Question

Explain the concept of shareholder wealth maximization. Is there a conflict between the goal of shareholder wealth maximization and the financial manager's need to act in an ethical manner? Why or why not?

Answer 1

Shareholders wealth maximization: One of the metric used for shareholders return on investment is ROE (return on equity). ROE is defined as profit after tax divided by the equity capital. The higher the profit after tax, the higher the ROE and more the shareholders wealth maximization. To increase this ROE figure, the manager needs to either increase the revenues or decrease the costs or do both.

In a temptation to increase the revenues, the company might miss-selling the products or overtly increase the price (if monopoly exists), thus acting un-ethical. But in the near future, the customers of the company will punish the company by refusing to use its products. Thus the revenue of the company will decrease, which will decrease profits & ROE figure.

In a temptation to decrease the costs, the company might miss-treat the suppliers of the company by cutting their margins, increase the credit period or not compensating the employees well. This will be un-ethical in nature, and these stakeholders of the company will punish the company in near future. The company will not get credit from the suppliers or the right talent in staff. Hence the profit of the company will decrease, which will decrease the ROE figures.

Hence finance managers need to act in an ethical manner if they want to put a sustained & strong ROE period for longer periods of time.

A perfect example of this is Berkshire Hathway headed by Mr. Warren Buffett. For the last 40 years, he has generated an ROE figure of 20% pa (something unheard of for such a long period of time). He has been very ethical in his practices.