Financial management is concerned with decision making regarding the size and composition of assets and the level and structure of financing. To make a wise financial decision in any corporation requires a clear understanding of the objective that is to be achieved. So the objective or goal provides a framework for optimal financial decision making. There are two widely discussed goals that a corporation has to undertake as profit maximization and wealth or value maximization. Here we will discuss the comparison between profit and value/wealth maximization goal and superiority of value maximization goal over profit maximization.
This goal is related to the maximization of the market value of the equity shares that maximize the value of the corporation to its shareholders. It is a universally accepted objective of the firm and it is also considered superior that the profit maximization goal of the corporation.
Maximization of wealth refers to maximizing the net present value of the business form/corporation. The net present value is the difference between the present value of future benefits or future cash flows and net cash outlay at year zero.
Therefore, NPV=PV of Future Cash Flow- Net Cash Outlay
The major arguments in the favor of wealth maximization goals are listed below; (Why wealth maximization is called superior goal over profit maximization?)
It is a clear goal
Value maximization is a clearer and certain goal in comparison with wealth maximization. Unlike profit maximization (that measures the benefits and of the project in terms of accounting profit) value maximization measures the same in terms of cash flows rather than in terms of accounting profit. It helps to reduce conflict and disputes among the stakeholders and corporations. According to wealth maximization, a good financial decision is that which increases the net present value of the corporation.
It considers the time value of money
Value maximization considers the concept of the time value of money. The fundamental weakness of profit maximization objective is not considering the concept of the time value of money. This objective emphasizes the timing of cash flow for decisions to take. It can be cleared with the help of following hypothetical example;
Time Pattern of Cash Flow
Considering the given hypothetical cash flow of two different alternative projects over three periods, we cannot say which alternative is viable under the profit maximization goal. However, if the goal is to maximize the value of the firm then Project-II is viable. It is because of having higher cash flow in the first period and that can be reinvested.
There is one doctrine in financial planning that the earlier the better as benefits received sooner are more valuable than benefits received later. The basis for the superiority of cash flow now over later holds in the fact that the previous can be re-invested to earn a return. This is referred to as the time value of money. This fact is entirely ignored by the profit maximization criterion of the corporation.
Quality of Benefits/Considers Risk Factors
The considerable technical limitation of the profit maximization goal of the corporation is ignorance of the quality aspect of benefits associated with a financial course of action. The term quality refers to the degree of certainty with which benefits can be expected. The rule is that the more certain the expected return, the higher the quality of the benefits. The more uncertain or fluctuation the expected benefits the lower the quality of benefit. So variability of cash flow stream for the particular financing decision determines the quality of benefits.
In general, investors are considered as risk averter so they want to avoid or at least minimize the risk. They can so reasonably be expected to have a performance for return which is more certain.
Profit maximization considers the only size of benefits ignoring the weight of the degree of uncertainty of the future benefits. This can be explained with the help of following hypothetical example;
|State of Economy||Profit in Alternative-I||Profit in Alternative-II|
From the table, we can see that the total benefits associated with two of the alternative are identical. Similarly, an expected amount of benefit in the normal period is similar but in alternative-B, there is a greater range of variation in comparison with alternative A.
The benefits associated with alternative-B are more risky and uncertain as they fluctuate widely based on the state of en economy. Alternative A is better from the point of risk and uncertainty. This attribute of returns is failed by the profit-maximization goal of the corporation.
Usable for all types of firms
The value maximization objective applies to all types of corporations. It is equally applicable in the firms whether it is a proprietorship, partnership, or a corporation. This goal is also usable in many non-profit organizations as well. It gives ideas and convincing meaning to maximize the value of the owner’s equity in the case of the absence of traded stock of the company or firm.
Suitable in the modern era of business
Wealth maximization objective is an ethical, suitable, realistic concept in the modern business era. Organizations having an objective of wealth maximization are almost no question in recent society. In contrast, the profit-maximization goal now days is subject to raising the figure and considering unethical, unsuitable, outdated, vague, unrealistic, and incomplete. Moreover, wealth maximizes goals to ensure a more competitive business environment and it will ensure a quality product and service delivery to the consumers. It also makes corporations responsible for societies.
These facts justify that the value maximization is far superior to the profit-maximization goal. The fundamental differences/comparison between profit and value/wealth maximization goal are shown in the table below;
|Point of Differences||Profit Maximization||Wealth Maximization|
|Time value of money||It does not consider the time value of money||It considers the time value of money.|
|Risk element||It does not consider the risk or uncertainty of benefits.||It considers the risk associated with benefits.|
|Main target||It is targeted towards the owner.||It is oriented towards the shareholders,|
|Nature||It is quantitative||It is qualitative|
|Welfare||It does not consider the welfare of stockholders.||It considers the welfare of stakeholders such as investors, creditors, society, and government.|
|Time||Short- term goal||Long term goal|
Looking at the comparison between profit and value/wealth maximization goal, in summary, we can say that the profit maximization criterion is inappropriate and unsuitable as an operational objective of investment, financial, and dividend decisions of the firm. It is vague and ambiguous and also ignores two important proportions of financial analysis as a risk and time value of money.
An appropriate operational decision criterion for financial management should be precise and exact, based on the bigger the better, consider both quantity and quality dimensions of benefits and recognizes the time value of money. Thus, such all the attributes are included by the wealth maximization goal and are considered a superior objective of the corporation to profit maximization goal.