Answer
The objective of the firm is to maximize its value to its shareholders. Value is represented by the market price of the company’s common stock, which, in turn, is a reflection of dividend decisions.
Profit Maximization vs. Wealth Maximization
Maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder wealth. Total profits are not as important as earning per share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills. Maximization of earning per share is not a fully appropriate objective, because it does not specify the timing or duration of expected returns.
Another shortcoming of the objective of maximizing earning per share is that it does not consider the risk or uncertainty of the prospective earning stream. Some investment projects are far more risky than the others. As a result, the prospective stream of earnings per share would be more uncertain if these projects were undertaken.
The risk as well as the level of earnings is important to shareholders. It is true that stockholders always prefer that the company achieve greater earnings per share than less.
Example: Policy A that provides completely safe future company earnings of $50,000 per year. Policy B that will result in earnings as high as $100,000 or as low as zero, with an equal chance for all amounts between zero to $100,000. Both policies imply an average of $50,000 per year in the firm’s earnings, but B is clearly less certain than A. It is likely that in a market of investors who do not like the value of the firm’s shares will be greater under policy A than under policy B.
Using share value maximization as the objective does not mean that management is concerned with day-to-day fluctuations in the stock market. It is true that as long as existing stockholders and other investors in the market have accurate and timely information on the firm’s activities, better performance will mean a higher market price of the stock. However, information may not be different views as to what the available information implies about the firms future performance. Hence the real concern of management is to maximize share value over the long term.