Profit vs Wealth maximization is a very common but a very crucial dilemma. The financial management has come a long way by shifting its focus from traditional approach to modern approach. The modern approach focuses on maximization of wealth rather than profit. This gives a longer term horizon for assessment, making way for sustainable performance by businesses.
A myopic person or business is mostly concerned about short term benefits. A short term horizon can fulfill objective of earning profit but may not help in creating wealth. It is because wealth creation needs a longer term horizon Therefore, financial management emphasizes on wealth maximization rather than profit maximization. For a business, it is not necessary that profit should be the sole objective; it may concentrate on various other aspects like increasing sales, capturing more market share etc, which will take care of profitability. So, we can say that profit maximization is a subset of wealth. Being a subset, it will facilitate wealth creation.
Managers are now giving priority to value creation. They have now shifted from traditional to modern approach of financial management that focuses on wealth maximization.
This leads to better and true evaluation of the business. For e.g., under wealth maximization, cash flows are more important than profitability. As we know, profit is a relative term, it can be a figure in some currency, a percentage etc. For e.g. we cannot judge a profit of say $10,000 as good or bad for a business, till we compare it with investment, sales etc. Similarly, duration of earning the profit is also important i.e. whether it is earned in short term or long term.
In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate various alternatives for decision making, cash flows are taken into consideration. For e.g. to measure the worth of a project, criteria like: “present value of its cash inflow – present value of cash outflows” (net present value) is taken. This approach considers cash flows rather than profits into consideration. It also use discounting technique to find out the worth of a project. Thus, maximization of wealth approach believes that money has time value.
An obvious question that arises at this point is that how can we measure wealth. Well, a basic principle is that ultimately wealth maximization should be discovered in increased net worth or value of business. So, to measure the same, value of business is a function of two factors. These are earnings per share and capitalization rate. And it can be measured by adopting following relation:
Value of Business = EPS / Capitalization rate
At times, wealth maximization may create conflict, known as agency problem. This describes conflict between the owners and managers of firm. Owners appoints managers as their agents to act on behalf of them. A strategic investor or the owner of the firm would be majorly concerned about the longer term performance of the business; that can lead to maximization of shareholder’s wealth. Whereas, a manager might focus on taking such decisions that can bring quick result, so that he/she can get credit for good performance. However, in course of fulfilling the same, a manager might opt for risky decisions which can put the owner’s objectives at stake.
Hence, a manager should align his/her objective to broad objective of organization and achieve a trade-off between risk and return while making a decision; keeping in mind the ultimate goal of financial management i.e. to maximize the wealth of its current shareholders.