For optimal financial decisions, it is essential to define objectives of financial management. These objectives serve as decision-criterion. Financing is a functional area of business and, therefore, the objectives of financial management must be in tune with the overall objectives of the business. The main objectives of business are survival and growth. In order to survive in the business and to grow, a business must earn sufficient profits. It must also maintain good relations with investors, employees, customers and other groups of society. It should also provide maximisation of owners’ economic welfare. Consequently, there are two well known criteria in this regard:
- Profit Maximisation
- Wealth Maximisation
Profit Maximisation
According to this criterion, the financial decisions (investment, financing and dividend) of a firm should be oriented to the maximisation of profits (i.e. select those assets, projects and decisions which are profitable and reject those which are not profitable). Hence, actions that increase the firm’s profit are undertaken while those that decrease profit are avoided.
Merits of Profit Maximisation:
- Excellent allocation of resources
- Main Source of Inspiration
- Maximum Social Welfare
- Basis of Decision-Making
Under perfect competition, profit maximisation behaviour by firms leads to an efficient allocation of resources with maximum social welfare. Since, the capital is a scarce material, the financial manager should use these capital funds in the most efficient manner for achieving the profit maximisation. It is, therefore, argued that profitability maximisation should serve as the basic criterion for the ultimate financial management decisions.
Drawbacks of Profit Maximisation
- It is vague
- It ignores time value of money
- It ignores risks
- It ignores social responsibility
Wealth Maximisation
Considering the shortcomings of profit maximisation, wealth maximisation is taken as the basic objective of financial management. It is also known as ‘Value Maximisation’ or ‘Net Present Value Maximisation’. 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.
Superiority of Wealth Maximisation
- It measures income in terms of cash flows, and avoids the ambiguity now associated with accounting profits as, income from investments is measured on the basis of cash flows rather than on accounting profits.
- It recognises time value of money by discounting the expected income of different years at a certain discount rate (cost of capital).
- It analyses risk and uncertainty so that the best course of action can be selected from different alternatives.
- It is not in conflict with other motives like maximisation of sales or market value of shares. It helps rather in the achievement of all these other objectives.
Comparison of Profit Maximisation & Wealth Maximisation
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Profit Maximisation |
Wealth Maximisation |
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It should be clear that profit maximisation is a strictly short-term approach to managing a business, which can be damaging over the long term. On the other hand, Wealth maximisation, which focuses attention on the long term, increases the value of the business and eventually pays-off better.
