If it is agreed to maximize the value of the firm, it is necessary to ask two fundamental questions: who is the firm?
What do we mean value?
In the United Kingdom the traditional view has been for the interests of a firm to equate with those of the current equity shareholders. But is it now recognized that this is much too narrow. The employees and lenders to a business certainly have a legitimate interest, probably also the government. Some companies would add a company‟s suppliers and customers as part of the stakeholders. Perhaps the general public also belongs to the list.
Each of the members of the above list has different key objectives. For example employees might want their labour remuneration to be larger, while the shareholders want labour costs to be low so that higher profits can lead to higher dividends. Shareholders might be uninterested whether the company invests in „unethical‟areas of business such as armaments or cigarettes, as long as their investment is profitable, while certain sections of the public will discourage unethical products.
The value of an investment in terms of financial management theory is the present value of the cash returns available from the investment. However this varies from investor to investor depending on personal discount rate, tax position, period of investment, etc. For example the value of a share bought today and expected to be sold in five years time will be the present value of the five years dividends plus the present value of the expected net realizable value at the end of the holding period. So the value of the same share will be different to different shareholders, and the job of the managers to maximize the total value becomes impossible.
A further problem arises in the conflict between short-term results and long-term viability. Managers might be on annual service contracts and therefore are motivated to report the highest possible short-term profits. This might involve cutting down on revenue investment such as maintaining fixed assets, advertising, research costs, etc. Such a policy is in the best interests of management, since they will be paid a bonus for reporting good results, but is not in the long-term interests of the company.
Financial managers often deal with the above conflicts adopting a satisfying approach rather than an optimizing approach. The hope to please everyone following moderate policies which are not exclusively in the interests of one of the sectional stakeholders of the business.