Profit Maximization Vs Wealth

Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing stockholder wealth. For one thing, total profits are not as important as earnings per stock. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills. Even maximization of earnings per stock, however, is not a fully appropriate objective, partly because it does not specify the timing or duration of expected returns. Is the investment project that will produce a $100,000 return 5 years from now more valuable than the project that will produce annual returns of $15,000 in each of the next 5 years? An answer to this question depends upon the time value of money. Few existing stockholders would think favorably of a project that promised its first return in 100 years, no matter how large this return. We must take into account the time pattern of returns in our analysis.

Another shortcoming of the objective of maximizing earnings per stock is that it does not consider the risk or uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per stock would be more uncertain if these projects were undertaken. In addition, a company will be more or less risky depending upon the amount of debt in relation to equity in its capital structure. This financial risk is another uncertainty in the minds of investors when they judge the firm in the marketplace. Finally, an earnings per stock objective does not take into account any dividend the company might pay.

For the reasons given, an objective of maximizing earnings per stock may not be the same as maximizing market price per stock. The market price of a firm's stock represents the value that market participants place on the firm.