The Goal of the Firm

Efficient {inancial management requires the existence of some objective or goal, because judgment as to whether or not a financial decision is effrcient must be made in light of some standard. Although various objectives are possible, we assume in this book that the goal of the firm is to maximize the wealth of the firm's present owners.

Shares of common stock give evidence of ownership in a corporation. Shareholder wealth is represented by the market price per share of the firm's common stock, which, in turn, is a reflection of the firm's investment, financing, and asset management decisions. The idea is that the success of a business decision should be judged by the effect that it ultimately has on share price.

Vatue Creation

Frequently, profit maximization is offered as the proper objective of the firm. However, under this goal a manager could continue to show profit increases by merely issuing stock and using the proceeds to invest in Treasury bills. For most firms, this would result in a decrease in each owner's share of pro{its - that is, earnings per shard would fall. Maximizing earnings per share, therefore, is often advocated as an improved version of profit maximization.

However, maximization of earnings per share is not a fully appropriate goal because it does not specifi the timing or duration of expected returns. Is the investment project that will produce a $100,000 return five years from now more valuable than the project that will produce annual returns of $15,000 in each ofthe next five years? An answer to this question depends on the time value of money to the firm and to investors at the margin. Few existing stockholders would think favorably of a project that promised its first return in 100 years, no matter how large this return. Therefore our analysis must take into account the time pattern of returns.

Another shortcoming of the objective of maximizing earnings per share - a shortcoming shared by other traditional return measures, such as return on investment - is that risk is not considered. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more risky if these projects were undertaken. In addition, a company will be more or less risky depending on the amount of debt in relation to equity in its capital structure. This financial risk also contributes to the overall risk to the investor. Two companies may have the same expected earnings per share, but if the earnings stream of one is subject to considerably more risk than the earnings stream of the other, the market price per share of its stock may well be less.

Finally, this objective does not allow for the effect of dividend policy on the market price of the stock. If the only objective were to maximize earnings per share, the firm would never pay a dividend. It could always improve earnings per share by retaining earnings and investing them at any positive rate of return, however small. To the extent that the payment of dividends can affect the value of the stock, the maximization of earnings per share will not be a satisfactory objective by itself.