Profit Maximization
Profit maximization would probably be the most commonly cited business goal, but this is not a very precise objective. Do we mean profits this year? If so, then actions such as deferring maintenance, letting inventories run down, and other short-run, cost-cutting measures will tend to increase profits now, but these activities aren’t necessarily desirable.
The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see, these numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us the appropriate trade-off between current and future profits.
The Goal of Financial Management in a Corporation
The financial manager in a corporation makes decisions for the stockholders of the firm. Given this, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders’ point of view, what is a good financial management decision?
If we assume stockholders buy stock because they seek to gain financially, then the answer is obvious: Good decisions increase the value of the stock, and poor decisions decrease it.
Given our observations, it follows that the financial manager acts in the shareholders’ best interests by making decisions that increase the value of the stock. The appropriate goal for the financial manager in a corporation can thus be stated quite easily:
The goal of financial management is to maximize the current value per share of the existing stock.
The goal of maximizing the value of the stock avoids the problems associated with the different goals we discussed above. There is no ambiguity in the criterion, and there is no short-run versus long-run issue. We explicitly mean that our goal is to maximize the current stock value. Of course, maximizing stock value is the same thing as maximizing the market price per share.
A More General Financial Management Goal
Given our goal as stated above (maximize the value of the stock), an obvious question comes up: What is the appropriate goal when the firm has no traded stock? Corporations are certainly not the only type of business, and the stock in many corporations rarely changes hands, so it’s difficult to say what the value per share is at any given time.
As long as we are dealing with for-profit businesses, only a slight modification is needed. The total value of the stock in a corporation is simply equal to the value of the owners’ equity. Therefore, a more general way of stating our goal is:
Maximize the market value of the existing owners’ equity.
With this goal in mind, it doesn’t matter whether the business is a proprietorship, a partnership, or a corporation. For each of these, good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it.
Finally, our goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. What we mean is that the financial manager best serves the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free marketplace. Our nearby Reality Bytes box discusses some recent ethical issues and problems faced by well-known corporations.
Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems arise?
In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management.
This separation of ownership from control in the corporate form of organization is what causes agency problems to exist.
Management may act in its own or someone else’s best interests, rather than those of the shareholders.
If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.
Ethics and Firm Goals. Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects such as customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Try to think of some specific scenarios to illustrate your answer.
An argument can be made either way. At one extreme, we could argue that in a market economy, all of these things are priced. This implies an optimal level of ethical and/or illegal behavior and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process.
The following is a classic (and highly relevant) thought question that illustrates this debate: “A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?”