Financial Management is concerned with the task of efficiently managing the resources of a company. This paper will attempt to discuss the relationship between shareholder wealth maximization and firm’s profit maximization. Additionally, the paper shall also explore the commonalities as well as the distinctive features of both the goals. Furthermore, the paper will contain an example which shows that sometimes maximizing profits might not lead to shareholder wealth maximization. Also, an article which is taken from a scholarly will be analyzed. Through the article, the goal of the wealth maximization will be critically examined.
Relationship between the two Goals
A positive relationship exists between shareholder wealth maximization and firm’s profit maximization in the short term. However, in the long term, relationship varies depending on some factors. Both the goals are governed by the internal policies of a firm, and both of them tend to maximize earnings for the firm.
Similarities and Differences
There exist various similarities and differences between the two goals. A similarity between the two goals is that they both focus on current assets. Moreover, they both have the objective of increasing the net worth of the business concerned. Another similarity is that both these goals operate to make the business sustainable in the long run.
There are several differences among the two goals as well. Nowadays, the modern financial management concerns itself with ways though which it can maximize shareholder wealth maximization. On the other hand, a traditional financial managmet was focused more on profit maximization. Another difference in that profit maximization focuses on short-term goals. On the other hand, wealth maximization focuses on long term goals. Moreover, by focusing on wealth maximization companies will be able to evaluate businesses in real time. Furthermore, in wealth maximization firms focus more on cash flows rather than profitability.
In some instances, profit maximization might not lead to shareholder wealth maximization. For instance, a firm decides to eliminate all research& development (R&D) expenses. While this would lead to an increase in short-run earnings and dividends but the long run earnings would be reduced. As a result, shareholder wealth would be reduced as well. The reason behind it is that the firm will not be able to produce new products and sell them if it has no R&D.
The article talks about the ethical considerations and shareholder wealth maximization. (Poitras, 1994). The main criticism is that ethical issues are not taken into account in shareholder wealth maximization. To maximize wealth for the shareholders, the management engages in unethical and socially reprehensible activities. For them, the only goal is to ensure shareholder wealth maximization, and they would go to any lengths to ensure it.
In my opinion, the criticism is valid. In pursuing shareholder wealth maximization, firm very often flouts rules and regulations with any regards for others. It is a firm’s responsibility to ensure that its dealings are ethical. After going through the article, I find no fault with the criticism and consider the criticism justified. I do not find myself questioning the goal of shareholder wealth maximization.
There is a positive relationship between the two goals in the short run. While in the long run, the relationship depends on other factors as well. Despite the similarities, there are stark differences between the two goals. Shareholder wealth maximization is a modern approach as compared to the traditional approach of profit maximization. In some instances, profit maximization does not necessarily translate into wealth maximization. Moreover, in attempt to maximize shareholder wealth, management flouts its social and legal responsibilities.
Laux, J. (2010). Topics In Finance Part I-Introduction And Stockholder Wealth Maximization. American Journal of Business Education (AJBE), 3(2). doi:10.19030/ajbe.v3i2.381
Poitras, G. (1994). Shareholder wealth maximization, business ethics, and social responsibility. Journal of Business Ethics, 13(2), 125-134. doi:10.1007/bf00881581
Shivdasani, A., & Zenner, M. (2004). 5. Best Practices in Corporate Governance: What, Two Decades of Research, Reveals /. U.S. Corporate Governance, 16(2-4), 29-41. doi:10.7312/chew14856-005