SHAREHOLDER WEALTH MAXIMIZATION OBJECTIVE OF FINANCIAL MANAGEMENT —MEANING, ADVANTAGES AND LIMITATIONS

The Shareholder wealth maximization objective of financial management means increasing the value of a company so that the value of its shares increases.

The use of wealth maximization is advocated as an appropriate and operationally feasible criterion to choose among the various alternative financial actions. 

It provides a clear picture of what financial managers should aim for when making investment and financial decisions.

The wealth maximization objective believes that a company should undertake activities that produce a positive net present value.

Wealth maximization means maximizing the net present value (or wealth) of a course of action

Wealth maximization objective

The net 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 that has a positive net present value creates wealth and is therefore desirable.

Conversely, a financial action that has a negative net present value reduces wealth and should be rejected outrightly.

The wealth maximization objective also means maximizing the market price of shares.

The objective of wealth maximization takes care of the issue of timing and risk of expected benefits.

These problems are solved by selecting an appropriate discount rate for discounting the expected flow of future benefits.

It should be noted that benefits are measured in terms of cash flows 

In finance, it is the flow of cash that's important, not accounting for profit

The wealth maximization objective is considered a better objective for a firm because it takes into account the time value of the money concept as well as the risks and returns concept.

In a nutshell, the wealth maximization objective involves increasing the earnings per share of the shareholders and increasing the net present worth of the company.

Advantages Of Wealth Maximization Objectives

1. It is superior: The wealth maximization objective is considered superior to the profit maximization objective because it focuses on the long-term growth and development of an organization. 

It is a general belief among financial analysts that wealth maximization is the best objective that a company can pursue.

2. Considers the time value of money concept: Wealth maximization considers the timing of cash flows as cash flows that occur at different periods are discounted using appropriate discount rates.

This helps the management in achieving the overall objectives of the business.

3. Considers risk: The wealth maximization objective also considers the risk associated with potential cash flows.

This is easily achieved through discount rates. The higher the discount rate, the higher the risk; the lower the discount rate, the lower the risk.

4. It is precise and clear: Shareholders' wealth maximization is based on cash flows rather than profit.

The net present value of a financial can be measured quantitatively,

Indeed, the use of cash flow in wealth maximization helps eliminate ambiguity regarding the exact meaning of the word profit.

5. It maximizes the returns of the owners: The wealth maximization objective is essentially about maximizing the returns of the owners (shareholders).

Indeed, financial decisions are made in a way that maximizes the dividend paid to shareholders while also increasing the stock market price.

6. Considers the interest of major shareholders: The wealth maximization objective takes into account the interests of owners, workers, financial institutions, and society.

This is why it is widely accepted as the best objective that a firm can pursue in finance

7. Less prone to manipulations: Profit can be manipulated by inflating the value of income or changing depreciation methods.

Wealth maximization is not based on profit, rather it is based on cash flows, which are less prone to manipulation.

Limitations Or Criticisms Of The Wealth Maximization Objectives

Even though wealth maximization is often viewed as the best objective for a company, it has the following drawbacks:

1. Unsuitable for small businesses: Wealth maximization is mostly suitable for large businesses like corporations.

Because Small businesses such as sole proprietorships usually have limited resources, they prefer to maximize profit first.

2. Tradeoff between dividends and retained earnings: There is a tradeoff between distributing profits to shareholders (dividends) and retaining profit for investment purposes (retained earnings).

If a company pays out too many dividends, it would not have enough funds to invest in productive activities that can increase its worth.

On the other hand, if a company retains too many funds, shareholders may be dissatisfied as some shareholders depend heavily on dividend income.

Thus, a wealth-maximizing firm is also limited by the tradeoff between dividends and retained earnings.

3. Conflict of interest: In most large organizations, the management (board of directors) is separate from the ownership (shareholders).

There can be a conflict of interest if the business is managed in such a way that management's interest is maximized while shareholders' interests are neglected

4. Dependent on profitability:  To some extent, the wealth maximization goal is dependent on profitability, as a company can only consider maximizing shareholder wealth after it has made a sufficient profit.

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