Wealth Maximization: Meaning, Differences of Wealth Maximization & Profit Maximization
Wealth maximization is an appropriate and operationally feasible criterion to choose among the alternative financial actions. It provides an unambiguous measure of what finance should seek to maximize in making investment and financing decisions on behalf of owners (shareholders).
Meaning Of Wealth Maximization
Wealth Maximization means maximizing the net present value (or wealth) of a course of action to shareholders. The net present value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs.
A financial action with a positive NPV creates wealth for shareholders and is, therefore, desirable. A financial action resulting in negative NPV should be rejected since it would destroy shareholders’ wealth.
Definition Of Wealth Maximization
Wealth maximization means maximizing the net present value or wealth of a course of action to shareholders. This is also known as value maximization or net present value maximization.
- “The firm’s goal should be to maximize stockholder wealth, which is accomplished by maximizing the current stock price.” – C. P. Jones.
- “Wealth maximization means maximizing the net present value (or wealth) of a course of action to shareholders.” -I. M Pandey.
- “Wealth maximization, which translates into maximizing the price of the firm’s common stock.”- Brigham & Ehrhardt.
- “Wealth maximization implies the maximization of the market price of the share.” – Khan & Jain.
In current academic literature value, maximization is almost universally accepted as an appropriate operational decision criterion for finance. It removes the technical limitations which characterize the earlier profit maximization entering.
Economic Value Added (EVA) and Wealth Maximization
Economic Value Added (EVA) is a popular measure used by many firms to determine whether an investment proposed or existing contributes positively to the owner’s wealth.
Economic Value Added (EVA) is calculated by subtracting the cost of funds used to finance an investment from its after-tax operation profits.
Investments with positive Economic Value Added (EVA) increase shareholder value, and those with negative EVA reduce shareholders’ value. Only the investment with positive EVA is desirable.
Focus on Stakeholders For Wealth Maximization
Although maximizing shareholder wealth is the primary goal, many firms broaden their focus, including the interests of stakeholders and shareholders.
Stakeholders include employees, customers, suppliers, credits, owners, and others who have a direct economic link to the firm. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder will but to preserve it.
The firm can better achieve its goal of shareholder wealth maximization by fostering cooperation with its other stakeholders rather than conflict with them.
Rationale for Wealth Maximization
The wealth will be maximized if this criterion is followed in making financial decisions:
- Time Value of Money: The wealth maximization objective distinguishes between returns received at different times. It considers the time value of money.
- Risk and Return: The objective of shareholders’ wealth maximization takes care of the questions of the risk of the expected returns.
- Select Discount Rate: By selecting an appropriate rate (discount rate, cost of capital) for discounting the expected cash flows of future returns.
- Cash Flows: It is important to emphasize that benefits are measured in terms of cash flows, which is important for investment and financing decisions.
- Economic Welfare: Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time.
- Increase Market Value: The wealth maximization principle implies that a firm’s fundamental objective is to maximize its shares’ market value.
For the above reasons, wealth maximization is superior to profit maximization as an operational objective. Wealth maximization achieves the objectives of the firm’s owners and interested parties, so it should be the main goal of finance.
Wealth Maximization vs. Profit Maximization – 10 Key Differences
|Topics||Profit Maximization||Wealth Maximization|
|1. Definition||Profit maximization means|
maximizing the profit of the firm.
The maximization of the firm’s net
income is called profit maximization.
|Wealth maximization means|
maximizing the net present value or
a wealth of a course of action to
|2. Subject Matter||To increase profit volume.||To increase wealth, not profit.|
|3. Risk||The risk would not be considered.||The risk would be considered.|
|4. Time Value||Time value is not considered.||Time value is considered.|
|5. Inflation||Inflation would not be evaluated.||Inflation would be evaluated.|
|6. Concept||It is an ambiguous concept.||It is an unambiguous concept.|
|7. Welfare||Social welfare is not considered.||Social welfare is considered.|
|8. Keeps interested||It keeps interested only owners.||It keeps interested for all interested|
parties of the firm.
|9. Indicator||It indicates increasing EPS.||It indicates an increasing share price.|
|10. Comment||Profit maximization should not be the goal of finance and firms.||Wealth maximization should be the main goal of finance as well as firms.|