Principles of Managerial Finance

14 PART 1 Introduction to Managerial Finance

2. Another criticism of profit maximization is the potential for profit manipulation through the creative use of elec-
   tive accounting practices.

EXAMPLE Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of

marine engine components, is choosing between two investments, Rotor and

Valve. The following table shows the EPS that each investment is expected to

have over its 3-year life.

In terms of the profit maximization goal, Valve would be preferred over

Rotor, because it results in higher total earnings per share over the 3-year period

($3.00 EPS compared with $2.80 EPS).

But is profit maximization a reasonable goal? No. It fails for a number of

reasons: It ignores (1) the timing of returns, (2) cash flows available to stockhold-

ers, and (3) risk.^2

Timing

Because the firm can earn a return on funds it receives, the receipt of funds sooner

rather than later is preferred.In our example, in spite of the fact that the total

earnings from Rotor are smaller than those from Valve, Rotor provides much

greater earnings per share in the first year. The larger returns in year 1 could be

reinvested to provide greater future earnings.

Cash Flows

Profits do notnecessarily result in cash flows available to the stockholders. Own-

ers receive cash flow in the form of either cash dividends paid them or the pro-

ceeds from selling their shares for a higher price than initially paid. Greater EPS

do not necessarily mean that a firm’s board of directors will vote to increase divi-

dend payments.

Furthermore, higher EPS do not necessarily translate into a higher stock

price. Firms sometimes experience earnings increases without any correspond-

ingly favorable change in stock price. Only when earnings increases are accompa-

nied by increased future cash flows would a higher stock price be expected. For

example, a firm in a highly competitive technology-driven business could increase

its earnings by significantly reducing its research and development expenditures.

As a result the firm’s expenses would be reduced, thereby increasing its profits.

But because of its impaired competitive position, the firm’s stock price would

drop, as many well-informed investors sell the stock in recognition of lower

future cash flows. In this case, the earnings increase was accompanied by lower

future cash flows and therefore a lower stock price.

Earnings per share (EPS)

Investment Year 1 Year 2 Year 3 Total for years 1, 2, and 3

Rotor $1.40 $1.00 $0.40 $2.

Valve 0.60 1.00 1.40 3.