Written by Shareholder wealth maximization refers to the management’s goal of making financial decisions that increase the value of shares owned by the company’s shareholders.
It is the fundamental objective of financial management that focuses on increasing the overall value of a company, which in turn leads to an increase in the value of its shares.
The wealth maximization objective is considered both and practical for guiding financial decisions by financial managers.
It provides a clear picture of what financial managers should aim for when making investment and financial decisions.
An important aspect of the wealth maximization objective is maximizing the net present value (or wealth) of a course of action.
This objective believes that a company should undertake activities that produce a positive net present value.
So, whenever a company undertakes a financial decision that produces a positive net present value, it is essentially maximizing its shareholder’s wealth.
The net present value of a course of action is the difference between the present value of its benefits and the present value of its costs.
A financial action that has a positive net present value creates wealth and is therefore desirable.
Conversely, a financial action that has a negative net present value reduces wealth and should be rejected outrightly.
Another aspect of the wealth maximization objective is about maximizing the market price of shares.
This involves increasing the overall value of the company so that the market price of its shares will increase as well.
The wealth maximization objective also addresses the issues of timing and risk associated with expected benefits.
These problems are resolved by carefully selecting an appropriate discount rate for discounting the expected future cash flows.
The objective of wealth maximization takes care of the issue of timing and risk of expected benefits.
These problems are solved by selecting an appropriate discount rate for discounting the expected flow of future benefits, which is usually expressed in terms of cash flows.
As you will see in the next heading, the wealth maximization objective is considered a better objective for a firm because it takes into account the time value of the money concept as well as the risks and returns concept.
Advantages Of Wealth Maximization Objective
1. It is superior: The wealth maximization objective is considered superior to the profit maximization objective because it focuses on the long-term growth and development of an organization.
It is a general belief among financial analysts that wealth maximization is the best objective that a company can pursue.
2. Considers the time value of money concept: The time value of money concept is the belief that a dollar received today is worth more than a dollar received in the future.
The wealth maximization objective takes into the time value of money concept by considering the timing of cash flows.
Cash flows received at different periods are discounted using appropriate discount rates.
By discounting cash flows, the wealth maximization objective provides a more accurate assessment of the value that a particular course of action will generate for the firm.
3. Wealth maximization objective considers risk: The wealth maximization objective also considers the risk associated with potential cash flows.
It recognizes that different investment opportunities or financial decisions carry varying levels of risk, and this risk should be accounted for when evaluating their value.
In fact, discount rates are applied to future cash flows so as to assess the level of risks associated with the cash flows.
So, a higher discount rate implies a higher perceived risk associated with the cash flows, while a lower discount rate suggests a lower perceived risk associated with the cash flows.
4. It is precise and clear: Shareholders’ wealth maximization is based on cash flows rather than profit.
The net present value of a financial can be measured quantitatively,
Indeed, the use of cash flow in wealth maximization helps eliminate ambiguity regarding the exact meaning of the word profit.
5. It maximizes the returns of the owners: The wealth maximization objective is essentially about maximizing the returns of the owners (shareholders).
It is centered around enhancing the value of the organization, increasing dividends for shareholders, and increasing the stock market price of the company’s shares.
Indeed, under the wealth maximization objective, financial decisions are made in a way that maximizes the dividend paid to shareholders while also increasing the stock market price.
6. Considers the interest of major shareholders: The wealth maximization objective takes into account the interests of owners, workers, financial institutions, and society.
This is why it is widely accepted as the best objective that a firm can pursue in finance
7. Less prone to manipulations: Profit can be manipulated by inflating the value of income or changing depreciation methods.
Wealth maximization is not based on profit, rather it is based on cash flows, which are less prone to manipulation.
Limitations or Criticisms Of The Wealth Maximization Objectives
Even though wealth maximization is often viewed as the best objective for a company, it has the following drawbacks:
1. Unsuitable for small businesses: Wealth maximization is mostly suitable for large businesses like corporations.
Because small businesses such as sole proprietorships usually have limited resources, they prefer to maximize profit first.
2. Wealth maximization objective is limited by the tradeoff between dividends and retained earnings: There is a tradeoff between distributing profits to shareholders (dividends) and retaining profit for investment purposes (retained earnings).
If a company pays out too many dividends, it would not have enough funds to invest in productive activities that can increase its worth.
On the other hand, if a company retains too many funds, shareholders may be dissatisfied as some shareholders depend heavily on dividend income.
Thus, a wealth-maximizing firm is also limited by the tradeoff between dividends and retained earnings.
3. Conflict of interest: In large organizations, the management (board of directors) is separate from the ownership (shareholders).
Conflict of interest may arise arises if the management team prioritizes its own interests or goals in the company over those of the shareholders.
4. Dependent on profitability: To some extent, the wealth maximization goal is dependent on profitability, as a company can only consider maximizing shareholder wealth after it has made a sufficient profit.
