Profit Maximization and Wealth Maximization Objectives of Financial Management Meaning, Arguments in Favour, Objections and Difference

Objectives of Financial Management

The firm’s investment and financing decision are unavoidable and continuous. In order to make them rational, the firm must have a goal. Two financial objectives predominate amongst many objectives. These are:

1. Profit maximization

2. Shareholders’ Wealth Maximization (SWM)

Profit maximization refers to the rupee income while wealth maximization refers to the maximization of the market value of the firm’s shares. Although profit maximization has been traditionally considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded as operationally and managerially the better objective. Both Profit maximization and Wealth Maximization are considered to be primary objectives of financial management.

1. Profit maximization objectives of financial management

Profit maximization implies that either a firm produces maximum output for a given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency.

In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. 

Arguments in favour of profit maximisation objectives of financial management

a) When profit earning is the aim of business then profit maximisation should be the obvious objective.

b) Profit is the barometer for measuring efficiency and economic prosperity of a business.

c) In adverse situation such recession, depression etc., a business can survive only when if it has past reserves to rely upon. Therefore, every business should try to earn more and more profit when situation is favourable.

d) The profits are the main source of finance for the growth of a business. So, a business should aim at maximisation of profits for enabling its growth and development.

e) Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximisation also maximises socio-economic welfare.

Objections to Profit Maximization objectives of financial management

Certain objections have been raised against the goal of profit maximization which strengthens the case for wealth maximization as the goal of business enterprise. The objections are:

(a) Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not at all possible to maximize what cannot be known. Moreover, the return profit vague and has not been explained clearly what it means. It may be total profit before tax and after tax of profitability tax. Profitability rate, again is ambiguous as it may be in relation to capital employed, share capital, owner’s fund or sales. This vagueness is not present in wealth maximisation goal as the concept of wealth is very clear. It represents value of benefits minus the cost of investment.

(b) The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt further to maximize. It is argued that firm’s goal cannot be to maximize profits but to attain a certain level or rate of profit holding certain share of the market or certain level of sales. Firms should try to ‘satisfy’ rather than to ‘maximise’.

(c)There must be a balance between expected return and risk. The possibility of higher expected yields are associated with greater risk to recognize such a balance and wealth maximisation is brought in to the analysis. In such cases, higher capitalization rate involves. Such combination of expected returns with risk variations and related capitalization rate cannot be considered in the concept of profit maximisation.

(d) The goal of maximisation of profits is considered to be a narrow outlook. Evidently when profit maximisation becomes the basis of financial decision of the concern, it ignores the interests of the community on the one hand and that of the government, workers and other concerned persons in the enterprise on the other hand.

(e) The criterion of profit maximisation ignores time value factor. It considers the total benefits or profits in to account while considering a project whereas the length of time in earning that profit is not considered at all. Whereas the wealth maximization concept fully endorses the time value factor in evaluating cash flows. Keeping the above objection in view, most of the thinkers on the subject have come to the conclusion that the aim of an enterprise should be wealth maximisation and not the profit maximisation.

(f) To make a distinction between profits and profitability. Maximisation of profits with a view to maximizing the wealth of shareholders is clearly an unreal motive. On the other hand, profitability maximisation with a view to using resources to yield economic values higher than the joint values of inputs required is a useful goal. Thus, the proper goal of financial management is wealth maximisation.

2. Wealth Maximization objectives of financial management

Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature. That is

NPV(A) + NPV(B) = NPV(A+B)

The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions. 

Also Read: Significance of Financial Management

Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time. The wealth created by a company through its actions is reflected in the market value of the company’s shares. Therefore, this principle implies that the fundamental objective of a firm is to maximize the market value of its shares. The market price, which represents the value of a company’s shares, reflects shareholders’ perception about the quality of the company’s financial decisions. Thus, the market price serves as the company’s performance indicator.

In such a case, the financial manager must know or at least assume the factors that influence the market price of shares. Innumerable factors influence the price of a share and these factors change frequently. Moreover, the factors vary across companies. Thus, it is challenging for the manager to determine these factors. 

WEALTH MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT

The primary objective of financial management is wealth maximization. The concept of wealth in the context of wealth maximization objective refers to the shareholders’ wealth as reflected by the price of their shares in the share market. Therefore, wealth maximization means maximization of the market price of the equity shares of the company. However, this maximization of the price of company’s equity shares should be in the long run by making efficient decisions which are desirable for the growth of a company and are valued positively by the investors at large and not by manipulating the share prices in the short run. The long run implies a period which is long enough to reflect the normal market price of the shares irrespective of short-term fluctuations. The long run price of an equity share is a function of two basic factors:

a)      The likely rate of earnings or earnings per share (EPS) of the company; and

b)      The capitalization rate reflecting the liking of the investors of a company.

