VALUE MAXIMIZATION OVER PROFIT MAXIMIZATION

The primary goal of the financial manager is shareholder wealth maximization. This done by
maximizing value. Profit maximization does not necessarily translates to value maximization.
The reasons are explained below. That’s why the goal of the financial manager is value
maximization not profit maximization.

1) Change in profit may pose a change in risk

> Profit does not consider risk of the company; Increase in profit may increase risk,
hence decreases value;
> Earnings may increase but this may pose increase in operational risk which may
affect the value of the company (e.g. increase in sales by lessening production costs or
costs of raw materials; this will increase profit but may result to problems in the
production and low quality products which is bad for the company and may affect
value);
> Value considers the risk of the company (operational risk in this case); the higher the
risk, the lower the value and vice-versa;
> In addition, investors are generally risk averse, meaning they do not like risk; If a
company has higher risk, investors would not buy the company’s stock; Demand for the
stock will be lower which will result to a lower stock price, and vice-versa; Profit does
not consider this risk;

2) Profit fails to consider the timing of benefits

 Profit does not consider the timing of the benefits;
 As long as there is profit and it is large, it is ok, regardless of its timing;
 Value considers the timing of the benefits (present value of the cash flows using the
time value of money);

 The following questions are related with the timing of benefits:

a) Which is better, to receive 1,000 in 1 year or 1,000 in 10 years? Answer is
P1,000 in 1 year since it will be received earlier;
b) Which is better, to receive 1,000 in 1 year or P1,500 in 5 years? It depends. To
answer this, other factors should be considered such as the rate (interest rate or
discount rate) to be used to get the present values; But it is possible that value
(present value) of P1,000 in 1 year may be higher than the P1,500 in 5 years even
if you will be receiving total profit P1,000 for the period of 5 years but you will be
receiving it after 1 year compared to receiving total profit of P1,500 for the period
of 5 years but you will be receiving it after 5 years. at higher interest rates; Using
an interest rate/discount rate of 15%, the PV of P1,000 in 1 year is P869.56
while the PV of P1,500 in 5 years is P745.77.

> In relation with above, there are various ways to increase value, as follows:
i) Speed up cash flows (e.g receive cash in 1 year instead of in 10 years),
ii) Increase the amount of cash flows (e.g. receive P1,500 cash instead of P1,000)
iii) Reduce the riskiness of the cash flows (e.g. receive cash from someone who has
more money and wealthy compared to someone who has less money and poor; to be
further explained in the succeeding topics or chapters).

3) Leaves the question of which year’s profit?

> Profit is measured on a year to year basis; if you are asked “What is the profit of the
company?” generally, you will answer the current year’s profit;
> Current profit may be increased by cutting expenses but may affect the succeeding
years’ profits (e.g. cutting of advertising/ promotional expenses to increase profit for
the current year may affect sales in the future periods particularly for new products,
hence may decrease future profits);
> In computing for the value, all current and future cash flows are considered.

4) Different accountants may calculate profits in different ways

> Profit has various computations (e.g. gross profit, operating income or earnings before
interest and taxes, earnings before taxes, net income after tax, net operating income
after taxes, net income after tax plus interest expense, etc.);
> One company may be profitable than the other using one profit computation but
maybe less profitable using another profit computation;
> Value computation only uses the concept of cash flow (cash inflow less cash outflow).