Question 1 (a)
Wealth maximisation versus profit maximisation
5 marks
- Time to write
- About 10 minutes
From an older CBCS paper
Question
Question 1 (a) · 5 marksDo you agree that "Wealth maximization is better criterion than Profit maximization"? 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
Read from the question
- agreeA statement to judge: take a stand on it in your first line, and come back to it at the end.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Profit maximisation and its weaknesses risk, financing, timing, vagueness 2 marks 3 min
- 2 Wealth maximisation: present value of cash flows, risk and timing, share price 2 marks 3 min
- 3 Conclusion, with reasons 1 mark 2 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks. End with step 3 in a line or two.
Try it first. About 10 minutes for 5 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.
Yes: wealth maximisation is the better criterion.
Profit maximisation and its weaknesses. Under this objective the finance manager takes the decisions that raise the firm's profit, profit being the yardstick of economic efficiency. As an operational criterion it has serious weaknesses:
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.
- It ignores risk: every profitable investment is taken up, whatever the risk attached to it.
- It ignores the financing side: it looks only at profitability, not at how a decision is financed or the risk of that financing.
- It ignores timing: costs and returns are compared without regard to when they arise, so the time value of money is ignored.
- It is vague: "profit" may mean short-term or long-term profit, before or after tax.
The DU text concludes that profit maximisation is inappropriate and unsuitable as an operational objective of financial management.
Wealth maximisation. Also called value maximisation or net present wealth maximisation, it judges a decision by its economic value: the present value of the future cash flows it generates, discounted at a rate that reflects their risk. So it:
- is based on cash flows, not accounting profit;
- takes account of the timing and the risk of the cash flows, through discounting;
- is reflected in the market price of the share, since shareholders' wealth is the present value of the benefits they expect.
Why it is better. It removes each technical limitation of profit maximisation (risk, timing and the precise meaning of the benefit are all built into the present value of cash flows), which is why value maximisation is universally accepted as the operational decision criterion of financial management.
Where the 5 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Profit maximisation and its weaknesses (risk, financing, timing, vagueness) | 2 |
| 2 | Wealth maximisation: present value of cash flows, risk and timing, share price | 2 |
| 3 | Conclusion, with reasons | 1 |
| Total | 5 |
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