SHAREHOLDER WEALTH MAXIMIZATION VS PROFIT MAXIMIZATION (DIFFERENCES)

There are two major objectives of financial management, namely: Shareholders' wealth maximization and profit maximization.

Before we look at the differences between these two objectives, Let's define each objective.

Shareholder wealth maximization

This is the dominant objective in finance and financial management.

Shareholder wealth maximization states that a business should engage in activities that increase its worth and increase the value of its shareholders.

The shareholder wealth maximization objective believes in maximizing the returns to shareholders or increasing the values of stocks held by shareholders.

The shareholder's wealth maximization objective has been advocated for the following reasons:

1. It is a superior objective to profit maximization as it focuses on the long term growth and development of the company.

2. It takes into account the interest of various stakeholders (such as financial institutions, owners, employees) of the business.

3. It takes into account the time value of money concept by discounting cash flows that occurred at different periods using different discount rates

4. It also considers the risk and uncertainty of cash flows

On the flip side, shareholder wealth maximization objective has been chastised for the following reasons:

1. There is a trade-off between dividend payment and retaining earnings

2. Conflict of interest may arise if the business management (board of directors) is different from its owners (shareholders)

3. It is also dependent on profitability.

Profit maximization objective

This is the dominant objective in economics. According to the profit maximization objective, a business should engage in activities that produce the most profit.

In other words, the profit maximization objective states that a company's financial actions and decisions should be driven by the desire to make the largest profit possible.

The profit maximization objective is advocated for the following reasons:

1. It encourages businesses to work harder and more efficiently.

2. It encourages the efficient utilisation of resources by encouraging businesses to devote more resources to profitable goods and services and less to unprofitable goods and services

3. Profit serves as a measure of financial stability.

On the negative side, profit maximization has been criticized for the following reasons

1. It is vague because profit is not precisely defined

2. It ignores the time value of the money concept

3. It ignores risk and uncertainty because it only considers the size of an earning stream.

4.  In today's world, where markets are imperfectly competitive, profit maximization cannot be the only objective of a firm

Differences between wealth maximization objective and profit maximization objective.

1. While the profit maximization objective focuses on increasing the profit of a business, the wealth maximization objective focuses on increasing the value of its shares.

2. The wealth maximization objective takes into account the time value of the money concept, whereas the profit-maximization objective does not.

3. Wealth maximization objective considers risk and uncertainty associated with cash flows whereas profit maximization does not

4. While profit maximization is a short term objective, wealth maximization is a long term objective

5. The profit maximization objective is based on profits, whereas the wealth maximization objective is based on cash flows

6. Profit maximization objective neglect the interest of stakeholders of the business such as consumers, employees.

For example, profit-maximizing have been known to charge ridiculously high prices to consumers in a bid to earn maximum profit.

In contrast, the wealth maximization objective incorporates the interests of various stakeholders of the businesses.

7. Profit maximization is the dominant objective in economics whereas wealth maximization is the dominant objective in financial management

8. Profit maximization objective neglects the effect of a company's dividend policy on the market price of the share.

In contrast, Wealth maximization considers the effect of dividend policy on the market price of shares.

9. While there is some ambiguity about what profit means in the profit maximization objective, there is none in the wealth maximization objective, which uses cash flow instead of profit.

10. Finally, Wealth maximization is a more modern financial management objective than profit maximization, which is a more narrow and traditional objective of financial management.

Got questions? do well to ask me in the comment box.

Alternatively, you can also our telegram community here

Help us grow our readership by sharing this post

Related Posts

Post a Comment

Subscribe Our Newsletter