Wealth Maximization Definition Example How It Works

What is Wealth Maximization?

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 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.read more 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.

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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 worthCompany’s Net WorthThe 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.read more 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 dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more 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 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. read more 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 profitabilityBusiness’s ProfitabilityProfitability 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.read more 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 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.read more.

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.

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