In order to maximize its shareholders’ value, a firm’s management must attempt to maximize the expected EPS.

In order to maximize its shareholders’ value, a firm’s management must attempt to maximize the expected EPS. (Points : 10) True False

The Correct Answer and Explanation is:

The correct answer is False.

Maximizing the expected earnings per share (EPS) does not necessarily maximize shareholder value. While EPS is an important indicator of a company’s profitability, it does not fully reflect a firm’s value or the factors that drive shareholder wealth. Shareholder value is primarily determined by the market value of the company’s stock, which depends on several factors beyond just earnings.

Here’s why maximizing EPS does not always equate to maximizing shareholder value:

1. Short-Term vs. Long-Term Focus: Management could focus on increasing EPS in the short term by cutting costs, delaying investments, or using financial engineering tactics (such as share buybacks). However, these actions might reduce the company’s future growth prospects, ultimately harming long-term shareholder value.
2. Risk and Return: Maximizing EPS may lead a firm to take on high levels of debt or make risky investments to boost short-term earnings. While this could improve EPS temporarily, it might increase the firm’s risk, which could lower its stock price in the long term, negatively impacting shareholder value.
3. Market Perception: Investors value companies based on their future growth potential, risk profile, and other qualitative factors, not just current EPS. Companies with strong growth prospects but lower EPS in the short term may still be more valuable in the eyes of investors.
4. Cash Flow: Shareholders care about returns on their investments, which can come in the form of dividends or capital gains. A focus solely on EPS may ignore the company’s ability to generate cash flow or invest in profitable projects, which are crucial for sustainable growth and long-term value creation.

Thus, a company’s management should focus on long-term value creation, which includes strategies that promote sustainable growth, healthy cash flow, and an appropriate balance of risk and return.