There are underlying incentives for managers to maximiz profit. Almost all of the top level managers have stock options as part of their pay package.
Sometimes, the quarterly and yearly profit maximization goal conflicts with the long term wealth maximization for the shareholders, which, we believe, is their main goal.
Time and again, the Wall Street pressures managers to maximize the profits and devastates the true value of the company in return. We, common investors, got to understand these two terms and apply in our investment process.
The wealth maximization goal overcomes the drawbacks of profit maximization goal in the following ways:
- Shareholders’ wealth maximization goal recognizes the concept of time value of money. Under shareholders’ wealth maximization decision all investment decisions are based on the present value of future cash flows.
- Shareholders’ wealth maximization is based on the consideration of the risk involved in financial decisions. The level of risk associated with cash flow streams is reflected by selecting an appropriate required rate of return to determine the present value.
- Shareholders’ wealth maximization promotes the efficient allocation of resources of the firm. It ensures the economic use of capital.
- In shareholders’ wealth maximization criterion, the cash flow is used rather than accounting profit as the basic input for decision-making. The accounting profit is ambiguous and it may mean different things to different people. However, the meaning of cash flows is clear-it means profit after tax plus non-cash outlays to all.
The main function of top managers is to make investment decision as such that present values of benefits are greater than the present value of costs. And always focus on the long term wealth maximization.
Arrow of Performance 