The following is from chapter one in the textFinancial Management and Policy, by James C. Van Horne, Copyright 1974 by Prentice-Hall. It is classic finance.
Profit Maximization vs. Wealth Maximization
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 firms 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 firms progress; it indicates how well management is doing in behalf of its stockholders.
Management vs. Stockholders
In certain situations the objectives of management may differ from those of the firms stockholders. In a large corporation whose stock is widely held, stockholders exert very little control or influence over the operations of the company.
It is true that in order to survive over the long run, management may have to behave in a manner that is reasonably consistent with maximizing shareholder wealth. Nevertheless, the goals of the two parties do not necessarily have to be the same.Maximization of shareholder wealth, then, is an appropriate guide for how a firm should act. When management does not act in a manner consistent with this objective, we must recognize this as a constraint and determine the opportunity cost. This cost is measurable only if we determine what the outcome would have been had the firm attempted to maximize shareholder wealth.
A Normative Goal
Because the principal of maximization of shareholder wealth provides a rational guide for running a business and for the efficient allocation of resources in society, we use it as our assumed objective in considering how financial decisions should be made. The purpose of capital markets is to efficiently allocate savings in an economy from ultimate savers to ultimate users of funds who invest in real assets. If savings are to be channeled to the most promising investment opportunities, a rational economic criteria must exist that governs their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk. The market value of a firms stock embodies both of these factors. It therefore reflects the markets tradeoff between risk and return. If decisions are made in keeping with the likely effect upon the market value of its stock, a firm will attract capital only when its investment opportunities justify the use of that capital in the overall economy.
Put another way, the equilibration process by which savings are allocated in an economy occurs on the basis of expected return and risk. Holding risk constant, those economic units (business firms, households, financial institutions, or governments) willing to pay the highest yield are the ones entitled to the use of funds. If rationality prevails, the economic units bidding the highest yields will be the ones with the most promising investment opportunities. As a result, savings will tend to be allocated to the most efficient users. Maximization of shareholder wealth then embodies the risk-return tradeoff of the market and is the focal point by which funds should be allocated within and among business firms. Any other objective is likely to result in the suboptimal allocation of funds and therefore lead to less than optimal level of economic want satisfaction.
This is not to say that management should ignore the question of social responsibility. As related to business firms, social responsibility concerns such things as protecting the consumer, paying fair wages to employees, maintaining fair hiring practices, supporting education, and becoming actively involved in environmental issues like clean air and water. Many people feel that a firm has no choice but to act in socially responsible ways; they argue that shareholder wealth and, perhaps, the corporations vary existence depends upon its being socially responsible. However, the criteria for social responsibility are not clearly defined, making formulation of a consistent objective function difficult.
Moreover, social responsibility creates certain problems for the firm. One is that it falls unevenly on different corporations. Another is that it sometimes conflicts with the objective of wealth maximization. Certain social actions, from a long-range point of view, unmistakably are in the best interests of stockholders, and there is little question that they should be undertaken. Other actions are less clear, and to engage in them may result in a decline of profits and in shareholder wealth in the long run. From the standpoint of society, this decline may produce a conflict. What is gained in having a socially desirable goal achieved may be offset in whole or part by an accompanying less efficient allocation of resources in society. The latter will result in a less than optimal growth of the economy and a lower total level of economic want satisfaction. In an era of unfilled wants and scarcity, the allocation process is extremely important.
Many people feel that management should not be called upon to resolve the conflict posed above. Rather, society, with its broad general perspective, should make the decisions necessary in this area. Only society, acting through Congress and other representative governmental bodies, can judge the relative tradeoff between the achievement of a social goal and the sacrifice in the efficiency of apportioning resources that may accompany realization of the goal. With these decisions made, corporations can engage in wealth maximization and thereby efficiently allocate resources, subject, of course, to certain governmental constraints. Under such a system, corporations can be viewed as producing both private and social goods, and the maximization of shareholder wealth remains a viable corporate objective.