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Profit Maximisation

1. Introduction

The primary goal of financial management is to guide a firm's investment and financing decisions. While profit maximization was traditionally considered the key objective, the modern consensus favors wealth maximization as the more appropriate and effective guiding principle.

2. Profit Maximization

2.1. Definition

Profit maximization aims to maximize a company's profits. Actions that increase profits should be undertaken, while those that decrease profits should be avoided. The term "profit" can be used in two senses:

  • Owner-Oriented: The amount of national income paid to the owners of a business (equity holders).
  • Operational Concept: Profitability, a measure of economic efficiency. It signifies the economic efficiency of business.

2.2. Rationale

The underlying idea is simple: profit is a measure of efficiency, a yardstick for performance, and a driving force for efficient resource allocation. It is also a source of finance and a way to meet social needs.

2.3. Shortcomings of Profit Maximization

Despite its apparent simplicity, profit maximization has several critical flaws:

  1. Ambiguity and Vague Definition of Profit: The term "profit" lacks a precise definition. It can be:

    • Short-term or long-term
    • Total profit or rate of profit
    • Net profit before or after tax
    • Return on total capital, assets, or shareholder equity

    This ambiguity makes it difficult to use profit as a clear operational objective.

  2. Ignores Time Value of Money: Profit maximization does not consider the time value of money, which is the idea that a dollar today is worth more than a dollar in the future due to its earning potential. It treats all profits the same regardless of when they are received.

  3. Ignores Quality Aspects: It ignores the certainty or risk associated with expected benefits. More certain returns are preferred over less certain ones.

  4. Ignores Risk: Profit maximization ignores risks, which can be internal or external.

In summary, profit maximization:

  • Is vague and lacks a clear definition
  • Disregards the timing of returns
  • Disregards risk

3. Maximizing Profit After Taxes

Maximizing profits after tax means maximizing net profit as reported on the income statement. However, this does not always maximize the economic welfare of owners:

  • A firm may increase profit after taxes by selling additional shares and investing in low-yielding assets, increasing profits, but reducing Earnings Per Share (EPS).

Example:

  • A company with 20,000 shares outstanding and Rs 100,000 profit has EPS of Rs 5.
  • Issuing 20,000 more shares and investing at a 5% return increases profit to Rs 150,000.
  • EPS falls to Rs 3.75, decreasing shareholder value.

4. Maximizing EPS (Earnings per Share)

EPS is a widely used measure of profitability, indicating how much money a company makes for each outstanding share. However, maximizing EPS also does not maximize the economic welfare of owners:

  • It ignores timing and risk

Therefore, maximizing profit after taxes or EPS is inadequate because it fails to take into account the timing and uncertainty of the benefits.

5. Technical Flaws of Profit Maximization

Profit maximization suffers from:

  • Ambiguity: The term "profit" is vague and subject to varying interpretations.
  • Timing of Benefits: It ignores that benefits received earlier are more valuable than later benefits.
  • Quality of Benefits: It disregards the degree of certainty of future benefits and ignores the risk of uncertainty.

Example of Time Value:

  • Alternative A: Returns Rs 50 (year 1), Rs 100 (year 2), and Rs 50 (year 3).
  • Alternative B: Returns Rs 0 (year 1), Rs 100 (year 2) and Rs 100 (year 3).
  • Profit maximization would say both are the same as they have total returns of Rs 200.
  • Wealth maximization will give greater value to Alternative A, as more returns come earlier.

Example of Uncertainty:

  • Alternative A: Returns Rs 9, Rs 10, and Rs 11 during recession, normal and boom respectively.
  • Alternative B: Returns Rs 0, Rs 10, and Rs 20 during recession, normal and boom respectively.
  • Profit maximization would say both are the same as they have total returns of Rs 30.
  • Wealth maximization will give greater value to Alternative A, as returns are more certain
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