PROFIT MAXIMIZATION VS.

STOCKHOLDER WEALTH MAXIMIZATION

Profit maximization is basically is a single-period or, at most, a short-term goal, to be achieved within one year;
it is usually interpreted to mean the maximization of profits within a given period of time. A corporation may
maximize its short-term profits at the expense of its long-term profitability. In contrast, stockholder wealth
maximization is a long-term goal, since stockholders are interested in future as well as present profits.
Wealth maximization is generally preferred because it considers (1) wealth for the long term, (2) risk or
uncertainty, (3) the timing of returns, and (4) the stockholders` return. Timing of returns is important; the earlier
the return is received, the better, since a quick return reduces the uncertainty about receiving the return, and the
money received can be reinvested sooner. Table 1-1 summarizes the advantages and disadvantages of these two
often conflicting goals.
TABLE 1-1
PROFIT MAXIMIZATION VERSUS STOCKHOLDER WEALTH MAXIMIZATION
Goal Objective Advantages Dis advantages

Easy to calculate profits.1.

Easy to determine the link Emphasizes the short-term.1.
Ignores risk or uncertainty.2.
Profit
between financial decisions and Ignores the timing of returns.3.
maximi zation Large profits profits.2. Requires immediate resources.4.

Offers no clear relationship

Emphasizes the long term.1. between financial decisions
Recognizes risk or uncertainty. and stock price.1.
2. Can lead to management
Recognizes the timing of anxiety and frustration.2.
returns.3. Can promote aggressive and
Stock holder Highest share
wealth maximi price of common
Considers stockholders` return. 3. creative accounting
zation stock 4. practices.
Note: The policy decisions that by themselves are likely to affect the value of the firm (maximize stockholder
wealth) include the:
Investment in a project with a large net present value.
Sale of a risky division that will now increase the credit rating of the entire company.
Use of a more highly leveraged capital structure that resulted in lower cost of capital.
Let us now see how profit maximization may affect wealth maximization.
EXAMPLE 1-1
Profit maximization can be achieved in the short-term at the expense of the long-term goal of wealth
maximization. For example, a costly investment may create losses in the short-term but yield substantial profits in
the long term; a company that wants to show a short-term profit may postpone major repairs or replacement even
though such postponement is likely to hurt its long-term profitability.
EXAMPLE 1-2
Profit maximization, unlike wealth maximization, does not consider risk or uncertainty. Consider two products, A
and B, and their projected earnings over the next five years, as shown below.
Product A
$20,000
$20,000
$20,000
$20,000
$20,000

$100,000
A profit maximization approach favors product B over product A because its totals projected earnings after five
years are higher. However, if product B is more risky than product A, then the decision is not as straightforward as
the figures seem to indicate because of the trade-off between risk and return. Stockholders expect greater returns
from investments with higher risk; they will demand a sufficiently large return to compensate for the comparatively
greater level of risk of producing product B

Profit Maximization vs. Wealth Maximization

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 firms 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
firms progress; it indicates how well management is doing in behalf of its stockholders.

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 shareholders 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 CF1 CF1 CFn

of cash inflows = (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.

o 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.
o 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.
o 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.
o 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.