Why Wealth Maximization is Considered to be Better Operating Goal?

The wealth maximization objective is almost universally accepted goal of a firm. According to this objective, the managers should take decisions that maximize the shareholders’ wealth. In other words, it is to make the shareholders as rich as possible. Shareholders’ wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Therefore, only those projects which have positive net present value should be accepted. For example, suppose a firm invests $ 10,000 in a project that generates net cash flow $ 3,000 each year for five years. If the firm requires 10% return on its capital, the net present value of the project is $ 1,372. Project like this should be accepted because the net present value accruing from the project belongs to shareholders, hence increases their wealth. Investors pay higher price for shares of a company which undertakes projects with positive net present value. As a result, wealth maximization is reflected in the market price of shares. Based on this logic, stock price maximization is equivalent to shareholders wealth maximization. It is because, market price of firm’s stock takes into account present and expected earnings per share; the timing, duration, and risk of these earnings; the dividend policy of the firm; and other factors that bear on the market price of the stock. Stock price maximization is considered superior goal to profit maximization 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 maximization 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 maximization 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 maximization objective considers time value of money. It recognizes 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 maximization objective is considered superior profit maximization objective. It may be noted here that value maximization objective is simply the extension of profit maximization to real life situations. Where the time period is short and magnitude of uncertainty is not great, value maximization and profit maximization amount almost the same thing.

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