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Foundation for Financial Decision Making: Maximization of Shareholder Wealth

by Dr. M Marie Sanders

 

To understand financial decision making, we first need to understand the goal of financial management. This is important because it leads to an objective basis for making and evaluating financial decisions.

Alfred P. Sloan, long time President and Chairman of General Motors is quoted as saying, "General Motors is not in the business of making automobiles. General Motors is in the business of making money."

Profit Maximization

Profit maximization is probably the most commonly cited business goal. However this is, at best, an ambiguous objective. Do we mean profits this month, this year? If so, then actions such as deferring maintenance, depleting inventories, and other short-term, cost-cutting measures will tend to increase profits now, but these activities aren't necessarily desirable.

On the other hand, the goal of maximizing profits may refer to some sort of "long-run" or "average" profits, but it's equally unclear what this means. First, do we mean something like accounting net income or earnings per share? These numbers have little to do with what is good or bad for the firm. These are reporting sources not management or leadership sources for financial decision making. Second, what is meant 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.

 

Financial Goal of the Firm

We designate the goal of the firm as maximization of shareholder wealth, by which we mean maximization of the price of the existing common stock. Not only does this goal directly benefit the shareholders of the company, but also it provides benefits to society as resources are directed to their most productive use by businesses competing to create wealth. With this goal in place, our job as financial managers is to create wealth for the shareholders.

The financial manager in a corporation makes decisions in behalf of or 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. It follows, therefore, that financial managers act in the shareholders' best interest by making decision that increase the value of their stock. The appropriate goal for the financial manager in a corporation can 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 previously discussed. 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. Maximizing stock value is the same thing as maximizing the market price per share or shareholder wealth.

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. Since our goal is maximize the value of the stock, an obvious question comes up: What is the appropriate goal when the firm has no traded stock? 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 owner's equity. Therefore, a more general way of stating our goal is:

Maximize the market value of the existing owner's 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 owner's equity and poor financial decisions decrease it.

Finally, our goal does not imply that the financial manager should take illegal or unethical actions in hope of increasing the value of the equity of the firm. The financial manager best serves the owners of the business by identifying good and services that add value to the firm because they are desired and valued in the free marketplace.

There are, of course, other goals of the firm all of which should be considered. However, all goals should work in concert with the goal of maximizing the market value of the existing owner's equity rather than in opposition to it.

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About the author

Dr. M Marie Sanders

Dr. M Marie Sanders (USA)

Ms. Sanders holds an MBA and a Doctorate and has 30+ years of business experience in privately held businesses and non-profit organizations. She was a professor for the University of Central Oklahoma teaching undergraduate and MBA classes in the college of business (Leadership and Human Resource Management) and holds real estate broker licenses in two U.S. states.

 

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