PROFIT MAXIMIZATION V/S WEALTH MAXIMIZATION
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The real lessons are learnt when the two (cash flow and earnings) depart.
A good case in point are small capitalized companies, especially internet companies like ebay.
Despite poor earnings, the market values for companies like ebay seems to escalate out-of -sight.
What is going on? What is happening is that
The marketplace determines value based on what it expects in the future and not on what past earnings were.
The marketplace comprehends that ebay will generate a lot of future cash flows because
It has reinvented how people buy and sell merchandise over the internet.
Financial Statements lag behind and fail to recognize the true sources of value in the marketplace.
Consider how profit maximization might work for a “ABC Company” Suppose that ABC Company generates Rs100,000 of profit by producing 10000 units of Product X, the difference between Rs 1,000,000 of revenue and Rs 900,000 of cost.
If profit falls from this Rs100,000 level when the ABC Company produces more (10001) or fewer (9999)units of Product X, then it is maximizing profit at 100,000.
What To Understand
Profit maximization is a very subjective, proposition
It varies as when scale of operation and operative structure ,such as costs change.
If we have to live like a long ranged firm what should our objective really be?
Profit Is Accounting Jugglery
Cash Flows are more realistic than profits.
In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate various alternatives for decision making, cash flows are taken under consideration.
For e.g. to measure the worth of a project, criteria like: “ present value of its cash inflow – present value of cash outflows” (net present value) is taken.
This approach considers cash flows rather than profits into consideration and also use discounting technique to find out worth of a project.
Thus, maximization of wealth approach believes that Money has Time Value.
Why Is Profit Maximization Obsolete ?
The profit maximisation criterion has, however, been questioned and criticised on the following grounds:
i. its vagueness
ii. it ignores the timing of benefits
iii. it ignores risk
One practical difficulty with profit maximisation criterion is that the term profit is vague and ambiguous as it is amenable to different interpretations, like, profit before tax or after tax, total profit or rate of return, etc.
If profit maximisation is taken to be the objective, the problem arises, which of these variants of profit to be maximised? Hence, a vague concept of profit cannot form the basis of operation for financial management.
Let Us Understand Better
A more important technical objection to profit maximisation is that it ignores the differences in the time pattern of the cash inflows from investment proposals.
In other words, it does not recognise the distinction between the returns in different periods of time and treat them at a par which is not true in real world as the benefits in earlier years should be valued more than the benefits received in the subsequent years.
Another limitation of profit maximisation as an operational objective is that it ignores the quality aspect of benefits associated with a financial course of action. The quality here refers to the degree of certainty with which benefits can be obtained. As a matter of fact, the more certain the expected return, the higher the quality of the benefits. Conversely, the more uncertain the expected returns, the lower the quality of benefits, which implies risk to the investors
The most widely accepted objective of the firm is to maximise the value of the firm for its owners.
The wealth maximisation goal states that the management should seek to maximise the present value of the expected returns of the firm.
The present value of future benefits is calculated by using its discount rate (cost of capital) that reflects both time and risk.
The discount rate (capitalisation rate) that is applied is, therefore, the rate that reflects the time and risk preferences of the suppliers of capital.