Differences between Wealth Maximisation and Profit Maximisation as Company Objectives - Essay Example

The Finance Management Objectives: Wealth Maximisation and Profit Maximisation Introduction Business organisations usually place greater emphasis ona particular objective, such as maximising profit or returns to the shareholders. Financial management, in fact, has two primary objectives: profit maximisation and wealth maximisation. A company’s financial performance can be assessed by examining its financial outcomes and/or its equity’s value in the market. This essay tries to answer the following questions: What are the differences between wealth maximisation and profit maximisation as company objectives? Is it possible to pursue both objectives at the same time? This essay argues that it is indeed possible to reconcile both objectives by providing concrete examples. The companies Beta Lending, the New York Times, and the Metropolitan Museum of Art are living testimonies that both finance and accounting objectives can be consolidated to work together for the overall interest of the firm. After all, wealth maximisation is merely a ‘positively sounding’ other term for profit maximisation. What is Wealth Maximisation? In theory, wealth maximisation is attained when resources are controlled by those who give or assign to them the greatest value. A person maximises his personal wealth every time he boosts the value of the goods he has; every time he is capable, for instance, of buying an item he values for any amount less than the maximum he would be eager to pay for it (Boyes & Melvin 2012). The value of the item to him is determined by the sum he would shell out if needed; if he is capable of paying, $8 for instance, for what he would pay $10 to own if needed, his wealth has been raised by $2. Society achieves wealth maximisation when all its resources are highly allocated that the totality of all these individual appraisals is as elevated as possible (Paramasivan 2009). Wealth maximisation is a contemporary model, which includes newest developments and advancements in the business arena. The concept of wealth implies shareholder wealth or the wealth of those engaged in a given enterprise. Furthermore, wealth maximisation is widely recognised as ‘value maximisation’ (Vishwanath 2007). This goal is a generally recognised notion in the business field. Not like profit, the concept of ‘value’ is long-term. The company’s value refers to the value of the company’s equity. The performance in the market of this equity dictates the company’s value. Reputable firms are highly valued by investors and thus their share price can be traded at a considerably greater rate than their original registered value. The company’s value is a direct outcome of its general performance and productive consistency of the company’s dividend choices, financing, and investment (Paramasivan 2009). This can be portrayed in the below figure: Figure 1. Components of Wealth Maximisation *image taken from http://librarysbbu.blogspot.com/2013/12/what-is-financial-management-and-its.html The notion of shareholders’ wealth maximisation implies making the most of shareholders’ wealth through Net Present Value (NPV) or value-creation and dividends. This is done in order to accurately determine and maximise the value of prospective inflows (Arnold 2013). The primary objective of this idea is to raise the company’s value and the shareholders’ market value. The present status of the stockholders’ wealth in the company is derived from the share price and the amount of shares owned. It can be portrayed in the following way (Sofat & Hiro 2011, p. 24): Wealth = No. of shares owned x Current stock price per share The justification underlying this notion is maximisation of the company’s value and boosting the wealth of its shareholders as an appreciation for their dedication of financial support and sustained investment in the firm. What is Profit Maximisation? Profit maximisation is a process that firms go through to identify the optimal price levels and production so as to maximise its profit. The firm will often modify important variables like levels of output, sale prices, and costs of production as a method of attaining its profit objective. There are two key techniques of profit maximisation employed—Total Cost-Total Revenue Method and Marginal Cost-Marginal Revenue Method (Carbaugh 2013, p. 104.) Maximisation of profit is a favourable goal for a firm, but can be a negative aspect for consumers if the firm chooses to increase prices or make use of low-cost, substandard products. Every business raise profits and it reveal it in its annual statement. Thus, profit maximisation is a major objective for all businesses as it is shown and explained in the income statement (Bender & Ward 2012). Profits are the leftover or excess revenue of the company: Profit = Revenue – Costs (Boyes & Melvin 2012, p. 101). In order to attain profit maximisation, caution is observed to lessen costs in any way possible and increase profits. Profit maximisation implies that the company makes the most of its profits or earnings after tax. It suggests that a company either generates maximum production for a particular input, or makes use of the least possible input for reaching a specific output. Hence, it implies the optimisation of the relationship between input and output in order to lessen the inefficient or unnecessary costs (Carbaugh 2013). The primary objective of profit maximisation