Question

Compare and contrast the objective of maximizing earnings per share with that of maximizing wealth.

Answer 1

Maximizing EPS is maximizing the ratio: Net income available to common stockholders/Number of common stock shares outstanding, while maximizing shareholders' wealth aims at maximizing the net present value of decisions taken.

Both have one feature in common, that is they aim at earning higher for the sake of common stockholders.

But, EPS maximization has the following drawbacks:

*It is based on accounting profits and not cash flows

*Accounting profits can be manipulated

*It ignores time value of money

*It can be manipulated by going for short term gains.

*It can be increased with very high leverage, which can be misleading as the risk factor is not considered. The P/E ratio may go down with higher leverage.

In contrast, the objective of maximization of wealth has the following advantages:

*It is based on cash flows, which are not capable of manipulation like accounting profits.

*It gives the addition to shareholders' wealth in current dollars

*It takes into account time value of money and also risk.

*It is applied to short term and long term decisions.