Question

As mentioned in Chapter 1, when making financial decisions (such as decisions relating to what investments to make and how to finance them), managers should choose the decision that maximizes owners' wealth. The book stresses that managers should target owners' wealth maximization rather than profit maximization. Please comment on one or more of the following: . Why is the textbook not recommending targeting maximizing of profits? What are the supposed benefits of targeting owners' wealth? . How can managers target owners' wealth when different owners (shareholders) have different amounts of wealth and may follow different investment strategies? What would your recommend - maximizing profits or maximizing owners wealth?

Answer 1

(1): The textbook is not recommending targeting maximization of profits because of the simple reason that maximization of wealth is a long term approach while profit maximization is a short to medium term approach. In the long run the different stakeholders of a company will stand to gain only if wealth maximization is pursued and not profit maximization.

(2): The supposed benefits of targeting owner’s wealth are that a myopic view of business strategy and business model is not taken and that only long term benefits are considered when making decisions. Targeting of owner’s wealth ensures that all stakeholders – vendors, suppliers, employees, customers, etc. – stand to gain from the growth of owner’s wealth. Increase in owner’s wealth leads to increase in the value of the firm and these benefits all the stakeholders in future. When owner’s wealth is targeted then other objectives like increase in market share and higher sales are automatically achieved.

(3): When there are different owners/shareholders and they have different amounts of wealth and have different investment strategies then managers can target owner’s wealth in an overall basis and in a holistic basis. The managers will focus on cash flow to different owners. For example the manager will separately determine cash flow to equity holders, cash flow to preferred stock holders etc. and will then integrate them in an optimal manner so that overall value creation is maximized and that investment strategies and constraints of different owners are also met.

(4): My recommendation is that managers should focus on maximizing owner’s wealth. This approach will lead to value creation and the value created by this approach will benefit the organization, its employees, its customers, its vendors and its investors in future.