Question
In: Finance
Why is maximizing current share price not equivalent to maximizing long-term value?
Why is maximizing current share price not equivalent to maximizing long-term value?
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Expert Solution
Long term value of a firm is discounted and brought back to current year to calculate the current price. A firm with very high level of risk will surely have a higher weighted average cost of capital. Weighted average cost of capital is used to discount the future cash flows and so as to discount Long term value of the firm. Therefore, if the weighted average cost of capital is high, it will produce a lower price of the stock and vice versa. Thus, maximizing current price includes maximizing the long term value of the firm and minimizing weighted average cost of capital.
Long term value of a firm is discounted and brought back to current year to calculate the current price. A firm with very high level of risk will surely have a higher weighted average cost of capital. Weighted average cost of capital is used to discount the future cash flows and so as to discount Long term value of the firm. Therefore, if the weighted average cost of capital is high, it will produce a lower price of the stock and vice versa. Thus, maximizing current price includes maximizing the long term value of the firm and minimizing weighted average cost of capital.
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