Profit Maximization Vs Shareholders Wealth Maximization
The two main Goals/Objectives of Financial Management are –
- Profit Maximization [Traditional]
- Shareholders wealth Maximization [Modern]
It is a traditional and narrow approach which aims at maximization of returns by the firm in terms of monetary resources and increasing the earning per share of the shareholders. Under such approach maximization of profit is the sole objective of a business and the behavior of a firm is analyzed in terms of its profit maximization ability.
Features of Profit Maximization –
- Firms choose investment proposals which suits profit maximization criteria and reject proposals which bring less profit.
- Firms set the product price and output in such a way that they bring maximum returns.
- Firms tend to lower their cost of capital in order to achieve maximum profit and maximize shareholders wealth.
- It is related to maximization of Earning per share of a firm.
- A firm maximizes business operations for profit maximization.
- Profit is the parameter to measure the efficiency, survival and growth of a business.
- Profit maximization objectives minimize risk and uncertainty factors in business and operations.
Favourable Arguments for Profit Maximization –
- It is a true measure of financial stability.
- A business`s ultimate aim is to earn profit.
- It reduces risk and uncertainty in business decisions and operations.
- It leads to maximum exploitation of financial resources.
- Retained earnings act as a major source of long term finance.
- Profitability meets all need.
Unfavourable Arguments against Profit Maximization –
- The term profit is vague and ambiguous and has no specific implications.
- It encourages unsocial and bad earning habits and may give rise to corrupt practices and unfair trade.
- It ignores time value of money i.e. it does not consider returns benefits received different period of time.
- It ignores uncertainty of returns and internal/external risks that may affect the overall operation of a business.
- It leads to inequalities among stakeholders.
Shareholders Wealth Maximization
It refers to maximization of the net present value of a course of action for increasing shareholders wealth.
Net Present Value– It is the difference between the present value of benefits realized and the present value of costs incurred by a business.
- A Positive NPV creates wealth and therefore is desirable.
- A Negative NPV brings losses wealth and therefore it acts as a contra-indicator.
Principle- Fundamental objective of a firm is to maximize the market value of its shares. The Market Value of shares is the parameter to judge the firms performance.
Favourable Arguments for Shareholders Wealth Maximization –
- It is a distinct and simple to understand concept.
- It considers time value of money and risks of the business concern.
- It considers the quantity and quality of benefits received by the firm.
- Shareholders wealth is maximized when market price per share is maximized.
- It promotes and improves optimum and efficient utilization of resources.
- It aims to achieve and fulfill the social and economic obligations upon a business.
- It ensures economic interest of its stakeholders.
Unfavourable Arguments against Shareholders Wealth Maximization–
- It ignores short-term economic benefits.
- It ignores an unstable share market i.e. there may be extensive fluctuations in share prices.
- It is indirect profit maximization.
- It creates a conflict of interest between management when the management is separate from ownership.
- Management enjoys extra benefits.
- Ultimate aim’s to maximize returns in order to reach a profitable position.