Question

In: Finance

explain why maximizing profits falls short of maximizing shareholders wealth

explain why maximizing profits falls short of maximizing shareholders wealth

Solutions

Expert Solution

Ans. Profit Maximizing simply means maximizing the income of the firm. Traditionally, a business firm is regarded as an economic entity whose fundamental objective is the maximization of profits. Economists are of the view that profits can be maximized when the differences of total revenue over the total cost is maximum or in other words total revenue is greater than total cost by the greatest amount.

The concept of profit maximization is deeply rooted in economic theory. Its appropriateness is justified on the following grounds:

1. This concept is analogous to rational behavior of a firm.

2. It ensures that the ultimate survivor in the corporate world is the profit maximiser.

3. It helps in the acquiring of monopoly in the imperfect product market.

However,it is often argued that this concept held good in the case of single entrepreneur firms where the same person was the owner, manager and the financer. The only aim of the single owner was to increase his individual wealth. But now a days, firms are characterised by limited liability and by a divorce between management and ownership. There exist different interest groups associated with a firm, whose interests do not coincide.

Again, the concept of profit maximizing is appropriate for short term profitability. Unfortunately, the objectives of profit maximization proves incapable of making a distinction between returns received in different time periods as also of analyzing the risk factors.

Further, profit maximization approach does take into account the timing of profits and benefits.

Also, this approach avoid the risk factors associated with the profits.

Wealth Maximization Approach:

In view of the limitations to the objectives of profit maximization, it is suggested that the objectives of the corporate financial decisions should be the maximisation of the value of the firm or of the corporate wealth.

The value of corporate wealth may be interpreted in terms of the value of the company's total assets. The value of total assets is the sum of the firm's productive assets and the value of wealth created by the firm through the use of productive assets.

The value of wealth is nothing but the present value of the future net proceeds of the firm's present and future assets.

The wealth maximization approach is better than the profit maximization approach on the following grounds:

1. Profit is vague term term and only focus is on short term profitability whereas profit maximization approach is concerned about the over all wealth/value of the firm. Therefore, wealth maximization approach is wider, long term approach.

2. Profit maximization creates a conflict between shareholders and owner whereas wealth maximization focuses on maximizing MPS which is good for both shareholders and owners.

3. Profit maximization approach does not consider the time value of money whereas wealth maximization approach consider time value of money; so its a realistic approach.

4. Profit maximization approach avoids the risk whereas wealth maximization approach consider the risk associated with return.

As explained above,it can be stated that maximizing profits falls short of maximizing shareholders wealth.


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