Why does profit maximization inconsistent with wealth maximization?

The objective of a Financial Management is to design a method of operating the Internal Investment and financing of a firm. The two widely used approaches are Profit Maximization and Wealth maximization.

Profit maximization: Profit maximization is considered as the goal of financial management. In this approach actions that increase the profits should be undertaken and the actions that decrease the profits are avoided. The term 'profit' is used in two senses. In one sense it is used as an owner oriented. In this concept it refers to the amount and share of national Income that is paid to the owners of business. The second way is an operational concept i.e. profitability. It is the traditional and narrow approach, which aims at, maximizes the profit of the concern. The Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. and hence Profit maximization objectives help to reduce the risk of the business. Its main aim is to earn profit. In this criteria Profit is the main parameter of business operation. It reduces the risk of business concern. In this criteria profit is the main source of finance and profitability meets the social needs.

Some of the unfavorable arguments of profit maximizations are that it leads to exploiting workers and consumers.  It also creates immoral practices such as corrupt practice, unfair trade practice, etc.  It also creates inequalities among the stake holders such as customers, suppliers, public shareholders, etc.

Some of the drawbacks of profit maximizations are

1. In Profit Maximization, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. For example, profit may be long term or short term. It may be total profit or rate of profit. It may be net profit before tax or net profit after tax. It may be return on total capital employed or total assets or shareholders equity and so on.
2. It ignores the time value of money:Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. When the profitability is worked out the bigger the better principle is adopted as the decision is based on the total benefits received over the working life of the asset, Irrespective of when they were received.
3. It ignores the quality aspects of benefits which are associated with the financial course of action. The term 'quality' means the degree of certainty associated with which benefits can be expected. Therefore, the more certain the expected return, the higher the quality of benefits. As against this, the more uncertain or fluctuating the expected benefits, the lower the quality of benefits.
4. It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.

Wealth Maximization: Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is a universally accepted concept in the field of business. It removes technical disadvantages of the profit maximization. Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders.  Wealth maximization considers the comparison of the value to cost associated with   the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. This concept considers both time and risk of business concern. This criteria provides efficient allocation of resources and it also ensures the economic interest of the society. The wealth maximization criterion is based on cash flows generated and not on accounting profit. The computation of cash inflows and cash outflows is precise. Wealth maximization can be activated only with the help of the profitable position of the business concern. So The goal of maximizing the value of the stock avoids the problems associated with the different goals we discussed above.in a simple language a good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it. So the financial manager best serves the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free marketplace. So it is a long term concept based on the cash flows rather than profits and hence there can be a situation where a business makes losses every year but there are cash profits because of heavy depreciation which indirectly suggests heavy investment in fixed assets and that is the real wealth and it takes into account the time value of money and so is universally accepted.

Profit maximization is the primary objective of the concern because of profit act as the measure of efficiency. On the other hand, wealth maximization aim at increasing the value of the stakeholders.

There is always a conflict regarding which one is more important between the two. So, in this article, you will find the significant differences between Profit Maximization and Wealth Maximization, in tabular form.

Content: Profit Maximization Vs Wealth Maximization

1. Comparison Chart
2. Definition
3. Key Differences
4. Video
5. Conclusion

Comparison Chart

Definition of Profit Maximization

Profit Maximization is the capability of the firm in producing maximum output with the limited input, or it uses minimum input for producing stated output. It is termed as the foremost objective of the company.

It has been traditionally recommended that the apparent motive of any business organisation is to earn a profit, it is essential for the success, survival, and growth of the company. Profit is a long term objective, but it has a short-term perspective i.e. one financial year.

Profit can be calculated by deducting total cost from total revenue. Through profit maximization, a firm can be able to ascertain the input-output levels, which gives the highest amount of profit. Therefore, the finance officer of an organisation should take his decision in the direction of maximizing profit although it is not the only objective of the company.

Definition of Wealth Maximization

Wealth maximizsation is the ability of a company to increase the market value of its common stock over time. The market value of the firm is based on many factors like their goodwill, sales, services, quality of products, etc.

It is the versatile goal of the company and highly recommended criterion for evaluating the performance of a business organization. This will help the firm to increase its share in the market, attain leadership, maintain consumer satisfaction and many other benefits are also there.

It has been universally accepted that the fundamental goal of the business enterprise is to increase the wealth of its shareholders, as they are the owners of the undertaking, and they buy the shares of the company with the expectation that it will give some return after a period. This states that the financial decisions of the firm should be taken in such a manner that will increase the Net Present Worth of the company’s profit. The value is based on two factors:

1. Rate of Earning per share
2. Capitalization Rate

The fundamental differences between profit maximization and wealth maximization is explained in points below:

1. The process through which the company is capable of increasing earning capacity known as Profit Maximization. On the other hand, the ability of the company in increasing the value of its stock in the market is known as wealth maximization.
2. Profit maximization is a short term objective of the firm while the long-term objective is Wealth Maximization.
3. Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which considers both.
4. Profit Maximization avoids time value of money, but Wealth Maximization recognises it.
5. Profit Maximization is necessary for the survival and growth of the enterprise. Conversely, Wealth Maximization accelerates the growth rate of the enterprise and aims at attaining the maximum market share of the economy.

Video: Profit Vs Wealth Maximization

Conclusion

There is always a contradiction between Profit Maximization and Wealth Maximization. We cannot say that which one is better, but we can discuss which is more important for a company. Profit is the basic requirement of any entity. Otherwise, it will lose its capital and cannot be able to survive in the long run. But, as we all know, the risk is always associated with profit or in the simple language profit is directly proportional to risk and the higher the profit, the higher will be the risk involved with it. So, for gaining the larger amount of profit a finance manager has to take such decision which will give a boost to the profitability of the enterprise.

In the short run, the risk factor can be neglected, but in the long-term, the entity cannot ignore the uncertainty. Shareholders are investing their money in the company with the hope of getting good returns and if they see that nothing is done to increase their wealth. They will invest somewhere else. If the finance manager takes reckless decisions regarding risky investments, shareholders will lose their trust in that company and sell out the shares which will adversely effect on the reputation of the company and ultimately the market value of the shares will fall.

Therefore, it can be said that for day to day decision making, Profit Maximization can be taken into consideration as a sole parameter but when it comes to decisions which will directly affect the interest of the shareholders, then Wealth Maximization should be exclusively considered.