Value maximisation of a firm implies maximisation of shareholder’s wealth. Therefore, this model is also known as “shareholders wealth maximisation model”.
Thus modern managerial economics departs from the traditional economic theory in which it is assumed that managers of corporate firms or owner-managers of self-owned business enterprises seek to maximise short-run profits. It has often been observed that firms sacrifice some short-run profits for the sake of higher profits in the future years.
That is, they aim at maximising long-run profits. It is because of this objective that business enterprises incur huge expenditure on research and development, new capital equipment and expensive promotional schemes for their products. Therefore, incorporation of time in the analysis of decision making by managers of business enterprises is essential. Modern theory of the firm assumes that primary objective of the firm or their managers are to maximise value of wealth or shareholder’s wealth.
Value Maximisation Model:
Value of the firm is measured by calculating present value of cost flows of profits of the firm over a number of years in the future. To do so profits of future years must be discounted because money value a rupee of profit in a future year is worth less than a rupee of profit in the present. Therefore, the value of the firm or shareholder’s wealth is given by the present value of all expected future profits of the firm.
Thus, the value of a firm may be expressed as follows:
Value of the firm = Present value of expected future profits
The primary goal or objective of the firm is to maximise value of the firm, that is, shareholders wealth. But to achieve its objective it faces many constraints. Thus, in making efficient or optimum decisions regarding pricing level of output, production method, costs, managers of the firms work under several constraints.
Subject to the various constraints a firm seeks to maximes its profits or the present value of the stream of expected future profits. Therefore, decision-making by a firm to maximise profits or value of the firm is called constrained optimisation. The constraints faced by a firm restrict the range of possible opportunities or alternative courses of action from which a firm has to choose for maximsing its profits or value.
These constraints are of the following types:
(i) Legal Constraints:
The legal constraints relate to such laws as minimum wage acts, company act to regulate corporate governance, Anti-Trust Act or Competition Promotion Act to prevent the emergence of monopolies and unfair trade practices, rules fixed by SEBI (Security and Exchange Board of India) regarding issue of shares and transactions in stock markets. Besides, there are laws which require the business firms to ensure pollution emission standard for protection of environment, required health and safety standards of the employees.
A society imposes these constraints on the firms in order to modify behaviour so as to make them consistent with the overall social objectives.
(ii) Input Constraints:
Another important type of constraints relates to the limited availability of essential physical inputs. A firm may not be able to obtain as many skilled workers as it needs for the production of a good. Further, a firm may also find difficulties in procuring specific raw materials it requires for its production. The limited factory space and storage facilities may also be other constraints which a firm may be facing.
(iii) Financial Constraints:
Another type of constraints under which a firm works relates to the financial resources it is able to raise.
Two important sources of raising resources for corporate firms are:
(1) Issuing shares or debentures to raise resources from stock market,
(2) Obtaining loans from the commercial banks and other financial institutions. The firms may find difficulties in raising the required financial resources from these two sources.
Limitations of the Value-Maximization Model of the Firm:
The basic model of the firm outlined above which considers that the primary objective of the manager is to maximise value of the firm or shareholders wealth has been criticized on the ground that it is quite unrealistic. More specifically it has been alleged that maximising short-run profits or present value of the firm considers higher profits alone as the sale objective of the firm or the basis of firm’s behaviour.
It is pointed out that in the present-day corporate form of business firms, in their decision making managers strive to promote their own interest by enhancing their power, prestige, leisure. In fact, managers may maximise their utility rather than profits or value of the firm. Thus, William Baumol has argued that managers seek to maximise sales rather than profits or value of the firm. He has put forward a sales maximisation model as an alternative to profit or value maximisation model.
Olivar Williamson has argued that managers of modern corporate firms seek to maximise their utility rather than maximising short-run profits or value of the firm. According to him, utility of a manager depends on their salaries, fringe benefits, stock options, the number of subordinate staff under him, and the extent of his control on the company.
Finally, following the work of Herbert Simon a Nobel Prize winner in economics, Richard Cyert and James March ‘ have suggested that in view of great uncertainty and a lot of constraints faced by a firm, the management of a modern corporation is a very difficult and complex task.
According to them, managers are not able to maximise profits even if they so desire. Therefore, in their opinion, managers only satisfied, that is, they attempt to have a satisfactory performance in terms of profits, sales, market share or growth of the firm. Thus, according to Simon, Cyert and March, managers of business corporations try to satisfy rather than to maximise.