Potential Side Costs of Value Maximization

If the objective when making decisions is to maximize firm value, there is a possibility that what is good for the firm may not be good for society. In other words, decisions that are good for the firm, insofar as they increase value, may create social costs. If these costs are large, we can see society paying a high price for value maximization and the objective will have to be modified to allow for these costs. To be fair, however, this is a problem that is likely to persist in any system of private enterprise and is not peculiar to value maximization. The objective of value maximization may also face obstacles when there is separation of ownership and management, as there is in most large public corporations. When managers act as agents for the owners (stockholders), there is the potential for a conflict of interest between stockholder and managerial interests, which in turn can lead to decisions that make managers better off at the expense of stockholders.

When the objective is stated in terms of stockholder wealth, the conflicting interests of stockholders and bondholders have to be reconciled. Since stockholders are the decision-makers, and bondholders are often not completely protected from the side effects of these decisions, one way of maximizing stockholder wealth is to take actions that expropriate wealth from the bondholders, even though such actions may reduce the wealth of the firm.

Finally, when the objective is narrowed further to one of maximizing stock price, inefficiencies in the financial markets may lead to misallocation of resources and bad decisions. For instance, if stock prices do not reflect the long term consequences of decisions, but respond, as some critics say, to short term earnings effects, a decision that increases stockholder wealth (which reflects long term earnings potential) may reduce the stock price. Conversely, a decision that reduces stockholder wealth, but increases earnings in the near term, may increase the stock price.

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Responses

  • Mark
    What is objectives value maximisation?
    8 years ago

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