Wealth and Profit maximisation in Financial Management

Profit maximisation and Wealth maximization in financial management.

Efficient financial management requires the existence of some objectives or goals because judgement as to whether or not a financial decision is efficient must be made in the light of some objective.
Profit vs wealth maximisation

Profit Maximization:It has traditionally been argued that the objective of a company is to earn profit, hence the objective of financial management is profit maximisation.

This implies that the finance manager has to make his decisions in a manner so that the profits of the concern are maximised. Each alternative, therefore, is to be seen as to whether or not it gives maximum profit.This implies that the finance manager has to make his decisions in a manner so that the profits of the concern are maximised.

Each alternative, therefore, is to be seen as to whether or not it gives maximum profit.However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise.

Profit maximisation as an objective is too narrow. It fails to take into account the social considerations as also the obligations to various interests of workers, consumers, society, as well as ethical trade practices.

If these factors are ignored, a company cannot survive for long. Profit maximisation at the cost of social and moral obligations is a short sighted policy.

Wealth / Value Maximisation: It is the duty of the finance manager to see that the shareholders get good returns on the shares. Hence, the value of the share should increase in the share market. The share value is affected by many things.

If a company is able to make good sales and build a good name for itself, in the industry, the company’s share value goes up.
If the company makes a risky investment, people may lose confidence in the company and the share value will come down.

So, this means that the finance manager has the power to influence decisions regarding finances of the company.

The decisions should be such that the share value does not decrease. Thus, wealth or value maximisation is the most important goal of financial management.

If a company is able to make good sales and build a good name for itself, in the industry, the company’s share value goes up.

If the company makes a risky investment, people may lose confidence in the company and the share value will come down. So, this means that the finance manager has the power to influence decisions regarding finances of the company.

The decisions should be such that the share value does not decrease. Thus, wealth or value maximisation is the most important goal of financial management.

Many companies have several other goals for the welfare of the society, like improving community life, supporting education and research, solving societal problems, etc. But wealth maximisation means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly.

If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.
But wealth maximisation means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly.

If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.
To achieve wealth maximization, the finance manager has to take careful decision in respect of Investment, Financing and Dividend payout.

Profit versus Wealth Maximization Principle of the Firm

The company may pursue profit maximisation goal but that may not result into creation of shareholder value. The profits will be maximized if company grows through diversification and expansion. But all growth may not be profitable.

Only that growth is profitable where ROA > WACC or ROE > KE or Firms invest in positive NPV profits.

However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.

If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.

Whereas, on the other hand, wealth maximisation, as an objective, means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly.

If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.

The maximisation of a firm’s value as reflected in the market price of a share is viewed as a proper goal of a firm. The profit maximisation can be considered as a part of the wealth maximisation strategy.

Limitations of Profit Maximization Objective of Financial Management

  • Time factor is ignored.
  • It is vague because it is not clear whether the term relates to economic profit, accounting profit, profit after tax or before tax.
  • The term maximization is also ambiguous.
  • It ignores the risk factor.

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