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Profit
The precise meaning of the profit maximization objective is unclear. The definition of the term profit is ambiguous. Does it mean short-or long-term profit? Does it refer to profit before or after tax? Total profits or profit per share? Does it mean total operating profit or profit accruing to shareholders?
Miximising profit after taxes
Let us put aside the first problem mentioned above. And assume that maximizing profit means maximizing profit after taxes, in the sense of net profit as reported in the profit and loss account (income statement) of the firm. It can easily be realized that maximizing this figure will not maximize the economic welfare of the owners. It is possible for a firm to increase profit after taxes by selling additional equity share and investing the proceeds in low-yielding assets, such as the government bonds. Profit after taxes would increase but earnings per share (EPS) would decrease. To illustrate, let us assume that a company has 10,000 shares outstanding, profit after taxes of $50,000 and earnings per share of $5. If the company sells 10,000 additional shares at $50 per share and invests the proceeds ($500.000) at 5 per cent after taxes, then the total profits after taxes will increase to $75,000. However, the earnings per share will fall to $3.75 (i.e. $75,000/20,000). This example clearly indicates that maximizing profit after taxes does not necessarily serve the best interests of owners.
Miximising EPS
If we adopt maximizing EPS as the financial objective of the firm, this will also not ensure the maximization of owners’ economic welfare. It also suffers from the flaws already mentioned, i.e. it ignores timing and risk of the expected benefits. Apart from these problems, maximization of EPS has certain deficiencies as a financial objective. For example, note the following observation:
Shareholders’ wealth maximization (SWM)
What is meant by shareholders’ wealth maximization (SWM)? SWM means maximizing the net present value of a course of action to shareholders. Net present value (NPV) or wealth of a course of action is the difference between the present values of its benefits and the present value of it costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV should be rejected since it would destroy share holders wealth, between mutually exclusive projects the one with the highest NPV should be adopted. NPVs of a firm’s projects are additives in nature. That is
NPV (A) + NPV (B) = NPV (A + B)
This is referred to as the principle of value-additivity. Therefore the wealth will be maximized if NPV criterion is followed in making financial decisions.
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Miximising profit after taxes
Let us put aside the first problem mentioned above. And assume that maximizing profit means maximizing profit after taxes, in the sense of net profit as reported in the profit and loss account (income statement) of the firm. It can easily be realized that maximizing this figure will not maximize the economic welfare of the owners. It is possible for a firm to increase profit after taxes by selling additional equity share and investing the proceeds in low-yielding assets, such as the government bonds. Profit after taxes would increase but earnings per share (EPS) would decrease. To illustrate, let us assume that a company has 10,000 shares outstanding, profit after taxes of $50,000 and earnings per share of $5. If the company sells 10,000 additional shares at $50 per share and invests the proceeds ($500.000) at 5 per cent after taxes, then the total profits after taxes will increase to $75,000. However, the earnings per share will fall to $3.75 (i.e. $75,000/20,000). This example clearly indicates that maximizing profit after taxes does not necessarily serve the best interests of owners.
Miximising EPS
If we adopt maximizing EPS as the financial objective of the firm, this will also not ensure the maximization of owners’ economic welfare. It also suffers from the flaws already mentioned, i.e. it ignores timing and risk of the expected benefits. Apart from these problems, maximization of EPS has certain deficiencies as a financial objective. For example, note the following observation:
Shareholders’ wealth maximization (SWM)
What is meant by shareholders’ wealth maximization (SWM)? SWM means maximizing the net present value of a course of action to shareholders. Net present value (NPV) or wealth of a course of action is the difference between the present values of its benefits and the present value of it costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV should be rejected since it would destroy share holders wealth, between mutually exclusive projects the one with the highest NPV should be adopted. NPVs of a firm’s projects are additives in nature. That is
NPV (A) + NPV (B) = NPV (A + B)
This is referred to as the principle of value-additivity. Therefore the wealth will be maximized if NPV criterion is followed in making financial decisions.
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