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Wealth Maximization

Updated on May 22, 2024
Article byWallstreetmojo Team
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What is Wealth Maximization?

Wealth maximization means maximizing the shareholder’s wealth due to an increase in share price, thereby increasing the company’s market capitalization. The share price increase directly affects how competitive the company is, its positioning, growth strategy, and profits.

Key Takeaways

  • Wealth maximization is a chain aiming to maximize shareholder wealth by increasing the share price, which technically increases market capitalization. 
  • Less uncertainty is associated with cash flows than profit maximization, and they are more predictable and consistent. So, profits are less important than cash flows.
  • To maximize value for shareholders, a company must first be profitable. Only then can it consider increasing shareholder wealth.
  • It is related to cash flows than profits, which are more certain and regular, with the absence of uncertainty associated with profit. However, it is based on a prospective and not a descriptive idea. 

Explanation

  • Finance managers serve a principal-agent relationship with the company’s shareholders and act as agents. They must cater to the interest of the shareholders.
  • The expectation of every shareholder or investor in a company would be to generate a good amount of return from their investment and safeguard their invested amount. Both the objectives mentioned here are catered by wealth maximization as a key decisive factor for every business. It also helps keep the shareholders happy about their investments made in the business.
Wealth-Maximization

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Example

  • Typical examples of wealth maximization can be the cases where the shareholders have benefited from investing in a particular stock over some time. Because the company’s net worth has grown, this has positively impacted the share values, too and thus increasing shareholders’ wealth. A very practical example can be an investment made in 1996 for a US-based company called Havells. It is observed that any investor who has invested in Havells to a tune of $1500 in this stock in 1996 and has retained the stock till now have seen a massive gain from a mere $1500 to $ 4,000,000.
  • This is what the company’s net worth has impacted the value of the stock and the wealth of the shareholders. Wealth maximization not only happens in terms of stock value appreciation, but there is one more way where one’s investment may make it grow significantly in terms of companies providing dividends at successive intervals. The accumulation of these dividends and stock value appreciation may also lead to gains for the shareholders.

Advantages

Some of the advantages are as follows:

  • It is more related to cash flows than profits. Cash flows are more certain and regular, and there is a lack of uncertainty that otherwise is associated with profit.
  • Profits are more manipulative, but cash flows are not. Thus, wealth maximization is less prone to manipulation than profit maximization, which relies on profit.
  • It is more long-term-focused than profit maximization, which has a short-term focus. Profit maximization is easy to attain because managers may adopt unethical ways to bring short-term profits based on long-term sustainability.
  • They consider risk and uncertainty factors while considering the discounting rate, which reflects both the time and risk.

Disadvantages

Some of the disadvantages are as follows:

  • It is more based on an idea that is prospective and not descriptive.
  • The objectives laid in such a technique are not clear.
  • Wealth maximization is largely dependent on the business’s profitability as only after the business is profitable can it think of enhancing the wealth of the shareholders.
  • It is based on the generation of cash flows and not on the accounting profit.

Conclusion

Wealth maximization has both merits and demerits attached to it. It is a very important factor for every investor before one invests in a company. They bring about happiness by generating good returns to their shareholders, and they tend to invest more in such companies, which may be required for their expansion or growth.

Frequently Asked Questions (FAQs)

Why is shareholder wealth maximization the primary goal?

To maximize shareholder wealth, a company’s main objective is to increase the price of its shares. Therefore, maximizing shareholder wealth might be beneficial since it offers managers of a company a specific goal for increasing value.

Why are wealth maximization and profit-maximizing at odds with one another?

Maximizing profits guarantees the company’s growth and longevity. Wealth maximization, in contrast, concentrates on a company’s long-term growth rate by growing its market share.

What is the theory of shareholder value in wealth maximization?

According to the shareholder theory, shareholders evaluate the worth of business assets using the two quantifiable indicators of dividends and share price. As a result, management should make choices that maximize the value of dividends and share price growth.

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