Question

Explain why “maximization of shareholders’ wealth” is the appropriate ultimate, long-term goal of the firm. Briefly explain some of the institutional arrangements that ensure that managers work toward increasing the value of a firm.

Answer 1

Under perfect market conditions, everyone can borrow or lend at the same interest rate. This implies that differences in consumption patterns can be adjusted in the financial markets. Given this, all investors will agree that they are better off if the firm maximizes their current wealth (i.e., maximizing shareholders' wealth).

• the board of directors, elected by shareholders, which scrutinizes managers’ actions
• competition among managers
• the threat of takeover that brings a new management team
• incentive schemes that are closely tied to the value of the firm like stock options

Thanks