ARGUMENT FOR AND AGAINST PROFIT AND WEALTH MAXIMIZATION GOALS IN LIGHT OF CORPORATE FINANCE
Every individual firm in any market segment has well set goals that it aims to achieve. These goals may be set by the owners or shareholders who must collaborate closely with the agents whom they have given the responsibility to manage the firm. The agents are basically the managers who through the agency theory must ensure that the firm is meeting its strategic goals. A firm with no set goals or one that doesn’t have good managers is set to fail in its bid to make profit and hence will definitely have to close down. To ensure that a firm meets its objectives, a few considerations must be looked at. These could include:
i) How it plans to finance its projects;
ii) The quality of its management team;
iii) The type of sector that the firm operates in;
iv) Government policy;
v) Risks that the firm faces.
Every firm must carry out a ‘SWOT ‘analysis that is, evaluate its Strengths, Weaknesses, Opportunities and Threats. After carrying out a ‘SWOT ‘analysis, a firm can now set the goals that it aims to achieve. The goals that a firm aims at achieving depend on its abilities analyzed through a well researched ‘SWOT’ analysis. Once a firm discovers what it is capable of then it can start implementing its objectives.
A firm’s goals may be classified into three, namely:
(a) Financial goals;
(b) Non-financial goals;
(c) Corporate goals.
(a) The financial goals of any profit making organisation include:
i) Profit maximization;
ii) Wealth creation/maximization.
(b) The non-financial goals include:
i) Environmental care;
ii) Enhancing ethics in business and finance;
iii) Employee welfare;
iv) Corporate social responsibility;
v) Good creditor relations;
vi) Compliance with government regulations;
vii) Addressing customers’ interests.
(c) The corporate goals include:
i) Return on investment
ii) Cash flow
iii) Enlarging/expanding market share
iv) Overall growth of the company.
v) Quality of the firm’s products
vi) Good industrial relations.
Expounding on Financial Goals i.e. Profit and Wealth Maximization.
Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at maximizing the profit of the concern.
However, unlimited profit maximization cannot be defended by any reasonable ethical theory. The idea that corporations should pursue the interests of their shareholders, takes its starkest form in the sentiment expressed by Milton Friedman, that ‘‘the social responsibility of business is to increase its profits’’ (Friedman, 1970). Friedman is very clear in stating that it is illegitimate for a corporation to act in a way that is detrimental to shareholder returns. Profit maximization is thus a moral imperative for corporate executives. The interests of groups other than the shareholders should thus only be given weight to the extent that pursuing these interests also benefits the shareholders. For instance the implication of CSR is permissible only if it is insincere i.e. used as an instrument to promote shareholder interests (Bakan, 2004).
To assess whether the Friedmanian position is tenable, first consider the arguments used to support it. Four basic arguments are commonly used to underpin this position.
i) First, it is argued that the contract between the shareholders and a manager of a firm, binds the manager to pursuing the interests of shareholders, and therefore makes it illegitimate to pursue other ends;
ii) Second, pursuing other ends to the detriment of shareholder returns, is equal to taxing the shareholders, and taxation is a task for democratically elected governments only, which it is illegitimate for managers to assume;
iii) Third, if businesses focus on too many tasks beyond their core operations, they become less efficient. An efficient division of labour between businesses and government is for businesses to create value, and the government to redistribute it;
iv) Fourth, a business that assumes responsibilities beyond maximizing profits, will incur added costs, and will therefore be wiped out in competition with firms that do not assume such responsibilities. In other words, assuming costly responsibilities will be self-defeating, and ultimately futile;
Profit maximization consists of the following important features:
i) Profit maximization is also called cashing per share maximization. It leads to maximize the business operation for profit maximization;
ii) Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern;
iii) Profit is the parameter of measuring the efficiency of the business concern. So, it shows the entire position of the business concern;
iv) Profit maximization objectives help to reduce the risk of the business;
Favourable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the business concern:
i) Main aim is earning profit;
ii) Profit is the parameter of the business operation;
iii) Profit reduces risk of the business concern;
iv) Profit is the main source of finance;
v) Profitability meets the social needs also;
Unfavourable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
i) May leads to exploiting workers and consumers;
ii) Creates immoral practices such as corrupt practice, unfair trade practice, etc;
iii) This objective leads to inequalities among the stakeholders such as customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern
ii) Ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period
iii) Ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.
Expounding Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is a universally accepted concept in the field of business.
Favourable Arguments for Wealth Maximization
i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders
ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern
iii) Wealth maximization considers both time and risk of the business concern
iv) Wealth maximization provides efficient allocation of resources
v) It ensures the economic interest of the society
Unfavourable Arguments for Wealth Maximization
i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities
ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization
iii) Wealth maximization creates ownership-management controversy
iv) Management alone enjoy certain benefits
v) The ultimate aim of the wealth maximization objectives is to maximize the profit. Wealth maximization can be activated only with the help of the profitable position of the business concern.
Cappelen, A. and I. Kolstad: 2006, When Is Profit Maximization Ethically Defensible (Chr. Michelsen Institute, mimeo, Bergen, Norway)
Bowie, N. E.: 1999, Business Ethics – A Kantian Perspective (Blackwell Publishers, Malden, Mass)
By Godfrey Chege
CPA Finalist (Kenya), BBM (Moi University, Finance and Banking)
By Godfrey Chege
CPA Finalist (Kenya), BBM (Moi University, Finance and Banking)