Profit maximisation vs Shareholder wealth maximisation

Profit maximisation refers to how much profit the company makes. It is a short term approach as the business is mostly concerned with short term benefits. But short term it can fulfill the objective of earning profit but may not help in creating wealth. Wealth creation needs to be longer term; therefore financial management emphasises on wealth maximisation rather than profit maximisation. Profit maximisation can be expressed in such a way that it depends on relative prices only. However, the choice of such an objective function need not be in the interest of the shareholders. This problem is overcome by relating the profits of a firm to the expenditure of its shareholders. Profit maximisation also has the disadvantages of being unable to predict future prospects and can be subject to risk, as accounting only goes on a periodic basis may cause accounting problems.

Therefore, to reduce the risk of this managerialism and the problems caused by profit maximisation, companies need to seek a value creating goal; such as a shareholder value maximisation. Maximising wealth can be defined as maximising purchasing power. Owners pay shareholders dividends which is the main reason why shareholders indulge in purchasing a part of that company. Shareholders are interested in the flow of dividends over a long time period and not necessarily a quick payback.

Maximisation of shareholders' real wealth is the main objective of a firm. This concept is based on profits and on shareholders' expenditures. Moreover, it depends on relative prices only rather than on arbitrary price normalisations.

Shareholders won't be the only ones to benefit from this type of value creation, stakeholders such as debtors and employees will also benefit from the increased value. By maximising the flow of discounted cash, all the stakeholders will be satisfied, and finally the shareholders will be satisfied, creating a domino effect that helps all aspects of the businesses interests. This system of value creation is also better for society, as the business will become more accountable for its actions based upon their shareholders and stakeholders.

There are many reasons why accounting profit may not be a good proxy for shareholder wealth such as:

· Prospects – One firm may fail to reflect the relative potential of the two firms.

· Risk – Greater variability means years of losses and possibly bankruptcy.

· Accounting problems – Mistakes by the accountant may be made.

· Communication – shareholders need to know as much as they can about the firm before investing so communication between them and the firm is crucial.

· Additional capital – profits can be increased by making use of more shareholders’ money.  

Profit maximisation and wealth maximisation are not two mutually exclusive events. In fact, profit maximisation can lead to wealth maximisation ultimately. The point is whether a firm should stop at short term target of profit making or long term target of sustained profit, which may ultimately lead to wealth maximisation. 

Jensen and Meckling 1976, focus almost entirely on the positive aspects of the theory as they see how to structure the contractual relation between the principal and agent to provide appropriate incentives for the agent to make choices which will maximize the principal’s welfare, given that uncertainty and imperfect monitoring exist.

However, Jensen and Meckling 2010 further go on to say they do not know whether or not firms are committed to 'maximizing shareholder wealth.' They believe it is 'puzzling,' however, state that the agent does not at least state the intention of benefiting the alleged principal.

Conclusively, I believe the advantages to shareholder wealth maximisation outweigh those of profit maximisation