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Wealth Maximisation

5.1. Definition

Wealth maximization focuses on improving the value or wealth of the shareholders. It's also known as value maximization or net present worth maximization. Wealth maximization considers:

  • The comparison of value to cost
  • Total value less the total cost
  • Time and risk

5.2. Key Characteristics

  • Cash Flow Based: It uses cash flows rather than accounting profit as its basis.
  • Long-Term Focus: It has a long-term perspective.
  • Time Value of Money: It considers the time value of money.
  • Risk Considerations: It acknowledges and accounts for risk.

5.3. Wealth Maximization as a Superior Goal

The goal of maximizing the value of the stock helps to avoid the problems associated with the different goals discussed earlier. Good financial decisions increase the market value of the owners’ equity, and poor financial decisions decrease it. Financial managers serve owners by adding value to the firm through effective investment, financing, and dividend decisions.

5.4. How Wealth Maximization Overcomes Profit Maximization Shortcomings

  • Planning Duration: Wealth maximization has a long-term perspective that supports long-term objectives like discretionary spending and investment.
  • Risk Management: Wealth maximization is more likely to pay for hedging strategies to reduce risk, unlike profit maximization which emphasizes expense minimization.
  • Pricing Strategy: Wealth maximization supports more strategic decisions like reducing prices to build market share, while profit maximization supports high prices for higher margins.
  • Capacity Planning: Wealth maximization favors more investment in capacity for long-term growth over short-term sales.

Wealth maximization overcomes these flaws:

  • Cash-Flow Based: It focuses on cash flows instead of accounting profits.
  • Time and Risk Adjustment: It uses discounting to account for both time and risk, bringing future cash flows back to their present value.
  • Precise and Unambiguous: It is a precise concept based on comparing value to cost.

5.5. Net Present Worth Calculation

The net present worth (W) is calculated as:

  • W = V - C

    • W = Net present worth
    • V = Gross present worth
    • C = Investment required

Where V (Gross Present Worth) is calculated as E/K. Where:

  • E = Size of future benefits available to the suppliers of the input capital
  • K = The capitalization (discount) rate reflecting the quality and timing of benefits attached to E.

Where E (Size of future benefits) is calculated as G-(M+I+T):

  • G = Average future flow of gross annual earnings expected from the course of action.
  • M = Average annual reinvestment required to maintain G at the projected level.
  • T = Expected annual outflow on account of taxes.
  • I = Expected flow of annual payments on account of interest, preference dividends and other prior charges.

An alternative formula for Wealth (net present value) is:

  • W = (A1/(1+K)) + (A2/(1+K)^2) + ... + (An/(1+K)^n) - C

    • A1, A2, …, An are the cash flows.
    • K is the appropriate discount rate to measure risk and timing.
    • C is the initial investment

5.6. Operationalizing Wealth Maximization

Wealth maximization is implemented by:

  • Maximizing the market value of shares, since the wealth of the owners is reflected in the market value of their shares.

5.7. Economic Value Added (EVA)

EVA is a measure that determines if an investment increases shareholder wealth. It is the difference between a firm's after-tax operating profit and the cost of funds used to finance investments. A positive EVA signifies an increase in owners' wealth and should be accepted.

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