What is Wealth Maximization?
Wealth maximization means maximization of the shareholder’s wealth as a result of increase in share price thereby increasing the market capitalization of the company. Share price increase is a direct function of how competitive the company is, its positioning, growth strategy and how it generates profits.
- Finance managers serve a principal-agent relationship with the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. of the company and act as the agent of the shareholders and 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 to safeguard their invested amount too. Both the objectives mentioned here are catered by wealth maximization as a key decisive factor for every business and it also helps to keep the shareholders happy about their investments made in the business.
- Typical examples of wealth maximization can be the cases where the shareholders have benefited from investing in a particular stock over some time and because the net worth of the company 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 the year 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 net worth of the companyNet Worth Of The CompanyThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus. has impacted the value of the stock and the wealth of the shareholders. Wealth maximization not only just happens in terms of stock value appreciation but there is one more way where one’s investment may make it grown significantly in terms of companies providing dividends at successive intervals. The accumulation of these dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity. along with stock value appreciation may also lead to gains for the shareholders.
Some of the advantages are as follows:
- It is more related to cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. 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 is reliant on the profit.
- It is more long term focussed as compared to 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 the factors of risk and uncertainty while taking into consideration the discounting rate which reflects both the time and risk.
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 to a great extent dependant on the profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. of the business as only after the business is profitable it can think of enhancing the wealth of the shareholders.
- It is based on the generation of cash flows and not on the accounting profitAccounting ProfitAccounting profit is the net income available after deducting all explicit costs and expenses from total revenue, and it is calculated in accordance with generally accepted accounting principles (GAAP). Operating expenses, labour, transportation, and sales expenses are common examples of these costs..
Wealth maximization has both merits and demerits attached to it. It is a very important factor though for every investor before one invests in a company. They bring about happiness in the form of generating good return to its shareholders and shareholders also tend to invest more in such companies which may be required for its expansion or growth.
This has been a guide to what is Wealth Maximization and its meaning. Here we discuss an example of wealth maximization along with advantages and disadvantages. You can learn more about from the following articles –