The objective of the firm should be to maximize shareholder wealth.
Shareholder wealth is the price of the stock times the
number of shares. Companies cannot maximize shareholder wealth by adjusting the
number of shares, so maximizing shareholder wealth is the same as maximizing the
Many people think the objective is to make the most profit or earnings per share, but this is not true. Profit is a short-term figure from the recent past. Profit also does not measure actual cash. A company cannot spend profits or pay dividends with just profits. It must have cash. For example, sales contribute to profits but some sales are not collected until years later and some never are. Expenses incurred are often not paid until later. Profit is also a figure that can be distorted by different accounting policies. Two accountants can legitimately record a transaction in two different ways.
Profit is only a noisy signal of how a company has recently performed. Profits do matter to government, however, because taxes are based on profits. Because a company should want to pay the lowest taxes possible, a good objective would actually be to minimize profits. As a practical reality, however, that would probably not work. Profits are somewhat correlated with cash flows, so firms would not want to take actions that would lower profits if these actions would also lower cash flows.
Since shareholder wealth reflects the value of the assets less the value of the debt, we can also say that the objective is equivalent to maximizing the value of the firm. Creditors can benefit by no more than what has been promised to them. Hence, making the assets as large as possible in value is equivalent to maximizing the value of the firm and shareholder wealth.
Thus, the stock price reflects the value of all future cash flows of the firm. Maximizing the stock price, shareholder wealth, and the value of the firm are all equivalent objectives. The entire purpose of financial management is, put simply, to create value - to turn money into more money – for the shareholders.
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Last updated: January 9, 2011