Profit and Wealth Maximization

  • Financial management is concerned with procurement and use of funds.   The main objective of Financial management is to ensure the maximization of the economic welfare of its shareholders. The maximization of economic welfare means maximization of wealth of its shareholders. Shareholder’s wealth maximization is reflected in the market value of the firm’s shares.

Profit Maximization:

  • Profit maximization is the objective of any economic activity. The performance and efficiency of a firm are evaluated in terms of profitability. Every business has to earn profit to cover its costs and provide funds for future growth.  Without profit, no business can survive. Profit provides a cushion for any random risk arising at any time.

Points in Favour of Profit maximization:

  • It is a barometer of the performance and efficiency of a firm.
  • It covers the cost of running a business.
  • It provides a fund for future growth.
  • Without profit, a business cannot survive.
  • It provides support in emergencies.

Criticism on Profit Maximization:

  • The concept of profit lacks clarity. profit is neither defined precisely nor correctly. What does profit mean? Is it profit after tax or before tax? Is it operating profit or net profit available to shareholders? Is it a long-term profit or a short-term profit? Differences in interpretation of the concept of profit thus expose the weakness of profit maximization.
  • Profit maximization is the traditional and narrow approach, which aims at maximizing the profit of the firm.
  • Due to the sole goal of profit maximization, there may be the exploitation of labours and consumers. It may lead to immoral marketing and killing of the competition.
  • Profit maximization objective ignores the time value of money and does not consider the magnitude and timing of earnings.  It treats all earnings as equal when they occur in different periods. It does not differentiate between the profits of the current year with the profits to be earned in later years. Similarly, it does not the difference for the firm between the cash received today and same cash received after one year.
  • It does not take into consideration the risk of the prospective earnings stream. It fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to the business risk, environmental risk or risky projects of the firm. Risks may be internal or external which will affect the overall operation of the firm.
  • The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximization.
  • Profit maximization has the above-mentioned drawbacks, but still, it is considered important because continued profit do wealth maximization for the shareholders.

Wealth Maximization:

  • The objective of wealth maximization is a universally accepted concept in the field of business. The term wealth means shareholder’s wealth. A shareholder’s current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share. The individual shareholder can use this wealth to maximize his individual utility.  Thus wealth maximization is maximizing shareholder’s utility.
  • Wealth maximization objective helps in increasing the market value of shares. The share’s market price is a performance index of the progress of a firm.  It also indicates the performance of management on the behalf of the shareholder.
  • Through the process of discounting, wealth maximisation takes care of the quality of cash flow.
  • The risks that are associated with cash flow are adequately reflected when present values are taken to arrive at the net present value of any project.

Points in favour of Wealth Maximization:

  • It overcomes the limitations of the policy of profit maximization.
  • It serves the interests of suppliers, financers, employees, management, consumers, and society.
  • The concept of wealth maximization is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation.
  • Wealth maximization considers the time value of money. Time value of money translates cash flow occurring at different periods

Criticism on Wealth Maximization:

  • It is a prescriptive idea. The objective is not descriptive of the policies the firm has to adapt to achieve wealth maximization. The policies of different firms may be different.
  • The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organizations.
  • Wealth maximization concept is useful for equity shareholders and not to debenture holders and society.

Difference Between Profit Maximization and Wealth Maximization:

Profit Maximization Wealth Maximization
Profit Maximization is based on the increase in sales and accounting profits of the organization. Wealth Maximization is based on the cash flows into the organization.
It emphasizes on short-term goals. It emphasizes on long-term goals.
It ignores the time value of money. It considers the time value of money.
It leads to the exploitation of employees and consumers It serves the interests of suppliers, financers, employees, management, consumers, and society.
The concept of profit lacks clarity. profit is neither defined precisely nor correctly. The concept is defined precisely but policies to achieve the object not elaborated.
Companies sticking to this policy stick to the same product line without modification or upgradation. Companies using this policy bring new innovative products and services to consumers
The object is profit maximization hence the quality of the product may not be maintained. The aim is to produce quality products at a low cost.
Profit Maximization ignores the risk and uncertainty. Wealth Maximization considers the risk and uncertainty.

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