The financial manager must identify those avenues of investment; modes of financing, ways of handling various components of working capital which ultimately will lead to an increase in the price of equity share. If shareholders are gaining, it implies that all other claimants are also gaining because the equity share holders are paid only after the claims of all other claimants (such as creditors, employees, and lenders) have been duly paid.

The following arguments are advanced in favour of wealth maximization as the goal of financial management:

a)      It serves the interests of owners, (shareholders) as well as other stakeholders in the firm; i.e. suppliers of loaned capital, employees, creditors and society.

b)      It is consistent with the objective of owners’ economic welfare.

c)       The objective of wealth maximization implies long-run survival and growth of the firm.

d)      It takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured.

e)      The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares.

f)       The goal of wealth maximization leads towards maximizing stockholder’s utility or value maximization of equity shareholders through increase in stock price per share.

Objectives to Wealth Maximization objectives of financial management

The wealth maximization objective has been criticized by certain financial theorists mainly on following accounts:

a)      It is prescriptive idea. The objective is not descriptive of what the firms actually do.

b)      The objective of wealth maximization is not necessarily socially desirable.

c)       There is some controversy as to whether the objective is to maximize the stockholders wealth or the wealth of the firm which includes other financial claimholders such as debenture holders, preferred stockholders, etc.

d)      The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organization. When managers act as agents of the real owners (equity shareholders), there is a possibility for a conflict of interest between shareholders and the managerial interests. The managers may act in such a manner which maximizes the managerial utility but not the wealth of stockholders or the firm.

Differences between profit maximization and wealth maximization are

1)      The process through which the company is capable of increasing is earning capacity is known as Profit Maximization. On the other hand, the ability of the company in increasing the value of its stock in the market is known as wealth maximization.

2)      Profit maximization is a short term objective of the firm while long term objective is Wealth Maximization.

3)      Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which considers both.

4)      Profit Maximization avoids time value of money, but Wealth Maximization recognizes it.

5)      Profit Maximization is necessary for the survival and growth of the enterprise. Conversely, Wealth Maximization accelerates the growth rate of the enterprise and aims at attaining maximum market share of the economy.  

Other Needs and Objectives of Financial Management

A part form profit maximization and wealth maximization, the Business finance is required for the establishment and existence of every business organization for the below mentioned purposes. Finance is required not only to start the business but also to operate it, it expand for modernize its operations and to secure stable growth. The importance of business finance arises basically to bridge the time gap. Manufacturers require business finance to bridge the time gap between the purchase of raw material and other supplies for production and recovery of sales. Traders require finance to bridge the time gap between the purchase of goods and recovery of sales. The need for business finance arises for the following purposes:

1.       To acquire Fixed Assets: Every business organization whether manufacturing or trading needs finance to acquire some fixed assets. Manufacturers need finance to acquire land & building, plant & machinery, furniture etc. Traders need finance to acquire shops for sale of goods, godowns for storage of goods and vehicles for distribution of goods.

2.       To purchase raw materials/goods: Manufacturers need finance to acquire raw-materials and consumable stores for production. Traders need finance to acquire goods for distribution.

3.       To acquire service of human being: Manufacturers need finance to pay their workers, supervisors, managers and other staff employed by them. Traders need finance to pay their staff employed by them.

4.       To meet other operating expenses: Every organization needs finance to meet day to day other operating expenses like payment for electricity bills, water bills, telephone bills, travelling & conveyance of staff, postage & telegram expenses & so on.

5.       To adopt Modern Technology: With fast changing technology, business organizations need finance to modernize their plans & machineries, production methods and distribution methods. An enterprise may decide to replace outdated and obsolete assets with new assets to operate more economically.

6.       To meet contingencies: Every organization needs finance to meet the ups and downs of business and unforeseen problems.

7.       To expand existing operations: Every organization needs finance to expand its existing operations. For example, a company manufacturing Pen Drives at a rate of 10,000 per day needs finance to increase its plant capacity to manufacture 20,000 Pen Drives per day.

8.       To diversity: Every organization which decides to diversify needs finance to add new products to the existing line. For example, the company manufacturing Pen Drive needs finance to add new products say Ganga Water.

9.       To avail of business opportunities: Finance is required to avail of business opportunities. For example, where raw-materials are available at heavy cash discounts, the enterprises need finance to avail of this opportunity.

Finance is said to be life blood of business. It is required not only at the time of setting up of business but at every stage during the existence of business. It must be available at the time when it is needed. It must also be adequate for the purpose for which it is needed. Thus, finance is required to bring a business into existence, to keep it alive and to see it growing. Men, materials, machinery and managers can be brought together and engaged in business when adequate finance is available. Many business firms are known to have failed mainly due to shortage of finance. The importance of finance has increased in modern times for two reasons viz., (i) the business activities are now undertaken on a much larger scale than in the past, and (ii) the manufacturing process has become more complex than it used to be. With the growth in size and volume of business and with the increasing complexity of production and trade there is growing need for finance.