Wealth maximization
Introduction
Wealth maximization means maximizing the net present value (or wealth) of a course of action. The neat present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which has a positive net present value creates wealth and therefore it is desirable. Wealth maximization objective is a widely recognized criterion with which the performance a business enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth maximization is also stated as net present worth. Net present worth is difference between gross present worth and the amount of capital investment required to achieve the benefits. Gross present worth represents the present value of expected cash benefits discounted at a rate, which reflects their certainty or uncertainty. Thus, wealth maximization objective as decisional criterion suggests that any financial action, which creates wealth or which, has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected.
Scope of financing to the Business Organization. According to the modern approach, the function of finance is concerned with the following three types of decisions - Financing decisions, Investment decisions, and Dividend policy decisions. The core objective of stockholder wealth maximization is highest market value of common stock which emphasizes the long-term, recognizes risk or uncertainty, recognizes the timing of returns, and considers stockholders’ return.
Normative dimensions
According to (Boatright, 2010) the descriptive, instrumental and normative dimensions of shareholder wealth maximization are mutually supporting. The descriptive dimension concerns a particular empirical view of laws, markets, motives and behaviors. The view posits relatively efficient markets, market-oriented institutions, and self interested economic rationality. Descriptively, the view that management (i.e, officers and directors) has strong fiduciary duties on behalf of shareholders, which are established by law and enforced by the market for corporate control. The instrumental dimension concerns the prescriptively best approach to managing a public corporation on behalf of the shareholders and handling the interests of multiple stakeholders in the corporation and its activities. The prescription is that shareholder wealth maximization will most efficiently and effectively advance the interests of shareholders and stakeholders and thus social welfare in a market economy.
Company’s common stock
Shareholders’ wealth is represented in the market price of the company’s common stock, which, in turn, is the function of the company’s investment; financing and dividend decision3.Managements' primary goal is shareholders' wealth maximization, which translates into maximizing the value of the company as measured by the price of the company’s common stock. Shareholders like cash dividends, but they also like the growth in EPS that results from ploughing earning back into the busines5s. The optimal dividend policy is the one that maximizes the company's stock price which leads to maximization of shareholders' wealth and thereby ensures more rapid economic growth.
(International Research Journal of Finance and Economics, 2008)
Time value of money
The wealth maximization objective considers time value of money. It recognizes that cash benefits emerging from a project in different years are not identical in value. This is why annual cash benefits of a project are discounted at a discount rate to calculate total value of these cash benefits. At the same time, it also gives due weightage to risk factor by making necessary adjustments in the discount rate. Thus, cash benefits of a project with higher risk exposure is discounted at a higher discount rate (cost of capital), while lower discount rate applied to discount expected cash benefits of a less risky project. In this way, discount rate used to determine present value of future streams of cash earning reflects both the time and risk. (http://www.mbaknol.com/business-finance/)
Wealth maximization goal as decision criteria suggests that any financial action which creates wealth or which has discounted stream of future benefits exceeding its cost, is desirable and should be accepted and that which does not satisfy this test should be rejected. The goal of wealth maximization is supposed to be superior to the goal of profit maximization due to the following reasons:
a) It uses the concept of future expected cash flows rather than the ambiguous term of profits. As such measurement of benefits in terms of cash flows avoids ambiguity.
b) It considers time value of money. It recognizes that the cash flows generated earlier are more valuable than those generated earlier. That is why while computing value of total benefits; the cash flows are discounted at a certain discounting rate. At the same time, it recognizes the concept of risk also, by making necessary adjustments in discounting rate. As such, cash flows of a project involving higher risk are discounted at a higher discounting rate and vise versa. Thus, the discounting rate used to discount future cash flows reflects the concepts of both time and risk.
Cost
The value of an asset is judged not in terms of its cost but in terms of the benefit it produces. Similarly the value of a course of action is judged in terms of benefits it produces less the cost of undertaking it. The benefits can be measured in terms of stream of future expected cash flows, but they must take into consideration not only their magnitude but also the extent of uncertainty. Investing in wealth maximization approaches may experience losses in the short-run but yield substantial profit in the long-run. Also, a firm that wants to show a short-term profit may, for example, postpone major repairs or replacement, although such postponement is likely to hurt its long-term profitability. (Putra, 2010).
