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Wealth maximization is a modern approach to financial management. Maximization of profit used to be the main aim of a business and financial management till the concept of wealth maximization came into being. It is a superior goal compared to profit maximization as it takes broader arena into consideration. Wealth or Value of a business is defined as the market price of the capital invested by shareholders.
The Concept of Wealth Maximization Defined as Follows
It simply means maximization of shareholder’s wealth. It is a combination of two words viz. wealth and maximization. A wealth of a shareholder maximizes when the net worth of a company maximizes. To be even more meticulous, a shareholder holds share in the company/business and his wealth will improve if the share price in the market increases which in turn is a function of net worth. This is because wealth maximization is also known as net worth maximization.
Finance managers are the agents of shareholders and their job is to look after the interest of the shareholders. The objective of any shareholder or investor would be a good return on their capital and safety of their capital.
Both these objectives are well served by wealth maximization as a decision criterion for business.
How to Calculate Wealth?
Wealth is said to be generated by any financial decision if the present value of future cash flows relevant to that decision is greater than the costs incurred to undertake that activity. Wealth is equal to the present value of all future cash flows less the cost. In essence, it is the net present value of a financial decision.
Wealth = Present Value of cash inflows – Cost.
|Present Value of Cash Inflows||=||CF1||+||CF1||+……….+||CFn|
|(1 + K)1||(1 + K)2||(1 + K)n|
Advantages of Wealth Maximization Model
Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as a goal of a financial decision.
- Firstly, the wealth maximization is based on cash flows and not profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated with accounting profits.
- Secondly, profit maximization presents a shorter term view as compared to wealth maximization. Short-term profit maximization can be achieved by the managers at the cost of long-term sustainability of the business.
- Thirdly, wealth maximization considers the time value of money. It is important as we all know that a dollar today and a dollar one-year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value.
- Fourthly, the wealth-maximization criterion considers the risk and uncertainty factor while considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.
Economic Value Added
In the light of modern and improved approach to wealth maximization, a new initiative called “Economic Value Added (EVA)” is implemented and presented in the annual reports of the companies. Positive and higher EVA would increase the wealth of the shareholders and thereby create value.
Economic Value Added = Net Profits after tax – Cost of Capital.
In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders to achieve their objectives and therefore is superior to profit maximization. For financial managers, it is a decision criterion being used for all the decisions. For more clarity, refer Profit Maximization vs. Wealth Maximization.
Capital investment decisions of a firm have a direct relation with wealth maximization. All capital investment projects with an internal rate of return (IRR) greater than 1 or having positive NPV creates value for the firm. These projects earn more than the ‘required rate of return’ of the firm. In other words, these projects maximize the wealth of the shareholders because they are earning more than what they can earn by investing themselves.
By analyzing the projects with the methods of capital budgeting, we come to know whether wealth will or won’t be created in a particular project. But, what is the real source of wealth creation? What is that characteristic of the project which becomes the root cause of value creation?
Source of Wealth Creation
Normally, two types of environment are faced by us – one is external and other is internal. If both the conditions support an organization, it tastes the success. A most important external factor which creates value is industry attractiveness and a similar internal factor is the competitive advantage of the firm.
Two main sources of wealth creation or value creations are the industry attractiveness and competitive advantage of the firm. Let us discuss them in little more details.
One of the most important factors for a firm to make profits is its industry attractiveness. Explained by Michael Porter, there are five forces of industry attractiveness which are as follows:
- Barriers to Competitor’s Entry: Higher the entry barrier, higher is the chances for a firm to sustain for a long term.
- Substitutes: Lower the substitutes, lesser are the chances of consumers switching the products.
- Bargaining Power of Buyers: Lesser the bargaining power of buyers, the firm becomes in a better position to dominate terms.
- Bargaining Power of Suppliers: Lesser the bargaining power of suppliers and buyers, the firm becomes in a better position to dominate terms.
- Competition among Competitors: It emphasizes the degree of competition which exists between the current competitors of the industry. Amicable conditions among the competitors would make the firms enjoy the better position.
There are two elements of competitive advantage as per Michael Porter which are cost advantage and differentiation advantage.
- Cost advantage means the cost at which a firm producing the goods cannot be produced by the competing firms at that cost. Due to this advantage, the firm can sell products at a lower price than the competitors and still earn profit out of that. Customers are cost conscious and therefore they are attracted towards the firm’s products. The firm enjoys good sales which lead to more profits and better cash flows and therefore achieve wealth creation.
- Differentiation advantage means the product offered by the firm can be easily differentiated from other competitor’s products. The customers are convinced with a different product which is available only with the firm under concern. In such cases where the product is unique, firms enjoy higher price and therefore this becomes the real source of value creation for those firms.