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Profit Maximization Inappropriate Goals

1. Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal of maximization of shareholder wealth?


2. Assume the following data for Cable Corporation and Multi-Media, Inc.

$ Cable Corporation Multi-Media, Inc.
Net income 30,000 100,000
Sales 300,000 2,000,000
Total assets 400,000 900,000
Total debt 150,000 450,000
Stockholders' equity 250,000 450,000

a. Compute return on stockholders' equity for both firms using ROE-ratio Net income / stockholders' equity. Which firm has the higher return?

b. Compute the following additional ratios for both firms:
Net income / Sales
Net income / Total assets
Sales / Total assets
Debt / Total assets

c. Discuss the factors from part b. above that added or detracted from one firm having a higher return on stockholders' equity than the other firm as computed in part a. above.

3. Assume you will need $30,000 each year over the next 20 years to live at the standard you desire. Also estimate the rate of return you can reasonably expect to earn annually, on average, during that 20 year period by investing in a stock portfolio similar to the S&P 500 (e.g. 9%).

a. How large a single lump sum would you need today to provide the annual cash required to allow you to live at the desired standard over the next 20 years?

b. Would the lump sum calculated in part a. be larger or smaller if you would have invested in a bond portfolio (e.g. 6%)? Explain.

c. What conclusions do you draw for your retirement investments?

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1. Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal of maximization of shareholder wealth?

Profit maximization is the process whereby firms devote their entire firm processes and resources to generating the greatest amount of profit possible. For most finance authors, profit maximization is the major objective of any firm.

Profit maximization can sometimes be an improper goal because it ignores other factors or objectives. For one a firm may seek to maximize its profits at the detriment of its corporate image e.g. if a firm marketed/sold medicine at a high markup to victims of a natural disaster.

Similarly the firm may in trying to maximize its profits ignore the cash flow situation of relevant decisions. Cash flow and profits are not always similar. A firm could generate a loss, for a year, and still report positive cash flows. The saying goes that "Cash is king". If the firm ignores its cash flow situation a point in time may arrive when it would become bankrupt.

2. Assume the following data for Cable Corporation and Multi-Media, Inc.
$ Cable ...

Solution Summary

Profit maximization inappropriate goals are examined.

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