Wealth maximization is a modern approach tofinancial management. Maximization of profit used to be the main aim of a business and financial management till the concept of wealth maximization came into being. It is a superior goal compared toprofit maximizationas it takes broader arena into consideration. Wealth or Value of a business is defined as the market price of the capital invested byshareholders.
It simply means maximization of shareholders wealth. It is a combination of two words viz. wealth and maximization. A wealth of a shareholder maximizes when the net worth of a company maximizes. To be even more meticulous, a shareholder holds share in the company/business and his wealth will improve if the share price in the market increases which in turn is a function of net worth. This is because wealth maximization is also known as net worth maximization.
Finance managers are the agents of shareholders and their job is to look after the interest of the shareholders. The objective of any shareholder or investor would be a good return on their capital and safety of their capital.
Both these objectives are well served by wealth maximization as a decision criterion for business.
Wealth is said to be generated by any financial decision if the present value of future cash flows relevant to that decision is greater than the costs incurred to undertake that activity. Increase in wealth is equal to the present value of all future cash flows less the cost/investment. In essence, it is thenet present value(NPV) of a financial decision.
Increase in Wealth = Present Value of cash inflows Cost.
Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as a goal of a financial decision.
and not on profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated withaccountingprofits. Profit can easily be manipulative, if there is a change in accounting assumption/policy, there is a change in profit. There is a change in method ofdepreciation, there is a change in profit. It is not the case in case of Cashflows.
view as compared to wealth maximization. Short-term profit maximization can be achieved by the managers at the cost of long-term sustainability of the business.
. It is important as we all know that a dollar today and a dollar one-year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value. Suppose there are two projects A and B, project A is more profitable however it is going to generate profit over a long period of time, while project B is less profitable however it is able to generate return in a shorter period. In a situation of an uncertainty, project B may be preferable. So, timing of returns is ignored by profit maximization, it is considered in wealth maximization.
Fourthly, the wealth-maximization criterion considers the
while considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.
In the light of modern and improved approach to wealth maximization, a new initiative called Economic Value Added(EVA) is implemented and presented in the annual reports of the companies. Positive and higher EVA would increase the wealth of the shareholders and thereby create value.
= Net Operating Profits after tax Capital EmployedxWeighted Average Cost of Capital.
In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders to achieve their objectives and therefore is superior to profit maximization. For financial managers, it is a decision criterion being used for all the decisions. For more clarity, referProfit Maximization vs. Wealth Maximization.
Capitalinvestment decisionsof a firm have a direct relation with wealth maximization. All capital investment projects with aninternal rate of return(IRR) greater thancost of capitalor having positive NPV or creates value for the firm. These projects earn more than the required rate of return of the firm. In other words, these projects maximize the wealth of the shareholders because they are earning more than what they can earn by investing themselves.
By analyzing the projects with the methods ofcapital budgeting, we come to know whether wealth will or wont be created in a particular project. But, what is the real source of wealth creation? What is that characteristic of the project which becomes the root cause of value creation?
Normally, two types of environment are faced by us one is external and other is internal. If both the conditions support an organization, it tastes the success. A most important external factor which creates value is industry attractiveness and a similar internal factor is the competitive advantage of the firm.
Two main sources of wealth creation or value creations are the industry attractiveness and competitive advantage of the firm. Let us discuss them in little more details.
One of the most important factors for a firm to make profits is its industry attractiveness. Explained by Michael Porter, there are five forces of industry attractiveness which are as follows:
Higher the entry barrier, higher is the chances for a firm to sustain for a long term.
Lower the substitutes, lesser are the chances of consumers switching the products.
Lesser the bargaining power of buyers, the firm becomes in a better position to dominate terms.
Lesser the bargaining power of suppliers and buyers, the firm becomes in a better position to dominate terms.
It emphasizes the degree of competition which exists between the current competitors of the industry. Amicable conditions among the competitors would make the firms enjoy the better position.
There are two elements of competitive advantage as per Michael Porter which are cost advantage and differentiation advantage.
means the cost at which a firm producing the goods cannot be produced by the competing firms at that cost. Due to this advantage, the firm can sell products at a lower price than the competitors and still earn profit out of that. Customers are cost conscious and therefore they are attracted towards the firms products. The firm enjoys good sales which lead to more profits and better cash flows and therefore achieve wealth creation.
means the product offered by the firm can be easily differentiated from other competitors products. The customers are convinced with a different product which is available only with the firm under concern. In such cases where the product is unique, firms enjoy higher price and therefore this becomes the real source of value creation for those firms.
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Whats your view on this? Share it in comments below.
Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain Financial Management Concepts in Laymans Terms.
Hello to all, the contents present at this site are actually amazing for people knowledge, well, keep up the good work fellows.
It is very useful for management students. Thanks
Very well brought out discussion. Found it useful for Management scholars.
Well done, it is a good guide for management scholars.
Wow.. well done. highly useful for management scholars
With the threatening global economic shifts that are in most cases unpredictable to some extent, the information provided on this site becomes very relevant not only to financial mamagement scholars or students but for everyone who is so passionate with wealth creation and wealth maximisation. Keep at it
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FINANCIAL MANAGEMENT CONCEPTS IN LAYMANS TERMS
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