Value Maximization Model

Spread the love

Introduction

Value maximization theory was developed as an alternative to the profit maximization theory due to weaknesses or limitations of profit maximization theory. This theory is also known as wealth maximization theory. According to this theory, value or wealth maximization is the long-run objective of the firm that guides resource allocation decisions of the firm to maximize shareholders’ wealth or value of the firm.

In the words of Solomon and Pringle, “When the time is short and uncertainty is not much, profit maximization and value maximization are same.”

According to L.J. Gitman, “Since share price represents owner’s wealth in the firm, the share price is consistent with owner’s wealth maximization”

This theory believes that firms need to sacrifice their short-term profits/short-term profit maximization objective for increasing future long-term profits. Therefore, the value maximization theory advocates for shareholder wealth maximization or value maximization.

The value of a firm can be defined as the present value of the firm’s expected future net cash flows/future long-term profits discounted to the present value at an appropriate rate of interest/discount rate. Thus,

Value of the Firm = Present Value of Expected Future Profits

So, PV = π1/(1+r)1+ π2/(1+r)2 + π3/(1+r)3 +…. + πn/(1+r) n……. (i)

Or PV = ∑ πt/(1+r) t……. (ii)

Where PV is the present value of expected future profits of the firm; π(1…n) re expected future profit on time 1 to n; is summation; r is the rate of interest or discount rate, and t is period or value of time from 1 to n year. So, the maximization of the value of the firm means maximization of the present value of all future profits/discounted value of all future profits.

Since profit is the difference between total revenue and total cost. Therefore, the equation (i) can be expressed as

Present value of the firm (𝑃𝑉)=∑ TRt– TCt/(1+r) t ……. (iii)

The value of equation (iii) represents the present value of the firm and according to this theory, the value of equation (iii) that is the present value of the firm is needed to maximize.

How to Increase the PV/Critical Appraisal

The present value of the firm can be increased by the joint efforts of different departments of the organization like the marketing department, finance department, production department, and research department, etc.

The marketing department has the responsibility to increase total revenue (TR). The production department has a major duty to improve the quality of product and total costs (TC) of production to control. The finance department has a major responsibility to find the least cost finance for needed capital/investment and the research and development department has a major duty to introduce innovation and invention to reduce costs and increase sales 

All those interrelated activities of different departments of an organization affect the value of total revenue (TR), total cost (TC), and risks associated with the future of the business. So, all the functional managers need to decide rationally to maximize the value of the firm.

Along with those functional determinants, other departments like accounting, personnel, transportation, and engineering, etc. provide information and services which are needed to boost the sales volume as well as to reduce the cost of production. Thus, to determine the value of total revenue and total cost, interrelationship, and coordination between all the functional departments are crucial. Therefore, the interrelationship between departments of the business firm and the overall market scenario affect the risk and discount rate used to determine the present value of expected long-term profit. Each managerial decision has a significant effect on the values of the variable that determine the total revenue, total cost, riskiness, interest rate, and profitability of the firm. Managers thus need to decide in such a way that their decisions will help them to increase the value of the firm.

Factors Affecting Value of the Firm

The following graphics show major factors affecting the value of the firm.

Value Maximization Model
Value Maximization Model

How Value Maximization Model is Superior to the Profit Maximization Model? /Differences

The value maximization model is superior to the profit maximization model in the following respects:

The profit maximization model deals with short-term profit-maximizing business projects. The value maximization model deals with long-run profit-maximizing business projects and this model incorporates all those activities including risk analysis.

The profit maximization model is static. It is because this model deals with the objective of a firm based on a single time. But the value maximization model is dynamic. It is because this model explains the objective of a firm with future risk and uncertainty based on a multi-period.

The profit maximization model is focused on the sole-trading business at which the welfare maximization of single owners is preferred. The value maximization model is focused on the corporate business at which welfare maximization of many shareholders is preferred.

Constraints on Value Maximization Objective (Limitations)

A large variety of constraints can arise in the managerial decision problems, which directly and indirectly affect the value maximization attempts of the managers. The major constraints are.

1. Resource constraints

This refers to the limitations of resources. Due to scarcity and limitations of resources managers may face constraints to increase the present value of the firm.

2. Contractual requirements

Managers sometimes may face difficulties making appropriate decisions to increase the value of the firm due to contractual requirements like minimum production, minimum profit, minimum consumer service satisfaction, etc.

3. Legal constraints

Several legal restrictions or provisions like minimum wage rate legislation, anti-pollution measures, fuel efficiency, health and safety standards, etc. also directly work as constraints for managerial decisions.  

4. Implicit constraints

Certain implied constraints like environmental issues, structure, and behavioral issues like corporate social responsibilities, etc. impliedly also affect the managerial decisions.

Despite those many constraints, the value maximization model is superior to the profit maximization goal of a firm as it considers multiple periods, time value of money, risks, and uncertainty, and long-term sustainable profit of the firm. But, many economists criticized this theory as not different than profit maximization theory and they call the theory old wine in a new bottle and fundamentally there is no difference between profit maximization and value maximization models.

Leave a Comment

Your email address will not be published. Required fields are marked *

Don`t copy text!