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Is it Profit or Wealth Maximisation?
By Sujit Mundul
Frequently, maximisation of profits is regarded a proper objective of the firm, but it is not as inclusive a goal as that of maximising shareholder’s wealth. For one thing, total profits are not as important as earning per share.
In the ’80s the financial world witnessed a number of intellectual advances in the valuation of a business in an uncertain world. Increased attention has been paid to the effect of market imperfections in value. It would not be out of place to mention that information economics gives us certain valuable insights into the market behaviour of financial instruments. This has also helped in better understanding the concept of profit and wealth maximisation.
Competition among supplier of capital and amongst providers of financial services is extremely keen. One needs to be mindful of the fact that the global financial markets in the last decade have been characterised by considerable volatility in inflation and in interest rates. Economic uncertainty worldwide, substantial volatility in foreign exchange and trade, numerous loan problems, arising from inflation-based lending practices, some speculative excesses and ethical concerns over certain financial dealings – all have been part of the financial landscape in recent years.
The confluence of these events has resulted in progressive changes in the external environment in which a company operates. The role of finance has undergone chemical changes from a field that was concerned primarily with the procurement of funds to one that includes the management of assets, the allocation of capital and valuation of the firm in overall market thus creating value for the corporation in the process.
We assume that the corporation’s objective is to create value for its stakeholders. Value is represented by the market price of the company’s common stock which in turn is a reflection of its investment, financing, and dividend decisions. The idea is to acquire assets whose expected return exceeds their cost, to finance with those instruments where there is particular advantage, tax or otherwise, and to undertake a meaningful dividend policy for stockholders.
Frequently, maximisation of profits is regarded a proper objective of the firm, but it is not as inclusive a goal as that of maximising shareholder’s wealth. For one thing, total profits are not as important as earning per share. A company could always raise total profits by issuing stock and using the proceeds to invest e.g. in treasury bills. Even maximisation of earning per share however, is not a fully appropriate objective partly because it does not specify the timing or duration of the expected returns. Is the investment project that will produce a $100,000 return five years down the line more valuable than a project that will produce an annual return of $15,000 each year for the next five years? An answer depends on the time value of money. Few stockholders would think favourably of a project which promised its first return in 15-20 years no matter how large this return. We must take into account the time pattern of the return in our analysis and understanding.
Another perceived shortcoming of the objective of maximising earnings per share is that it does not consider risk or uncertainty of the prospective earning stream. Some investment projects are far more risky than others. As a result, the prospective stream of earning per share would be more uncertain if these projects were undertaken. In addition, a company will be either more or less risky depending on the debt amount in relation to equity in its capital structure. This financial risk is another uncertainty in the investors’ minds when they judge the company in the market place which finally leads to the creation of value.
As the principle of maximisation of shareholder’s wealth provides a rationale of guide for running a business and for the efficient allocation of resources in society, we use it as our assumed objective considering how financial decisions should be made. The purpose of capital market is to allocate savings efficiently into an economy, from ultimate savers to ultimate users of fund who invest in real assets. If savings are to be channelled to the most promising investment opportunity, a rational economic criterion must govern their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk. The market value of a company stock, embodying both of these factors therefore reflects the market’s tradeoff between risk and return. If decisions are taken in keeping with the likely effect of market value of its stock, a company will attract capital only when its investment opportunities justify the use of that capital in the overall economy. Any other objective is likely to result in the sub-optimum allocation of funds and therefore lead to less than optimum capital formation and growth in the economy. In the process it would hurt the concept of profit and wealth maximisation.
Based on the empirical evidences globally, a company can be viewed as producing both private and social goods and the maximisation of profit and wealth remains a viable corporate objective.
(Mundul is CEO of Standard Chartered Bank Nepal Ltd.)
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