why the goal of a firm is maximizing the wealth?

Expert Solution

The goal of a firm is 'maximizing owners' wealth' for two reasons:

The first reason is that, it emphasizes that any decision taken should create positive 'net present value' and among alternatives, that alternative which gives maximum NPV should be selected. As NPV goes to the owners, it gives the absolute addition to the owners' wealth, which is what a firm should aim for.

Positive NPV results when, the discounted value of cash inflows is more than the discounted value of cash out flows, the discount rate being the cost of funds used for generating the cash flows.

The second reason is that all other alternative goals, like, maximizing sales, maximizing profits, maximizing market share do not independently constitute a comprehensive goal. They all have several drawbacks and do not take into consideration the time value of money. Further, they are relevant to the extent they help in maximizing the NPV.

For instance, profit is term that can have difference connotations. It can be profit before tax or after tax, it can be long term profit or short term profit. it can be profit from the entire funds or profit from equity funds and so on. More importantly, it does not consider time value of money and it is not cash flow based.

In contrast the NPV [which is the index of addition to shareholders' wealth] is based on cash flows, because of which it is not capable of different connotations, and also takes into account the time value of money. It simply tells what the owners' would gain in present value terms if, a particular decision is taken.

Hence, maximizing shareholder wealth can be considered the goal of the firm.

jeff jeffy answered 2 months ago

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