Wealth Maximization

Wealth maximization is a modern approach to financial 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 to profit maximization as it takes broader arena into consideration. Wealth or Value of a business is defined as the market price of the capital invested by shareholders.

Wealth maximization simply means maximization of shareholder’s wealth. It is combination of two words viz. wealth and maximization. Wealth of a shareholder maximize 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 good return on their capital and safety of their capital. Both these objectives are well served by wealth maximization as a decision criterion to business.

How to calculate wealth?

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. Wealth is equal to the present value of all future cash flows less the cost. In essence, it is the net present value of a financial decision.

Wealth = Present Value of cash inflows – Cost.

Where,  

Present Value of cash inflows

=

CF1

+

CF1

+……….+

CFn

(1 + K)

(1 + K) 2

(1 + K) n

Why wealth maximization model is superior to profit maximization?

Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as a goal to financial decision.

  • Firstly, the wealth maximization is based on cash flows and not profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated with accounting profits.
  • Secondly, profit maximization presents a shorter term 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.
  • Thirdly, wealth maximization considers the time value of money. 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.
  • Fourthly, the wealth maximization criterion considers the risk and uncertainty factor 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 of 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.

Economic Value Added = Net Profits after tax – Cost of Capital.

In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders achieve their objectives and therefore is superior to profit maximization. For financial managers, it is a decision criterion being used for all the decisions.

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