Question 2 OR (a)

Is profit maximisation a better criterion than wealth maximisation?

4 marks

Time to write
About 8 minutes

From an older CBCS paper

Question

Question 2 OR (a) · 4 marks

As a criterion, profit maximisation is better than wealth maximisation. Do you agree? Explain.

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Read from the question

  • ExplainA statement to explain: say what it means first, then build the answer around it.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Verdict ½ mark 2 min
  3. 2 Weaknesses of profit maximisation 1½ marks 2 min
  4. 3 Why wealth maximisation is better 2 marks 3 min

Short on time? Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks.

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

No, I do not agree: wealth maximisation is the better criterion.

Weaknesses of profit maximisation

  1. It ignores risk: every profitable project is accepted, however risky.
  2. It ignores the financing side and the risk of the way a decision is financed.
  3. It ignores timing: returns are compared without regard to when they come, so the time value of money is ignored.
  4. It is vague: short-term or long-term profit, before or after tax?

For these reasons the DU text describes profit maximisation as inappropriate and unsuitable as an operational objective of financial management.

Picture itIs profit maximisation a better criterion than wealth maximisation?

1Quick cash today: the deal is struck even as the godown behind them crumbles.

Weaknesses of profit maximisationIt ignores the risk of the profits; it ignores the timing of costs and returns.

2Asha weighs time against risk on the scale—and the share price curve climbs behind her.

Strengths of wealth maximisationIts result is visible in the market price of the share.

Why wealth maximisation is better. Wealth (value) maximisation judges a decision by the present value of the cash flows it generates, discounted at a rate that reflects their risk:

  • it uses cash flows, which are precise, rather than an ambiguous profit figure;
  • it allows for the timing of the returns, through discounting, and for risk, through the discount rate;
  • it is reflected in the market price of the share, so its result can be observed.

Because it removes the technical limitations of profit maximisation, value maximisation is universally accepted as the operational decision criterion of financial management.

Where the 4 marks sit

#ComponentMarks
1Verdict0.5
2Weaknesses of profit maximisation1.5
3Why wealth maximisation is better2
Total4
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