- Why wealth maximization should be the ultimate objective of the firms
Profit maximization is the traditional and narrow approach; in this process, the firms undergo to determine the best output and price level to maximize their return. The company will usually adjust its influential factors such as production costs, sales price, and output level as a way of reaching its profit goal.
The wealth maximization objective is an almost universally accepted goal of the firm. According to this objective, the managers should take decisions that maximize the shareholders' wealth. In other words, it is to make the shareholders as rich as possible. Shareholders' wealth is increased when a decision generates a net present value.
Following points are important for understanding why the wealth maximization should be the ultimate objective of the firms than profit maximization
Firstly wealth maximization is based on cash flows and not on profits. Unlike profits, cash flows are exact and definite and therefore are avoiding any ambiguity associated with the accounting profits.
Secondly, profit maximization presents a short term view as compared to wealth maximization. Short term profit maximization can be achieved by the managers at the cost of long term sustainability of the business.
Thirdly, the wealth maximization considers the time value of money. It is important because everyone knows that the US dollar today will be not equal to the US dollar one year later and both may have not of the same value. In wealth maximization, the future cash flows are discounted at an appropriate discount rate to present their present value.
Fourthly, the wealth maximization considers the risk and uncertainty factors while considering the discounted rate. The discounted rate considers both time and risk. Higher the uncertainty, the discounting rate is higher and vice versa.
If we consider the above main points then we can easily get toward a conclusion. The conclusion can be summarized as below
Wealth maximization is superior to profit maximization because the main objective of the business concern under this concept is to improve the value or wealth of the shareholders.
Wealth maximization considers the comparison of the value to the cost associated with the business concern. The total value is detected from the total cost incurred in the business operation.
Wealth maximization considers both the time and risk of the business while such things are ignored or given less importance in the profit maximization.
Wealth maximization provides an efficient allocation of resources.
It ensures the economic interest of the society.
From the points discussed above, we can say that the ultimate objective of the firms should be to increase the wealth of the
shareholders by increasing the net worth of the value of the shares traded in the exchange because a business needs to sustain in the long run. Companies should focus on achieving the long-run objectives rather than the short run because the success of any organization can be evaluated by its sustainability in the long run..