Short Note on Wealth Maximization
According to this objective, the owners of the company i.e. the shareholders are more interested in maximizing their wealth rather than in profit maximization. Maximization of the wealth of the shareholders means maximizing the net worth of the company for its shareholders. This reflected in the market price of the shares held by them. Therefore, wealth maximization means creation of maximum value for company’s shareholders which mean maximizing the market price of the share. Wealth maximization refers to the gradual increase in value of the net assets of the organization. Profit generation adds to the increase in the value of the net assets of the organization. With greater profits, the EPS (earnings per share) goes up; resulting an increase in the value of the net assets belonging to the shareholders of the company.
The market price of the shares is an important indicator of the wealth maximization of the organization. Wealth maximization is the net present value of a financial decision. Net present value is the difference between the gross present value of the revenue generated from such decision and the cost of such decision. A financial action with a positive net present value creates wealth and therefore is desirable. The total cash inflows over the years in terms of present value must be greater the outflows of cash invested for generating such cash inflows. This results in financial advantage leading to increase in the value of net assets. The increase in the value of net wealth should in turn help in generating greater volume of profits. This action results in financial gains to the shareholders increasing the earnings per share.
Prof. Solomon has suggested wealth maximization as the best criterion. According to him “Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does meet this test should be rejected”.
Solomon states that wealth maximization provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decisions.
Future earnings of a company are subject to uncertainties and exposed to risk. Financial decisions for which the consequences are known at a later date may either result in increasing or decreasing the net wealth of the shareholders. Unforeseen economic and social conditions may adversely affect the company. Hence the process of wealth generation is a difficult task.
Therefore, the goal of wealth maximization implies a long term perspective of the goal. The interest of the management in maximizing the market price of the share is compatible with that of the shareholders’ interest. This helps the management in allocating the resources in the best possible manner balancing the risks and the returns.