Question

can someone tell me as to how maximizing shareholder's wealth is different from maximizing firm value?

Answer 1

When maximizing shareholder wealth, managers will conduct themselves and the business in a way that produces more value in the Stockholder's Equity portion of a financial statement, thus increasing stockholder wealth.

Example, increasing the sales force of a company and not reinvesting the revenue gained in plant or capital, the retained earnings could then go to the stockholders!

When Maximizing firm value managers engage in activities such as acquiring plant, capital and technological processes may return a higher value for the company down the road, sometimes at the expense of shareholder equity.

Example: Company A sells a broad service that could be enhanced by expanding its infrastructure and acquiring Start-Up Company Z. Company A takes on a lot of debt to do this which creates an unfavorable leverage ratio for investors in the short-term and decreases the average stock price. Over time, however, these activities create more lucrative opportunities and assets.

Another way the difference can be illustrated is by looking at how managers act in mutual companies versus publicly traded companies.

Answer 2

Firm value is simply the value of the debt+equity. Shareholder value is the value of the equity. Management can increase firm value simply by borrowing more debt, however there is no guarantee that this debt will lead to increased shareholder wealth.

Shareholder wealth will only be increased if the borrowed money is invested in projects that earn more than the cost of the debt. Otherwise the increased firm value is destroying shareholder wealth.

It's important to remember the role that debt and equity play. Debt holders tradeoff full participation in the business' profits for first claim to those profits. Equity holders are subordinated claimants to the profits however they can capture a large part of the residual upside. The goal of management is to maximize shareholder value which involves shrewdly using debt to exploit opportunities where the returns are higher than the cost of the debt.