Why wealth maximization is considered to be better operating goal?

Wealth maximization objective is a widely recognised criterion with which the performance a business enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth maximisation is also stated as net present worth. Net present worth is difference between gross present worth and the amount of capital investment required to achieve the benefits. Gross present worth represents the present value of expected cash benefits discounted at a rate, which reflects their certainty or uncertainty. Thus, wealth maximisation objective as decisional criterion suggests that any financial action, which creates wealth or which, has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected. The wealth maximisation objective when used as decisional criterion serves as a very useful guideline in taking investment decisions. This is because the concept of, wealth is very clear. It represents present value of the benefits minus the cost of the investment. The concept of cash flow is more precise in connotation than that of accounting profit. Thus, measuring benefit in terms of cash flows generated avoids ambiguity.

The wealth maximisation objective considers time value of money. It recognises that cash benefits emerging from a project in different years are not identical in value. This is why annual cash benefits of a project are discounted at a discount rate to calculate total value of these cash benefits. At the same time, it also gives due weightage to risk factor by making necessary adjustments in the discount rate. Thus, cash benefits of a project with higher risk exposure is discounted at a higher discount rate (cost of capital), while lower discount rate applied to discount expected cash benefits of a less risky project. In this way, discount rate used to determine present value of future streams of cash earning reflects both the time and risk. .

In view of the above reasons, wealth maximisation objective is considered superior profit maximisation objective. It may be noted here that value maximisation objective is simply the extension of profit maximisation to real life situations. Where the time period is short and magnitude of uncertainty is not great, value maximisation and profit maximisation amount almost the same thing.

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]
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