Financial decision making
Effective financial decision making requires an understanding of the goal(s) of the firm. What objectives should guide business decision making—that is what should management t try achieve for the owners of the firm? The most widely accepted objective of the firm is to maximize the value of the firm for its owners that is to maximize shareholder wealth. Shareholder wealth is represented by the market price of the firm’s common stock (Moyer, et.al, 2009)
According to (Ellsworth, 2002) in this time of great paradox the allegiance of maximization of shareholder wealth is stronger than ever before; yet the importance of shareholder’s contribution to competitive advantage has never been smaller. Capital is readily available and has given way to knowledge—to the ingenuity and dedication of people—as the key to competitive advantage and wealth creation.
Critique
Much has been spoken about wealth maximization but there is a school of thought with a view that wealth maximization does not necessary lead to economic development. Wealth maximization excludes distributional considerations in that many people in the public sphere especially the poor may be excluded and therefore it may lead to unfairness especially in an economy controlled by forces of demand and supply. Another critique is that even though wealth maximization tries to predict the future, future economic performances can be volatile and unpredictable the best example being the world financial crisis otherwise known as the credit crunch.
Conclusion
It is now accepted that the objective of the business should be to maximize its wealth and value of shares of the company. The object can also be stated as maximization of the value.
References
Boatright, John, R (2010) (Ed) Finance Ethics: Critical Issues in Theory and Practice. John, Wiley, Hoboken.
Ellsworth, Richard R (2002) leading with purpose: the new corporate realities. Stanford University Press, Stanford.
International Research Journal of Finance and Economics (2008) ISSN 1450-2887 Issue 20 EuroJournals Publishing, Inc. http://www.eurojournals.com/finance.ht
Moyer, Charles, James, et.al (2009) Contemporary Financial Management 11th edition
Cengage learning, New York.
Putra (2010) Profit vs. Stockholder Wealth Maximization, New Delhi
http://www.mbaknol.com/business-finance/
Wealth maximization means maximizing the net present value (or wealth) of a course of action. The neat present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which has a positive net present value creates wealth and therefore it is desirable. Wealth maximization objective is a widely recognized criterion with which the performance a business enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth maximization is also stated as net present worth. Net present worth is difference between gross present worth and the amount of capital investment required to achieve the benefits. Gross present worth represents the present value of expected cash benefits discounted at a rate, which reflects their certainty or uncertainty. Thus, wealth maximization objective as decisional criterion suggests that any financial action, which creates wealth or which, has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected.
Scope of financing to the Business Organization. According to the modern approach, the function of finance is concerned with the following three types of decisions - Financing decisions, Investment decisions, and Dividend policy decisions. The core objective of stockholder wealth maximization is highest market value of common stock which emphasizes the long-term, recognizes risk or uncertainty, recognizes the timing of returns, and considers stockholders’ return.
Normative dimensions
According to (Boatright, 2010) the descriptive, instrumental and normative dimensions of shareholder wealth maximization are mutually supporting. The descriptive dimension concerns a particular empirical view of laws, markets, motives and behaviors. The view posits relatively efficient markets, market-oriented institutions, and self interested economic rationality. Descriptively, the view that management (i.e, officers and directors) has strong fiduciary duties on behalf of shareholders, which are established by law and enforced by the market for corporate control. The instrumental dimension concerns the prescriptively best approach to managing a public corporation on behalf of the shareholders and handling the interests of multiple stakeholders in the corporation and its activities. The prescription is that shareholder wealth maximization will most efficiently and effectively advance the interests of shareholders and stakeholders and thus social welfare in a market economy.
Company’s common stock
Shareholders’ wealth is represented in the market price of the company’s common stock, which, in turn, is the function of the company’s investment; financing and dividend decision3.Managements' primary goal is shareholders' wealth maximization, which translates into maximizing the value of the company as measured by the price of the company’s common stock. Shareholders like cash dividends, but they also like the growth in EPS that results from ploughing earning back into the busines5s. The optimal dividend policy is the one that maximizes the company's stock price which leads to maximization of shareholders' wealth and thereby ensures more rapid economic growth.
