Question 1 (a)
Why profit maximisation is inappropriate; justifying wealth maximisation
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 1 (a) · 8 marksAs the goal of financial management, why is it inappropriate to seek profit maximization? How would you justify adopting wealth maximization as an apt substitute for it?
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
- Why…?How…?Two asks in one question: answer both.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Why profit maximisation is inappropriate 3½ marks 6 min
- 2 Wealth maximisation: meaning and features 2 marks 3 min
- 3 Justification: comparison 2 marks 3 min
- 4 Note of balance ½ mark 2 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Step 2 opens with the meaning: a one-line definition, the quickest mark in it.
Short on time? Trim steps 1–3 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 16 minutes for 8 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.
Meaning of shareholders' wealth maximisation. Wealth maximisation, also called value maximisation or net present wealth maximisation, holds that the finance manager should take the decisions that maximise the present value of the shareholders' benefits. A decision is judged by its economic value: the present value of the cash flows it generates, discounted at a rate that reflects their timing and risk.
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.
- Shareholders' wealth = number of shares × market price per share; in an efficient market the share price reflects the present value of the dividends and other benefits shareholders expect.
- So a decision that adds to the net present value of the firm raises the share price and the wealth of the shareholders.
- Its features: it is based on cash flows, not accounting profit; it accounts for the time value of money by discounting; and it accounts for risk through the discount rate.
Profit maximisation. The traditional objective: take each decision so as to maximise the firm's profit. As an operational guide it has serious weaknesses:
- Vagueness: "profit" may mean short-term or long-term, total or rate of profit, before or after tax.
- It ignores risk: risky proposals usually promise higher profits; maximising profit alone would accept them.
- It ignores the timing of returns: a project with larger profits ten years away is preferred to one with smaller but earlier profits; the time value of money is ignored.
- It is too narrow: it ignores social considerations and obligations to workers, consumers and society.
Why wealth maximisation is superior
| Point | Profit maximisation | Wealth maximisation |
|---|---|---|
| Measure of benefit | Accounting profit, a vague concept | Cash flows, precise |
| Time value of money | Ignored | Built in by discounting |
| Risk | Ignored | Built in by the discount rate |
| Basis for decisions | Not operational | Present value: a clear accept/reject rule (NPV > 0) |
| Link to owners | Indirect | Direct: reflected in the market price of the share |
| Time horizon | Tends to the short run | Long run |
Because it removes each technical limitation of profit maximisation, value maximisation is universally accepted as the operational decision criterion of financial management, and in today's uncertain, multi-period conditions it is the better objective.
A note of balance. Wealth maximisation does not mean ignoring other stakeholders: a firm that treats employees, customers and society badly is unlikely to sustain its value. Managers, as agents, may also pursue their own goals (the agency problem), which is why their incentives are linked to the share price.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Why profit maximisation is inappropriate | 3.5 |
| 2 | Wealth maximisation: meaning and features | 2 |
| 3 | Justification: comparison | 2 |
| 4 | Note of balance | 0.5 |
| Total | 8 |
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