Question

The goal of the firm is to maximize firm value (maximize the stock price). How can the managers of the firm make this happen? How might agency costs get in the way? Explain

Answer 1

Profit Maximization- Earlier, Companies wanted to maximize the profit and work together for a single goal to achieve this motive. Increasing profit is a common goal that further increases salaries and bonus of managers. Managers always want to maximize the profits as they get benefit from this.

Wealth Maximization- Nowadays, companies are more modern and have adopted modern approach, i.e. "Wealth maximization". Shareholders get only a part of profit in form of dividend; they want more in the form of increasing stock as well as firm value. Companies reinvest their profits for expansion purpose and this strategy boosts the company's earning growth and its share price increases in the stock market. Shareholders sell the shares at higher price and get the capital appreciation.

Conflict between Management and Shareholders- Managers want to maximize profit while shareholders want to maximize the wealth, due to this, conflict arises between the management and shareholders. This problem is called Agency problem.

Agency Cost- Agency cost is the result of agency problem. Management get agree only after they get some extra benefits or increment in their salaries. Sometimes this cost is higher but when managers get agree for wealth maximization, it becomes a win win situation.