Corporate Finance

Introduction 
 25

a firm and indirectly, that of its managers? Why should anyone have an objective in the first place? Without
an objective one wouldn’t know if one has achieved what one set out to achieve. Corporate Finance theoret-
icians generally agree that the objective of a firm is to maximize wealth although there may be some disagree-
ment as to whether it should be the wealth of shareholders or the wealth of the firm, which includes bondholders
and preferred stockholders. Shareholder wealth maximization rule requires managers to work towards a
sustainable increase in the price of the firm’s stock.

FIRM^

Shareholders

Suppliers Customers

Banks

Government

Employees

Bondholders

Stakeholders in a firm

COMPETITORS TO THE WEALTH MAXIMIZATION RULE

Profit maximization, social welfare and growth are the three principal competitors to the wealth maximization
rule. These alternative objectives are supposed to be proxies for the wealth maximization rule. The underlying
assumption is that, an increase in any of these proxies results in an increase in the value of the firm (alternatively,
shareholder value).

Profit Maximization

Profit is the excess of revenue over expenses. Profit maximization requires managers to keep all expenses
low (including salaries and wages), extract the last rupee from the customer, sell spurious goods as long as
it is legal, pay the lowest possible price to suppliers, etc. That is, hoodwink all the stakeholders for the sake
of profit. Some point out that profit maximization is all right as long as managers consider the long-run con-
sequences of their actions. How long is long? How does one estimate the long-run consequences at the time
of decision making? Anyway, since long-run is long way off, why bother? If profit maximization is the ob-
jective, then why provide housing facility to employees or spend millions on research and development
(R&D)? The message is: we do not see profit maximizing behavior in reality although the proponents of
profit vouch for the contrary. Moreover, accrual profits can hardly be taken as a proxy for value given the
creativity of accountants when it comes to reporting income.

Social Welfare

Businessmen are supposed to be socially responsible. They do not live in an ethical vacuum. But the social
welfare objective, often pursued by government organizations, has conceptual problems such as: What con-
stitutes society—social welfare? Can we make one section of society better off without making another
section worse off, and so on. Moreover, what was considered moral 30 years ago could be immoral now?