Question

The financial manager should attempt to maximize the wealth of the firm’s shareholders through achieving the highest possible value for the firm. a) Please explain how this concept is different from the idea of earning the highest possible profit for the firm

b) explain how social responsibility and ethical behavior on the part of corporate management affects the value of the firm;

Answer 1

a. Role of financial manager is to maximize shareholder's wealth through value maximization. The value of firm is dependent on the potential cash flow earning opporutnity and capaity that a firm has. Higher the PV of future cash flows and higher the terminal value, higher will be the value of the firm. Profit is one aspect of this cash flows but it is not always the case. When we go for profit maximization approach, there is focus on revenue maximization and cost minimization. for cost minimization, the firm may tend to reduce expenses, some of which have future earning potential. For example, installation of new production line, plant has a direct cost impact and depreciation expense impacts the profit. But these also have future revenue earnign potential. Thus, profit maixmization can be termed as a short-term goal which is different from value maximization which is a long-term goal.

b. Let us consider the two aspects seperately.

• ​Social responsibility: If the firm is into CSR and is known to have positively impacted the society thorugh its activities, more and more investors are inclined to the firm as they see it as a sign for good operating behavior. Aso, corporate lending might be available easily and at preferential rates to such firms thus reducing the interest expenses as compared to firms with no or very less CSR activities. This in turns positively impacts the cash flows thus increasing the value of the firm
• Ethical behaviour: if a firm is known to follow ethical business practices both in terms of operations and reporting, the corporate lending is easy and at preferential rates. Also, more and more investors tend to associate themselves with such firms. This in turn positively impacts the value of the firm.