Question

Why is it more important for a company to maximize shareholders wealth, rather than to maximize profits? Discuss with details should be minimum 400 words.

Answer 1

There is no way we are going to write an answer of 400 words for you. I have put together my thoughts below. Please add your own thoughts and ideas and expand your answer.

Shareholders own the company but they don’t manage it. They elect Board of Directors: Executive vs. non executive directors; independent directors. Board appoints top management and is supposed to ensure that managers act in the shareholders’ best interests.

Corporation is a permanent. Employees and managers are not. Even if managers quit or are dismissed and replaced, the corporation can survive. Existing shareholders can sell all their shares to new investors without disrupting the operations of the business.

Hence, the goal of an organization should be a permanent and long term and not transient or short term. It is therefore more important for a company to maximize shareholders wealth, rather than to maximize profits. Please see the explanations below:

Sl. No.	Factor	Wealth maximization	Profit maximization
1.	Approach	Modern, wider approach, sustainable growth	Traditional, narrower, short term growth
2.	Impact	Long term, deeper, leads to superior performance over the life of the company	Short term, usually a year, leads to a superior performance only in a year or two
3.	Basis	Cash flows; Present value i.e. time value of cash flows is considered	Profits, accruals, not cash flows, profits can be misleading, time value of money is ignored
4.	Consideration to risk	Yes, discount rate used to calculate the present value incorporate the riskiness of the cash flows	Riskiness is ignored
5.	Allocation of resources	Sustainable, efficient	Profit oriented, opportunistic, short term

Shareholders'wealth maximization therefore appears to be a superior goal than profit maximization:

• Such a goal leads to creation of a sustainable organization with long term focus, profit maximization leads to a very narrow approach by managers that may compromise the sustainability for near term profits.
• Profit maximization may lead the managers to undertake frauds and manipulations.
• And last but not the least, wealth maximization in a way automatically leads to profit maximization. You can't create wealth unless you create sustainable profits. The other way round is not true. Profits may not necessarily create wealth or value for the shareholders.