Profit Maximization vs Wealth Maximization: Explanation
Profit Maximization and Wealth Maximization: Definition, Explanation and Advantages and Disadvantages (merits and demerits). The management of finance means financial management. Finance is the blood of business. The existence of human life is not possible without the circulation of blood. In the same way, the existence of a business is not possible without finance. Finance is required to continue the business transactions regularly. Financial management utilizes financial resources in such a manner that a satisfactory return is earned along with the optimum utilization of finance. The objective of financial management should be “maximization of owner’s economic welfare.” Through the use of financial resources, financial management aims at the economic maximization of the owners who are the shareholders of the company.
Profit maximization: According to this approach, the company should earn profit out of its available resources and dividend policy should be based on the maximization of profit. It means maximizing the income of the company. Investors purchase the share of the company hoping to get the maximum dividends.
In the traditional approach, business is considered to be an economic organization and profit is considered to be a good standard to measure its efficiency. In addition, this approach suggests that the company should accept profitable projects only. The company can increase earnings per share through the objective of maximization of profit.
In economics, profit maximization is the short-run or long-run process by which a firm may determine the price, input, and output levels that lead to the highest profit.
Advantages and Disadvantages of Profit Maximization:
Profit maximization is justified on the ground of rationality and considered as an indicator of economic efficiency. It is a traditional or natural objective of the business. Profit maximization has efficient allocation and utilization of resources. It can be used for the measurement of the success of a business and is easy to calculate. It also maximizes the social benefit.
In profit maximization the term profit is vague. It ignores the time value of money and overlooks quality aspects. Profit maximization also ignores the social responsibility of the business and has a narrow concept. Profit maximization has to be attempted with a realization of risk.
Wealth maximization is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders.
Also Read: Equity Share: Features, Types, Advantages, Disadvantages
Advantages and Disadvantages of Wealth Maximization:
Wealth maximization is a clear indication and it includes the net present value and cash flow. It is based on the time value of money and has universal acceptance. Wealth maximization provides due direction to the management for a clear dividend policy and considers risk factors.
Shareholder wealth maximization: Wealth maximization is considered as the main objective rather than profit maximization. Those companies which issue equity shares and the prices of those shares are quoted in the stock market, then the market price of shares is an indicator whether the value of assets of the firm is increasing or not. The objective of wealth maximization is also known as ‘Net present value.’ The net present value creates wealth for the shareholders. The wealth of the shareholders increases only when there is an increase in the price of shares. Hence, the financial decisions resulting in increasing net present value should only be accepted by the company. The wealth maximization approach is based on the concept of cash flow. Only cash flow is considered as a measurement and the accounting profit is ignored.
The net present value is the difference between the present value of wealth and the investment required.
Financial management should take such financial decisions by which the wealth of the company is maximized. If the wealth of the company is maximized, it will be reflected in the price of the share of the company on the stock exchange. The market price of the share will increase in the share market. As a result, shareholders’ wealth will be maximized. Due to this, shareholder’s assets increase.
The objective of wealth maximization is appropriate and universally accepted. The objective of wealth maximization is superior to that of profit maximization. Prof. Solomon has favored the objective of wealth maximization.
How to achieve Wealth Maximization:
- Avoid a high level of risk
- Reduction in cost
- Pay dividend
- Seek growth
- To maintain the market price of shares
- Attaining the large market share
- Increasing consumers satisfaction
- Gaining leadership in the market in terms of product and technology
Also Read: How To Buy Shares [Complete Guide]
How to measure the Value/Wealth of a Firm:
- Shareholders hire managers to run their firm because shareholders have absolute power to hire and fire managers.
- Managers set aside their interest and maximize stock prices because markets are efficient.
- Shareholder’s wealth is maximized because lenders are fully protected from shareholder’s actions.
- Firm value is maximized because there is no cost created for society.
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