Why maximization of shareholder wealth is important

Decrease unit cost. Will maximizing profits maximize shareholder wealth? Wealth maximization is long term process. It refers the value of the company generally expressed in the value of the stock. Value maximization says that managers should make all decisions so as to increase the total long run market value of the firm.

Maximizing share price will maximize owner wealth. What defines a shareholders wealth? Shareholders do. Shareholder wealth is the appropriate goal of a business firm in a capitalist society, whereby there is private ownership of goods and services by individuals. Those individuals own the means of production by the business to make money. How do you achieve wealth maximization? In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders to achieve their objectives and therefore is superior to profit maximization.

How does NPV maximize shareholder wealth? The NPV technique measures the present value of the future cash flows that a project will produce.

A positive NPV means that the investment should increase the value of the firm and lead to maximizing shareholder wealth. Why maximizing wealth is a better goal than maximizing profit?

The wealth maximization objective is almost universally accepted goal of a firm. Shareholders' wealth is maximized when a decision generates net present value. What do shareholders care about? Shareholders seek out investments that have the lowest potential for financial loss and do what's necessary to prevent the loss of their principal. If shareholders lose confidence in a firm's ability to lower risk and ensure shareholder profits, they will quickly divest themselves from the firm.

Other firms, such as Panhandle Eastern, International Multifoods, and Ford Motor Company, for example, expect top managers and directors to have a significant ownership stake in the firm. Ford requires each of its top 80 officers to own common stock in the company at least equal to their annual salary. The existence of divergent objectives between owners and managers is one example of a class of problems arising from agency relationships.

Agency relationships occur when one or more individuals the principals hire another individual the agent to perform a service on behalf of the principals. In the context of finance, two of the most important agency relationships are the relationship between stockholders and creditors and the relationship between stockholders owners and managers.

Because the returns offered to creditors are fixed whereas the returns to stockholders are variable, conflicts may arise between creditors and owners. When this occurs, bondholders suffer because they do not have an opportunity to share in these higher returns.

The issue of bondholder rights remains controversial, however. These covenants take many forms, such as limitations on dividend payments, limitations on the type of investments and divestitures the company can undertake, poison puts, 14 and limitations on the issuance of new debt.

The constraints on the owner-managers may reduce the potential market value of the firm. In addition to these constraints, bondholders may also demand a higher fixed return to compensate for risks not adequately covered by bond indenture restrictions. Inefficiencies that arise because of agency relationships have been called agency problems. These problems occur because each party to a transaction is assumed to act in a manner consistent with maximizing his or her own utility welfare.

The example cited earlier the concern by management for long-run survival job security rather than shareholder wealth maximization is an agency problem. Another example is the consumption of on -the -job perquisites such as the use of company airplanes, limousines, and luxurious offices by managers who have no or only a partial ownership interest in the firm.

Shirking by managers is also an agency-related problem. In , the board of Enron permitted its CFO, Andrew Fastow, to set up and run partnerships that purchased assets from and helped to manage the risk of Enron. Fastow stood to make millions personally.

These agency problems give rise to a number of agency costs , which are incurred by shareholders to minimize agency problems. Examples of agency costs include. A number of different mechanisms are available to reduce the agency conflicts between shareholders and managers. These include corporate governance, managerial compensation, and the threat of take overs. First, the board of directors of a corporation should have a majority of independent directors. Independent directors are individuals who are not current or former employees of the company and who have no significant business ties to the company.

Additionally, the committee responsible for nominating members of the board of directors must be composed only of independent directors. Further more, the post of chairman of the board of directors should be split from the CEO position or, alternatively, an independent lead, or presiding, director should chair board meetings.

Also, all members of the audit and compensation committees, must be independent directors. Finally, the company must disclose whether it has adopted a code of ethics for the CEO and senior financial officers and, if not, explain why it has not done so. Many of these proposals have been or are in the process of being implemented by public companies.

In addition to these proposed changes in how corporations govern themselves, the Sarbanes Oxley Act, passed by Congress in , mandated various changes in the processes used by corporations to report their financial results.

Properly designed compensation contracts can help to align shareholder management conflicts. For example, providing part of the compensation in the form of stock or options to purchase stock can reduce agency conflicts. Stock options granted to managers entitle them to buy shares of the company at a particular price exercise price.

Typically, the options are set at an exercise price greater than the price of the stock at the time options are granted and can be exercised only after a certain period of time has elapsed. More important to stock value, this is an attempt to align their interests more closely with those of the shareholders. As a result, some firms have adopted alternative incentive compensation policies. Such stock cannot be sold unless the manager remains with the company for a stated period of time.

Microsoft, for example, stopped issuing stock options in and instead began offering restricted stock to its executives and all other employees. For Microsoft managers, the restricted shares vest, or can be sold, over a 5 -year period. For example, in General Electric GE stopped issuing stock options to its CEO and instead offered , performance share units. Each performance share unit was equal to one share of common stock.

If there is an agency problem, it is imperative to find a resolution as soon as possible to prevent problems within the business that can impede performance. There is an idea that businesses focused on money are greedy and don't care about social issues or that socially responsible businesses can't increase stock values.

The truth is that a company can be both profitable and socially responsible. Consider the Great Recession and one of its main causes; the subprime mortgage crisis.

Theses banks were more concerned about their investment portfolios instead of properly loaning money to customers, which is their charge. Those investment portfolios were filled with toxic assets, which eventually compromised the operations of many financial institutions and caused the failure of several big banks.

As a result, their share prices fell right along with them. In this case, greed and a lack of social concern led to their downfall.

On the other hand, after almost failing during the Great Recession, GM turned itself around, repaid its debt, and developed "greener" vehicles. As a result, it realized an increase in its share price. GM took on the mantle of social responsibility rather than exploiting consumers for financial gain.

Business firms cannot exist and profit in the long run without being socially responsible. Why are business firms not seeking profit rather than an increase in share price? One reason is that profit maximization does not take the concepts of risk and reward into account as shareholder maximization does. The goal of profit maximization is, at best, a short-term goal of financial management.

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