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Maximize earnings vs firm value

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Explain why managers who attempt to maximize earnings might not maximize firm value.

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Solution Summary

This solution of 500+ words explains the counter-intuitive fact that maximizing earnings does not always lead to maximizing firm value. It also lists three main factors that need to be taken under consideration when maximizing firm value.

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The Value of a Firm is based on a multitude of factors including Market related factors, Firm specific factors as well as Investment factors. Also, Value Based Management practices indicate that the Value of a Firm is dependent on the Future Cash Flows of a company which is a culmination of all the three key factors mentioned above. However, since Earnings are one of the key factors in the cash flows, managers tend to equate a higher earnings to the share price. Though current earnings are strongly correlated to the cash flows, the value of an organization is dependent on the Future Cash Flows it is expected to generate and hence Managers who attempt to maximize earnings might not maximize firm value.

Finance theories postulate that the Cash Flows of a ...

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