The precise meaning of the profit maximization objective is unclear. The definition of the term profit is ambiguous. Does it mean short-or long-term profit? Does it refer to profit before or after tax? Total profits or profit per share? Does it mean total operating profit or profit accruing to shareholders?
Maximizing profit after taxes
Let us put aside the first problem mentioned above. And assume that maximizing profit means maximizing profit after taxes, in the sense of net profit as reported in the profit and loss account (income statement) of the firm. It can easily be realized that maximizing this figure will not maximize the economic welfare of the owners. It is possible for a firm to increase profit after taxes by selling additional equity share and investing the proceeds in low-yielding assets, such as the government bonds. Profit after taxes would increase but earnings per share (EPS) would decrease. To illustrate, let us assume that a company has 10,000 shares outstanding, profit after taxes of $50,000 and earnings per share of $5. If the company sells 10,000 additional shares at $50 per share and invests the proceeds ($500.000) at 5 per cent after taxes, then the total profits after taxes will increase to $75,000. However, the earnings per share will fall to $3.75 (i.e. $75,000/20,000). This example clearly indicates that maximizing profit after taxes does not necessarily serve the best interests of owners.
If we adopt maximizing EPS as the financial objective of the firm, this will also not ensure the maximization of owners' economic welfare. It also suffers from the flaws already mentioned, i.e. it ignores timing and risk of the expected benefits. Apart from these problems, maximization of EPS has certain deficiencies as a financial objective. For example, note the following observation:
Shareholders' wealth maximization (SWM)
What is meant by shareholders' wealth maximization (SWM)? SWM means maximizing the net present value of a course of action to shareholders. Net present value (NPV) or wealth of a course of action is the difference between the present values of its benefits and the present value of it costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV should be rejected since it would destroy share holders wealth, between mutually exclusive projects the one with the highest NPV should be adopted. NPVs of a firm's projects are additives in nature. That is
NPV (A) + NPV (B) = NPV (A + B)
This is referred to as the principle of value-additively. Therefore the wealth will be maximized if NPV criterion is followed in making financial decisions.
Prof. Knight in his work Risk, Uncertainty and Profit (1940) surveyed the existing theories and famed his own theory. According to Prof. Knight Profit is the reward of uncertainty risk bearing. Profit accurse to entrepreneur, because he bears uncertainty in business. Prof. Knight divided risk into two heads:
(i) Foreseeable risk: which entrepreneur can risk and provide against such as risk of fire, theft etc. can be removed by taking out insurance. The premium paid can be concluded in cost of production.
(ii) Unforeseeable risk: These risks are not foreseeable by the government Prof. Knight calls that market accures profit to entrepreneur. Uncertainty may be due to uncertain behavior of competitions. Technical changes in machines and equipments, business cycle and risks of government intervention.
Knight explained undesirable risks thus "the modern economic order is built around the concept of enterprise the correlate of which life is necessary involves much uncertainty referred to as profit system. Economic fife necessary involves much as more insurance is impracticable. Enterprise economy adds to this the far greater uncertainty associated with the almost universal production of goods anticipation of the wishes of consumers.
Uncertainty bearing as a function of the entrepreneur: Knight emphasized uncertainty bearing as the main function of the entrepreneur. In a way he gave uncertainty bearing the status of a separate factor which has a supply side on the degree of uncertainty involved in a venture. Unless uncertainty is rewarded with a degree of goods in anticipation of the wishes of consumers involved.
Prof. Knight showed that the presence of uncertainty about future may allow entrepreneurs to learn positive despite product exhaustion and competitive equilibrium. This positive profit may exist even perfect competition.
Prof. Knight's theory assumes uncertainty as a unique factor giving rise to profit. His theory does not contribute profit simply to dynamic change. In so far as the changes are profits due to risks for known risk is hanged against by taking out insurance.
The following are some of the criticisms of the uncertainty bearing theory of profits:
1. According to this theory profit is the reward for uncertainty-bearing. But sometimes an entrepreneur earns no profit despite uncertainty-bearing. Critics point out that there are other causes of profit in addition to uncertainty bearing. Others functions like initiating coordinating and bargaining also fetch point.
2. Uncertainty beating is considered as an independent factor of production. If an entrepreneur earn profit in an atmosphere of uncertainty on the basis of business ability it does not mean that this profit is due to his ability.
The uncertainty bearing theory like the earlier theories does not furnish a comprehensive explanation of profit and therefore it is inadequate. However we cannot ignore its importance as a determination of profit.
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