is to capitalise on the profitability obtained from the firm’s economic operations. This is show in the diagram below: Figure 2. Profit Maximisation Diagram *image taken from http://12ryuhae.wordpress.com/2011/01/24/using-at-least-one-diagram-explain-the-differnece-between-profit-maximization-and-sales-revenue-maximization-as-goals-of-the-firm/ The notion of profit maximisation is derived from the identification of maximisation of profits. The logic underlying this idea is the necessity to acquire maximum returns and accrued profits for success in the future and a defence against uncertainties such as cutthroat competition, unexpected losses, natural disasters, and economic slumps (Khan 2004). This idea concerns a fairly briefer duration of time (e.g. financial year); hence a short-range one-sided goal. It does not take into account the subjects of money’s time value. It identifies earnings for the financial year and takes for granted discounting aspect of profits (Sofat & Hiro 2011). The instant value of this idea is obtained first by management and subsequently by the shareholders, particularly when management is separated from ownership. Describe Criteria of Company Objectives Objectives of finance and accounting are based on corporate objectives. A company’s financial goals are a precondition to financial planning and strategic moves. The financial model is rooted in the basic principle that a company’s main commitment is to its shareholders. There are other stakeholders like employees, consumers, providers, communities, and so on, who are actively involved in the activities and performance of the financial system of the business (Trent 2008). A firm coordinates and harmonises its goals in such a way that all these stakeholders attain the utmost gratification, yet it is generally recognised that its main duty is to its shareholders. In owner-managed businesses, the goals of the owner and company overlap. A joint stock firm’s owners are its average shareholders. Basically, they are the remaining petitioners of its assets and profit streams. Moreover, they are the ones answerable for its losses or failures. Thus, the main objective of a joint stock firm is wealth maximisation of its average shareholders, who are the owners themselves (Atrill & McLaney 2013). Hence financial management’s paramount objective is to maximise its owners’ wealth. A shareholder’s wealth in a firm is the multiplication of the sum of shares owned by the shareholder and the share’s present market price. This can be depicted as follows (Agarwal 1982, p. 575): Shareholder’s wealth in the firm = number of shares owned x market price per share. Even though working under the wealth maximisation goal, the company will formulate its operations in ways that the shareholders acquire the optimum dividends and capital returns accumulated from the boost in the shares’ market value (Arnold 2013). Profit maximisation is frequently considered as the necessary, appropriate objective of a firm. It implies that the business must raise its profits by as huge a sum as possible in the shortest time possible. It is claimed that if a company raises optimum profit, it will spontaneously be shown in its share prices (Moyer et al. 2011). Furthermore, it is a more practical and measurable objective than wealth maximisation. According to the profit maximisation model, activities that raise profits must be pursued and those that reduce earnings are to be prevented. In a concrete operational sense, as related to financial management, the principle of profit maximisation suggests that the company’s dividend choices, financing, and investment must be directed towards profit maximisation (Shim & Siegel 2008). On the other hand, in existing scholarly literature wealth maximisation is practically universally recognised as a suitable operational decision principle for financial management choices since it gets rid of the technical weaknesses which define the profit maximisation principle. Its operational characteristics meet the three prerequisites of an appropriate operational goal of financial decision, which are time value of money, quality of gains, and precision (Vishwanath 2007). An asset’s value must be seen in terms of the gains it can generate. The value of a decision can also be assessed in relation to the quality of the gains it generates minus the cost of carrying it out. An important aspect in calculating the worth of a financial decision is the accurate valuation of the gains related to it. The wealth maximisation principle is rooted in the notion of cash flows produced by the course of action instead of the accounting revenue which is the core of the assessment of gains as regards the profit maximisation principle (Paramasivan 2009). Similarities and Differences between Profit Maximisation and Wealth Maximisation Profit maximisation is essentially a short-range, single-period objective, to be attained in a year; it is generally thought to imply profit maximisation in certain duration of time. A company could take full advantage of its short-term revenues to the detriment of its long-range success or productivity (Boatright 2010). On the contrary, shareholders’ wealth maximisation is a long-range objective because shareholders are as concerned with the future as they are with current profits. Wealth maximisation is usually favoured for it takes into consideration the following: ‘(1) wealth for the long term, (2) risk or uncertainty, (3) the timing or returns, and (4) the stockholders’ return’ (Shim & Siegel 2008, p. 2). The third one, which is timing of returns, is crucial; the timelier the return is obtained, the more advantageous, because an immediate return lessens doubts about getting the return, and cash obtained can be put back into investment quicker (Shim & Siegel 2008, p. 2). Profit maximisation can be attained temporarily to the detriment of the long-range objective of wealth maximisation. An expensive investment, for instance, could incur losses temporarily but generate sizeable profits in the long range; a firm that desires short-term profitability could delay important reforms or maintenances in spite of the fact that such suspension will probably damage its long-term success (Boatright 2010). Not like wealth maximisation, profit maximisation disregards uncertainties or risks. Take for instance two products, Product 1 and Product 2. A profit maximisation perspective will prefer product 2 over product 1 because its overall return after three years is greater. Nevertheless, if product 2 is riskier than product 2, then the choice will not be as upfront or direct as the numbers will show due to the compromise between return and risk. Shareholders anticipate higher returns from high-risk investments; they will expect an adequately sizeable return to pay off the relatively higher degree of risk of creating and developing product 2 (Arnold 2013). Not like profit maximisation, maximisation of wealth fulfils the objective of the company’s shareholders, generate high return and secure capital, investment, and assets. If profit maximisation is a firm’s objective, wealth maximisation is the instruments to sustain the objectives (Moyer et al. 2011). Because wealth maximisation is derived from the cash flow, it can dispel any uncertainty in accounting the return. Even though profit maximisation is derived from profit, it is somewhat ambiguous. There are numerous forms of profit (e.g. net profit, gross profit, and so on). In addition, wealth maximisation takes into account risks whereas profit maximisation takes it for granted (Shim & Siegel 2008). Pursuing Profit Maximisation and Wealth Maximisation Simultaneously Thus the crucial question is is it possible to pursue both profit maximisation and wealth maximisation objectives at the same time? Due to the markets’ highly competitive environment, there are a number of sensible answers to this question. In a strongly competitive market, a firm’s objective is commonly survival. And it accomplishes such by generating outputs that have a higher value than its inputs in the marketplace (Bender & Ward 2012). Such added value will come to light as profits; hence it can be assumed that the objective of the company is profit maximisation. It may also be assumed that its objective, as a node of voluntary contractual networks, is to deal with these networks so that the finest parties- such as investors eager to offer the most favourable terms, premium suppliers, highly skilled and innovative workers- aim to keep on consolidating their resources in the company’s team production (Doumpos & Zopounidis 2014). And such indicates that it must promote the collective welfare of its major stakeholders. However, it can be much more precise that the above: any particular company is allowed to establish any objective for itself, involving those that demand relinquishing profit. One of the companies frequently mentioned here is The New York Times. It is a rigidly owned public firm with a contract that protects it from annexation (Boatright 2010). And its main declared objective is to remain profitable enough to be capable of delivering excellent news service for the sake of public interest and the larger society. Fascinatingly though, the sorts of thinkers most strongly related to the shareholders’ wealth maximisation corporate objective—theorists like Friedman—have nothing against companies committing themselves openly to objectives that are non-profit maximising, provided that they declare this frankly when looking for investment (Sofat & Hiro 2011). As argued by Easterbrook and Fischel (1991) (as cited in Boatright 2010, p. 154): An approach that emphasises the contractual nature of a corporation removes from the field of interesting questions one that has plagued many writers: what is the goal of the corporation? Is it profit, and for whom? Social welfare more broadly defined? Is there anything wrong with corporate charity? Should corporations try to maximise profit over the long run or the short run? Our response to such questions is: who cares? Therefore, it may be supposed that when someone probes about the definitive objective of the company, what s/he is really trying to know is the definitive objective of the market. Numerous people think that the main objective of businesses is profit maximisation. One of the major supports for this perspective is a widely utilitarian model that claims that companies have this objective because maximisation of profit will result in a ‘welfare maximising’ result, which is referred to as the ‘efficiency argument for profit maximisation’ (EAPM) (Hussain 2012, p. 312). EAPM claims that companies can pursue profit maximisation and wealth maximisation simultaneously. It argues that companies must capitalise on their long-term market value through profit maximisation. This argument can be more accurately substantiated through concrete examples. Beta Lending is a banking firm with important connections to the