Question

The goal of the firm is to create value for the firm’s owners (that is, its shareholders). Thus the actual goal is to “maximize shareholder wealth” by maximizing the price of the existing common stock. However in some situation management may make decisions that are not consistent with the goal. For instance, management decided that the profit for this year reinvested in the company. Based on the situation, briefly explain which principles of finance that the management violated.

Answer 1

The management, by reinvesting the profits in the company, violated the financial principle that an agent should act in the best interest of the principal. In finance agents are managers of the company while the principals are the owner or the shareholders.

The best interest of the principal lies in their wealth maximization and this happens in two forms – increase in the prices of the shares and payout of dividends. Dividends are paid from the net profit (or profit after tax) of a company. In this case the management, instead of declaring and paying dividends, ploughed back the profits back in the company. This is in violation of the principle of the agency theory of finance. Managers are agents for the owners and are obligated to represent their best interests. Here apparently the best interest of the owners was not considered by not paying them dividends.