Question 1 (a)
Why modern finance aims at shareholders' wealth, not profit
6 marks
- Time to write
- About 12 minutes
Question
Question 1 (a) · 6 marksModern finance functions aim at maximizing the net worth of shareholders, not the profits of the business. Elucidate.
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
- ElucidateA statement to explain: say what it means first, then build the answer around it.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of the statement 1 mark 1 min
- 2 Limitations of profit maximisation 2 marks 4 min
- 3 Wealth maximisation: present value, cash flows, risk and timing, share price 2 marks 4 min
- 4 Conclusion 1 mark 1 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Meaning of the statement (step 1, 1 mark): a definition in one or two lines. It opens the answer, so it takes a minute or two.
Short on time? Keep step 1 short. Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks. End with step 4 in a line or two.
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.
The statement. Modern financial management takes as its goal the maximisation of shareholders' wealth (net worth), measured by the market value of their shares, rather than the maximisation of the firm's profit. The reason is that profit maximisation, though a natural aim, cannot guide financial decisions properly, while wealth maximisation can.
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 profit maximisation is set aside
- It ignores risk. All profitable opportunities are taken up, whatever the risk attached to them.
- It ignores the financing side. It looks at profitability only, not at how a decision is financed and the risk of that financing; a firm might borrow beyond its capacity to fund a profitable project.
- It ignores timing. It does not consider when costs and returns arise, so it ignores the time value of money.
- It is vague. It does not say whether short-term or long-term, before-tax or after-tax profit is meant.
For these reasons the DU text calls profit maximisation inappropriate and unsuitable as an operational objective, and names shareholders' wealth maximisation as its alternative.
Why wealth maximisation is preferred
- It judges a decision by the present value of the cash flows it brings, discounted at a rate that reflects their risk and timing, so all three defects above are removed.
- It is based on cash flows, which are definite, rather than on accounting profit.
- Shareholders' wealth is reflected in the market price of the share, so a decision that raises the share price raises net worth; the finance manager has a clear, measurable target.
Conclusion. Profit still matters, since it is the source of cash flows and dividends, but the operational goal of modern finance functions is to maximise the net worth of the shareholders, because only that objective takes account of the amount, timing and risk of the benefits.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of the statement | 1 |
| 2 | Limitations of profit maximisation | 2 |
| 3 | Wealth maximisation: present value, cash flows, risk and timing, share price | 2 |
| 4 | Conclusion | 1 |
| Total | 6 |
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