Profit Maximization vs. Wealth Maximization
The objective of the firm is to maximize its value to its shareholders. Value is represented by the market price of the company’s common stock, which, in turn, is a reflection of the firm’s investment, financing, and dividend decisions.
The idea of wealth maximization involves increasing the Earning per share of the shareholders and to maximize the net present worth.
Wealth is equal to the the difference between gross present worth of some decision or course of action and the investment required to achieve the expected benefits.
Gross present worth involves the capitalised value of the expected benefits.This value is discounted a some rate,this rate depends on the certainty or uncertainty factor of the expected benefits.
The Wealth Maximization approach is concerned with the amount of cash flow generated by a course of action rather than the profits.
Any course of action that has Net Present Value above zero or in other words,creates wealth should be selected.
Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder wealth. For one thing, total profits are not as important as earnings per share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills. Even maximization of earnings per share, however, is not a fully appropriate objective, partly because it does not specify the timing or duration of expected returns. Is the investment project that will produce $100,000 return 5 years from now more valuable than the project that will produce annual returns of $15,000 in each of the next 5 years? An answer to this question depends upon the time value of money to the firm and to investors at the margin. Few existing stockholders would think favorably of a project that promised its first return in 100 years. We must take into account the time pattern of returns in our analysis.
Another shortcoming of the objective of maximizing earnings per share is that it does not consider the risk or uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more uncertain if these projects were undertaken. In addition, a company will be more or less risky depending upon the amount of debt in relation to equity in its capital structure. This risk is known as financial risk; and it, too, contributes to the uncertainty of the prospective stream of earnings per share. Two companies may have the same expected future earnings per share, but if the earnings stream of one is subject to considerably more uncertainty than the earnings stream of the other, the market price per share of its stock may be less.
For the reasons above, an objective of maximizing earnings per share may not be the same as maximizing market price per share. The market price of a firm’s stock represents the focal judgment of all market participants as to what the value is of the particular firm. It takes into account present and prospective future earnings per share, the timing, duration, and risk of these earnings, and any other factors that bear upon the market price of stock. The market price serves as a performance index or report card of the firm’s progress; it indicates how well management is doing in behalf of its stockholders.