African-Americans in West Philadelphia. The bank’s chief executive made a decision to reorient the direction of the firm. He proposed to shift the firm’s objectives from mere profit maximisation to a combination of maximisation of profit and wealth, specifically promotion of home ownership for the Black community in the region. Everybody approved the proposal, and the firm changes its fundamental objectives. The bank successfully fulfilled these new objectives over time, giving more favourable lending rates to eligible minority claimants, while at the same time sustaining a sensible profit level (Hussain 2012, p. 321). Without a doubt, it is feasible for businesses to pursue wealth-maximising objectives like sponsoring home ownership for minority groups in ways that enhance their reputation and in the end maximise their profits. Beta Lending promotes home ownership for minority groups as an objective in itself, and such adds to the firm’s long-term profitability. The overall outcome is that the firm consistently raises a judicious profit, yet not the maximum profit achievable. Another example is the Metropolitan Museum of Art, which is a company that derives goods from the economy as production materials and returns goods to the economy as commodities. Among the production materials that it gets are labour, building materials, and electrical energy. Among the products that it offers is the experience of seeing remarkable artistic works (Hussain 2012, p. 326). People would be eager to pay to view the museum’s collection of artistic works, yet it does not collect an entrance fee—the museum gives up the prospective profit and lets the public view the collection at no cost. This case shows that so long as a company derives goods from the economy as production materials and returns goods to the economy as commodities, the greatest thing that it can achieve from the point of view of aggregate wealth maximisation is to maximise profits. Even though the museum does not have a current market value, this is simply because the museum is not present on the market. The museum may trade or sell shares to financiers, and if it also embarked on asking admission fees, these shares may become highly valued. Putting the museum on the market in this manner would raise its market value from naught to millions of revenues (Hussain 2012, pp. 326-7). If the EAPM argues that companies are obliged to capitalise on their long-term market value, then this case appears obviously to be the direction or decision that it calls for. Advantages and Disadvantages Profit maximisation has several advantages and disadvantages. Its major advantages are the following: (1) profitability satisfies social welfare; (2) profit is the primary monetary or financial source; (3) profit decreases risk; (4) profit is the factor or measure of corporate activities; and, (5) primary objective is generating profit. On the other hand, some of its major disadvantages are (1) it results in gaps or inequities among stakeholders; (2) encourages unethical practices like corruption; and (3) it results in oppressing employees and consumers (Boatright 2010). Aside from these disadvantages, profit maximisation is also ambiguous and takes for granted risk and time value of money. Similarly, wealth maximisation has both positive and negative aspects. Some of its positive characteristics are the following: (1) it guarantees the society’s economic interest; (2) creates effectual resource allocation; (3) takes into account risk and time; and (4) its major objective is to enhance shareholders’ wealth (Shim & Siegel 2008). In contrast, some of the negative aspects are as follows: (1) it can be initiated only with the assistance or support of the profitable status of the industry; (2) the decisive objective of wealth maximisation is, essentially, profit maximisation; and, (3) it encourages conflict between management and owners (Carbaugh 2013). Conclusion Profit maximisation certainly capitalises on profits but in the end unable to satisfy the shareholders’ demands. Shareholders are pleased when their share in the company rises alongside the increase in the company’s profitability. Maximisation of profit is attained with the assistance of all the financiers. If any of these creditors decide to pull out his/her shares, the objective of profit maximisation is disrupted. This objective could also take for granted issues of social welfare and employee wellbeing. Therefore, the wealth maximisation objective is certainly a more favourable approach and shareholders can assess it in relation to growth in dividends and their shares’ market value. However, wealth maximisation is merely ‘more acceptable’ synonym for profit maximisation. Nevertheless, as shown in the cases of Beta Lending, The New York Times, and the Metropolitan Museum of Art, it is possible to reconcile both profit maximisation and wealth maximisation objectives. However, there will be compromises at first, such as foregoing profits, in order to achieve long-term profitability. References Agarwal, R (1982) Organisation and Management. UK: Tata McGraw-Hill Education. Arnold, G (2013) Financial Times Handbook of Corporate Finance. UK: Pearson. Atrill, P & McLaney, E (2013) Accounting and Finance for Non-Specialists. UK: Pearson. Bender, R & Ward, K (2012) Corporate Financial Strategy. UK: Ward Elsevier. Boatright, J (2010) Finance Ethics: Critical Issues in Theory and Practice. 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