Prime Decision Process of Wealth Maximization Objective of a Company –
Wealth maximization is a modern approach to financial management. It simply means maximization of shareholder’s wealth. The shareholder wealth maximization goal states that management should seek to maximize the present value of the expected future returns to the owners (that is, shareholders) of the firm. Maximization of profit used to be the main aim of a business and financial management till the concept of wealth maximization came into being. Shareholder wealth maximization should be the basic goal of any corporation. The justification for this goal are as follows:
(1) Wealth Maximization Objective Recognizes The Time Value Of Money
Time value of money is an important concept in financial decision making. Wealth maximization goal recognizes this concept. According to this concept, all cash flows generated over the life of the project are discounted back to present value using required rate of return as a discount rate, and the decision is based on the present value of future returns.
(2) Consideration Of Risk
Wealth maximization objective also considers the risks associated with the streams of future cash flows. The risk is taken care of by using appropriate required rate of return to discount the future streams of cash flows. Higher the risk higher will be the required rate of return and vice versa.
(3) Efficient Allocation Of Resources
Shareholders wealth maximization objective provides a guideline for a firm’s decision making and also promotes an efficient allocation of resources in the economic system. Resources are generally allocated taking into consideration the expected return and risk associated with a course of action. The market value of the stock itself reflects the risk-return trade-off associated with an investor in the capital market. In other words, shareholder wealth, maximization considers the riskiness of the income stream. Therefore, if a firm makes financing decisions considering the market price of share maximization, it will raise necessary capital only when the investment ensures the economic use of capital. In the absence of pursuing the goal of shareholders wealth maximization, there is a danger of sub-optimal allocation of resources in an economy that leads to the inadequate capital formation and low rate of economic growth.
(4) Residual Owners
Shareholders are residual claimants in earnings and assets of the company. Therefore, if shareholders wealth is maximized, then all others with a prior claim that shareholders could be satisfied.
(5) Emphasis On Cash Flow
Wealth maximization objective uses cash flows rather than accounting profit as the basic input for decision making. The use of cash flows is less ambiguous because it represents means profit after tax plus non-cash outlays to all.