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Profit Vs. Stockholder Wealth Maximization

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Profit MaximizationTypical goals of the firm include (1) stockholder wealth maximization; (2) profit maximization; (3) managerial reward maximization; (4) behavioral goals; and (5) social responsibility. Modern managerial finance theory operates on the assumption that the primary goal of the firm is to maximize the wealth of its stockholders, which translates into maximizing the price of the firm’s common stock. The other goals mentioned above also influence a firm’s policy but are less important than stock price maximization. Note that the traditional goal frequently stressed by economists—profit maximization—is not sufficient for most firms today. The focus on wealth maximization continues in the new millennium. Two important trends—the globalization of business and the increased use of information technology—are providing exciting challenges in terms of increased profitability and new risks.

This post briefly overview profit and stockholder’s wealth maximization as a fundamental goal of the modern financial management. Enjoy!

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Profit maximization is basically a single-period or, at the most, a short-term goal. It is usually interpreted to mean the maximization of profits within a given period of time. A firm may maximize its short-term profits at the expense of its long-term profitability and still realize this goal.

In contrast, stockholder wealth maximization is a long-term goal, since stockholders are interested in future as well as present profits. Wealth maximization is generally preferred because it considers:

(1) wealth for the long term;
(2) risk or uncertainty;
(3) the timing of returns; and
(4) the stockholders’ return.

 

Profit Maximization Goal

Objective: Large amount of profits

Advantages:
1. Easy to calculate profits
2. Easy to determine the link between financial decisions and profits

Disadvantages:
1. Emphasizes the short term
2. Ignores risk or uncertainty
3. Ignores the timing of returns
4. Requires immediate resources

 

Stockholder Wealth Maximization Goal

Objective: Highest market value of common stock

Advantages:
1. Emphasizes the long term
2. Recognizes risk or uncertainty
3. Recognizes the timing of returns
4. Considers stockholder’s return

Disadvantages:
1. Offers no clear relationship between financial decisions and stock price
2. Can lead to management anxiety and frustration
3. Can promote aggressive and creative accounting practices

 

Profit maximization can be achieved in the short term at the expense of the long-term goal, that is, wealth maximization. For example: a costly investment may experience losses in the short term but yield substantial profits in the long term. Also, a firm that wants to show a short-term profit may, for example, postpone major repairs or replacement, although such postponement is likely to hurt its long-term profitability.

Example

Profit maximization does not consider risk or uncertainty, whereas wealth maximization does. Consider two products, A and B, and their projected earnings over the next 5 years, as shown below:

Year    Product A      Product B

1         $10,000        $11,000
2         $10,000        $11,000
3         $10,000        $11,000
4         $10,000        $11,000
5         $10,000        $11,000
           $50,000        $55,000

 

A profit maximization approach would favor product B over product A. However, if product B is more risky than product A, then the decision is not as straightforward as the figures seem to indicate. It is important to realize that a trade-off exists between risk and return. Stockholders expect greater returns from investments of higher risk and vice versa. To choose product B, stockholders would demand a sufficiently large return to compensate for the comparatively greater level of risk.

2 Comments

2 Comments

  1. Oct 6, 2010 at 6:15 pm

    Great anwser for paper or presentation.

  2. Apr 10, 2011 at 3:30 pm

    wealth maximization is based on cash flow, where as profit maximization does not consider cash flow.

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