Question 1 (a)

Profit maximisation and wealth maximisation

6 marks

Time to write
About 12 minutes
Topic
Nature, scope and objectives of financial management

Question

Question 1 (a) · 6 marks

Explain the concepts of profit maximisation and of wealth maximisation. Which one of the two is a better operational guide for finance manager?

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

12 minfor 6 marks

Read from the question

  • Explain…Which…?Two asks in one question: answer both.
  • Which one of the two is…End with a clear choice and the reason for it.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Profit maximisation explained, with its limitations risk, financing, timing, vagueness 2 marks 3 min
  3. 2 Wealth maximisation explained: present value of cash flows, risk and timing, market price of the share 2 marks 3 min
  4. 3 Wealth maximisation identified as the better operational guide, with reasons 2 marks 3 min
  5. Check: every ask answered, key terms underlined 2 min

Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.

Try it first. About 12 minutes for 6 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.

Profit maximisation. Under this objective the finance manager takes the decisions that raise the firm's profit, profit being treated as the yardstick of the firm's economic efficiency. As an operational guide it has four serious weaknesses:

Picture itProfit maximisation and 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.

  1. It ignores risk. Every profitable investment is taken up, whatever the risk attached to it.
  2. It ignores the financing side. It looks only at profitability, not at how a decision is financed and the risk of that financing; a firm may borrow beyond its capacity to fund a profitable project.
  3. It ignores timing. Costs and returns are compared without regard to when they arise, so the time value of money is ignored.
  4. It is vague. "Profit" may mean short-term or long-term profit, before or after tax; the objective does not say.

A variant, maximising the return on investment, steers decisions the same way. The DU text therefore 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 measures a decision by its economic value: the present value of the future cash flows the decision generates, discounted at a rate that reflects their risk, so a riskier or more distant flow is discounted more heavily. Three features follow:

  • it is based on cash flows, not accounting profit;
  • it takes account of the timing of the cash flows and of their risk, through discounting;
  • shareholders' wealth is the present value of the dividends and other benefits they expect, which the market price of the share reflects, so a decision that raises the share price raises shareholders' wealth.

Which is the better operational guide. Wealth maximisation. It removes each technical weakness of profit maximisation: risk, timing and the precise meaning of the benefit are all built into the present value of cash flows. It is the criterion the DU text describes as universally accepted for financial decisions. The finance manager should therefore choose, among the alternatives open, the one that adds most to the present value of the shareholders' expected benefits, which in an efficient market shows up in the share price.

Where the 6 marks sit

#ComponentMarks
1Profit maximisation explained, with its limitations (risk, financing, timing, vagueness)2
2Wealth maximisation explained: present value of cash flows, risk and timing, market price of the share2
3Wealth maximisation identified as the better operational guide, with reasons2
Total6
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