently given as the goal of the firm. Profit maximization stresses the efficient use of capital resources, but it is not specific with respect to the time frame over which profits are to be measured. Do we maximize profits over the current year, or do we maximize profits over some longer period? A financial manager could easily increase current profits by eliminating research and development expenditures and cutting down on routine maintenance. In the short run, this might result in increased profits, but this clearly is not in the best long-run interests of the firm. If we are to base financial decisions on a goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the real world. In microeconomics, profit maximization functions largely as a theoretical goal, with economists using it to prove how firms behave rationally to increase profit. Unfortunately, it ignores many real-world complexities that financial managers must address in their decisions. In the more applied discipline of financial management, firms must deal every day with two major factors not considered by the goal of profit maximization: uncertainty and timing. Another problem with the goal of profit maximization is that it ignores the timing of the project’s returns. If this goal is only concerned with this year’s profits, we know it inappropriately ignores profits in future years. If we interpret it to maximize the average of future profits, it is also incorrect. Inasmuch as investment opportunities are available for money in hand, we are not indifferent to the timing of the returns. Given equivalent cash flows from profits, we want those cash flows sooner rather than later. Thus, the real-world factors of uncertainty and timing force us to look beyond a simple goal of profit maximization as a decision criterion. We now turn to an examination of a more robust goal for the firm: maximization of shareholder wealth. M AXIMIZATION OF S HAREHOLDER W EALTH

In formulating the goal of maximization of shareholder wealth we are doing nothing more than modifying the goal of profit maximization to deal with the complexities of the operating environment. We have chosen maximization of shareholder wealth—that is, maximization of the market value of the existing shareholders’ common stock—because the effects of all financial decisions are thereby included. Investors react to poor investment or dividend decisions by causing the total value of the firm’s stock to fall, and they react to good decisions by pushing up the price of the stock. In effect, under this goal, good decisions are those that create wealth for the shareholder. To employ this goal, we need not consider every stock price change to be a market interpretation of the worth of our decisions. Other factors, such as changes in the economy, also affect stock prices. What we do focus on is the effect that our decision should have on the stock price if everything else were held constant. The market price of the firm’s stock reflects the value of the firm as seen by its owners and takes into account the complexities and complications of the real-world risk. As we follow this goal throughout our discussions, we must keep in mind one more question: Who exactly are the shareholders? The answer: Shareholders are the legal owners of the firm. Reference: Stanly B. Block, Geoffrey A. Hirt, Foundation of Financial Management, I O/e Irwin/McGraw Hill – 13th Edition

Goals of the Firm

MAXIMIZE SHAREHOLDER WEALTH:
Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s owners—the stockholders. The simplest and best measure of stockholder wealth is the firm’s share price, so most textbooks (ours included) instruct caption is that when firms strive to make their shareholders happy, they do so at the expense of...
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