What should be the objective of the financial management of a firm? The answer to this question is significant since it would affect the firm's goals and how the business operates. The finance literature argues that managers should seek to increase the value of the firm.
The value maximization aims to maximize the firm's value when a decision is made, whether it is an investment decision, financing decision, dividend payment decision, or hedging decision. In other words, the manager’s primary goal should be to maximize the value created, which is equal to the net present value of the incremental cash flows generated by the management decisions taken.
This might seem to be equal to aiming to increase the profits of the firm. However, value maximization and profit maximization are different concepts. First, profits are not necessarily equal to cash flows. Your company might not have a cash inflow, although it is profitable if its sales are on credit and are not collected yet.
Second, profit maximization does not take into account the business risk. Some businesses are less prone to market-related shocks, such as political uncertainties, economic recessions, and more stable revenue and cash flows. Healthcare and education are examples of such businesses. You might want to invest in these businesses even if their cash flows to your investments might be lower on average because there is less uncertainty. Conversely, you would require a higher expected return if you invest in high-risk businesses whose profits fluctuate enormously due to external and internal shocks. When you calculate the net present value to check whether your decision increases the firm value, you discount the expected incremental cash flows generated by the project using a risk-dependent required rate of return. Therefore, the business risk is taken into account when the objective is value maximization.
Similarly, profit maximization ignores the time value of money. If all earnings, regardless of the timings, are treated as equal, the opportunity that is missed to earn returns by investing the funds that you will receive in the future instead of today is not taken into account. The larger returns in the first years of a project are preferred since they can be reinvested to earn more in the future.
What’s more, profit maximization is criticized for focusing on short-term goals and ignoring long-term targets. A firm might try to increase its short-term profitability at the expense of its long-term performance. To increase the profit in the short term, firm management might decide to cut expenditures, such as research and development, that would have long-term effects on the firm's revenues. To increase the profit margins, the firm management might cancel expenditures for equipment maintenance at the risk of and/or increase the product prices, which would damage the firm's market share over the long term.
Due to these issues, profit maximization might lead to suboptimal decisions, resulting in lower stock prices and shareholder wealth. On the other hand, value maximization has been criticized for ignoring/harming other stakeholders. This approach argues that a firm's goal should be to satisfy the other stakeholders, such as debtholders, employees, customers, and shareholders. The supporters of value maximization argue that the stakeholder perspective doesn't necessarily contradict value maximization. On the contrary, the competition in the markets makes it necessary to avoid conflicts with other stakeholders, which would result in employee turnover, customer dissatisfaction, or damaged reputation to maximize the firm value. Furthermore, all stakeholders interested in the firm and an increase in the value would also benefit the other stakeholders.
Prof. Dr. Cenktan Özyıldırım
*Gitman, L.J., Hennessey, S.M. (2007) Principles of Corporate Finance, Pearson