(International Research Journal of Finance and Economics, 2008)
Time value of money
The wealth maximization objective considers time value of money. It recognizes that cash benefits emerging from a project in different years are not identical in value. This is why annual cash benefits of a project are discounted at a discount rate to calculate total value of these cash benefits. At the same time, it also gives due weightage to risk factor by making necessary adjustments in the discount rate. Thus, cash benefits of a project with higher risk exposure is discounted at a higher discount rate (cost of capital), while lower discount rate applied to discount expected cash benefits of a less risky project. In this way, discount rate used to determine present value of future streams of cash earning reflects both the time and risk. (http://www.mbaknol.com/business-finance/)
Wealth maximization goal as decision criteria suggests that any financial action which creates wealth or which has discounted stream of future benefits exceeding its cost, is desirable and should be accepted and that which does not satisfy this test should be rejected. The goal of wealth maximization is supposed to be superior to the goal of profit maximization due to the following reasons:
a) It uses the concept of future expected cash flows rather than the ambiguous term of profits. As such measurement of benefits in terms of cash flows avoids ambiguity.
b) It considers time value of money. It recognizes that the cash flows generated earlier are more valuable than those generated earlier. That is why while computing value of total benefits; the cash flows are discounted at a certain discounting rate. At the same time, it recognizes the concept of risk also, by making necessary adjustments in discounting rate. As such, cash flows of a project involving higher risk are discounted at a higher discounting rate and vise versa. Thus, the discounting rate used to discount future cash flows reflects the concepts of both time and risk.
Cost
The value of an asset is judged not in terms of its cost but in terms of the benefit it produces. Similarly the value of a course of action is judged in terms of benefits it produces less the cost of undertaking it. The benefits can be measured in terms of stream of future expected cash flows, but they must take into consideration not only their magnitude but also the extent of uncertainty. Investing in wealth maximization approaches may experience losses in the short-run but yield substantial profit in the long-run. Also, a firm that wants to show a short-term profit may, for example, postpone major repairs or replacement, although such postponement is likely to hurt its long-term profitability. (Putra, 2010).
Financial decision making
Effective financial decision making requires an understanding of the goal(s) of the firm. What objectives should guide business decision making—that is what should management t try achieve for the owners of the firm? The most widely accepted objective of the firm is to maximize the value of the firm for its owners that is to maximize shareholder wealth. Shareholder wealth is represented by the market price of the firm’s common stock (Moyer, et.al, 2009)
According to (Ellsworth, 2002) in this time of great paradox the allegiance of maximization of shareholder wealth is stronger than ever before; yet the importance of shareholder’s contribution to competitive advantage has never been smaller. Capital is readily available and has given way to knowledge—to the ingenuity and dedication of people—as the key to competitive advantage and wealth creation.
Critique
Much has been spoken about wealth maximization but there is a school of thought with a view that wealth maximization does not necessary lead to economic development. Wealth maximization excludes distributional considerations in that many people in the public sphere especially the poor may be excluded and therefore it may lead to unfairness especially in an economy controlled by forces of demand and supply. Another critique is that even though wealth maximization tries to predict the future, future economic performances can be volatile and unpredictable the best example being the world financial crisis otherwise known as the credit crunch.
Conclusion
It is now accepted that the objective of the business should be to maximize its wealth and value of shares of the company. The object can also be stated as maximization of the value.
References
Boatright, John, R (2010) (Ed) Finance Ethics: Critical Issues in Theory and Practice. John, Wiley, Hoboken.
Ellsworth, Richard R (2002) leading with purpose: the new corporate realities. Stanford University Press, Stanford.
International Research Journal of Finance and Economics (2008) ISSN 1450-2887 Issue 20 EuroJournals Publishing, Inc. http://www.eurojournals.com/finance.ht
Moyer, Charles, James, et.al (2009) Contemporary Financial Management 11th edition
Cengage learning, New York.
Putra (2010) Profit vs. Stockholder Wealth Maximization, New Delhi
http://www.mbaknol.com/business-finance/
posted by mwesigye herbert at 7:27 AM
0 Comments:
Post a Comment
<< Home