Profit Maximization vs. Wealth Maximization in Financial Management

Posted on Jun 17, 2024 in Economy

Profit Maximization vs. Wealth Maximization

Profit Maximization

The main aim of any economic activity is earning a profit. Profit is the metric used to understand the business efficiency of a concern.

Profit maximization consists of the following important features:

Profit maximization is also called cash per share maximization. It leads to maximizing business operations for profit maximization.
The ultimate aim of a business concern is earning a profit; hence, it considers all possible ways to increase the profitability of the concern.
Profit is the parameter for measuring the efficiency of a business concern. So, it shows the entire position of the business concern.
Profit maximization objectives help reduce the risk of the business.

Points in Favor of Profit Maximization

It is a parameter to measure the performance of a business.
It ensures maximum welfare to the shareholders, employees, and prompt payment to creditors.
It increases the confidence of management in expansion and diversification.
It indicates the efficient use of funds for different requirements.

Points Against Profit Maximization

It is not a clear term like accounting profit, before-tax or after-tax profit, net profit, or gross profit.
It encourages corrupt practices.
It does not consider the element of risk.
Time value of money is not reflected.
It attracts cutthroat competition.
Huge profits attract government intervention.
It invites problems from workers.
It affects the long-run liquidity of a company.

Wealth Maximization

Wealth maximization is one of the modern approaches. The term wealth means shareholder wealth or the wealth of the people involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is a universally accepted concept in business.

Favorable Arguments for Wealth Maximization

Wealth maximization is superior to profit maximization because the main aim 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 cost associated with the business concern. Total value is detected from the total cost incurred for business operations. It provides the extract value of the business concern.
Wealth maximization considers both the time and risk of the business concern.
Wealth maximization provides efficient allocation of resources.
It ensures the economic interest of society.

Unfavorable Arguments for Wealth Maximization

Wealth maximization leads to a prescriptive idea of the business concern, but it may not be suitable for present-day business activities.
Wealth maximization creates an ownership-management controversy.
Management alone enjoys certain benefits.
The ultimate aim of wealth maximization objectives is to maximize profit.
Wealth maximization can be activated only with the help of the profitable position of the business concern.

Basis	Wealth Maximization	Profit Maximization
Definition	It is defined as the management of financial resources aimed at increasing the value of the stakeholders of the company.	It is defined as the management of financial resources aimed at increasing the profit of the company.
Focus	Focuses on increasing the value of the stakeholders of the company in the long term.	Focuses on increasing the profit of the company in the short term.
Risk	It considers the risks and uncertainty inherent in the business model of the company.	It does not consider the risks and uncertainty inherent in the business model of the company.
Usage	It helps in achieving a larger value of a company’s worth, which may reflect in the increased market share of the company.	It helps in achieving efficiency in the company’s day-to-day operations to make the business profitable.

Nature of Financial Management

Financial Management is an integral part of overall management. Financial considerations are involved in all business decisions. So, financial management is pervasive throughout the organization.
In most organizations, financial operations are centralized. This results in economies.
Financial management involves data analysis for use in decision-making.
The central focus of financial management is the valuation of the firm. That is, financial decisions are directed at increasing/maximizing/optimizing the value of the firm.
Financial management essentially involves a risk-return trade-off. Decisions on investment involve choosing the types of assets that generate returns accompanied by risks. Generally, the higher the risk, the higher the returns might be, and vice versa. So, the financial manager has to decide the level of risk the firm can assume and be satisfied with the accompanying return.

Scope of Financial Management

Financial Planning: It involves forecasting the future financial needs of the organization and developing budgets, plans, and strategies to meet those needs.
Investment Management: Investment management revolves around allocating an organization’s resources to various assets to maximize returns while minimizing risk. It entails selecting suitable investment options, such as stocks, bonds, or real estate, and monitoring their performance.
Cash Flow Management: Cash flow management focuses on maintaining sufficient liquidity to cover daily operational expenses and meet short-term financial obligations. It is vital to preventing financial crises and ensuring the organization’s stability.
Financial Reporting: Financial reporting involves the preparation and presentation of financial information to both internal and external stakeholders. It includes creating financial statements like income statements, balance sheets, and cash flow statements to provide an accurate financial snapshot.
Risk Management: Risk management entails identifying, assessing, and mitigating financial risks that could adversely affect an organization’s financial stability. These risks encompass market risk, credit risk, operational risk, and more.
Investment decisions
Financing decisions
Dividend decisions
Liquidity and solvency

Objectives of Financial Management

To ensure a regular and adequate supply of funds to the concern.
To ensure adequate returns to the shareholders, which will depend upon the earning capacity, market price of the share, and expectations of the shareholders.
To ensure optimum funds utilization. Once the funds are procured, they should be utilized in the maximum possible way at the least cost.
To ensure safety on investment, i.e., funds should be invested in safe ventures so that an adequate rate of return can be achieved.
To plan a sound capital structure – There should be a sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Finance Functions

The finance function is the process of acquiring and utilizing the funds of a business. Finance functions are related to the overall management of an organization.
The finance function is concerned with policy decisions such as the line of business, size of the firm, type of equipment used, use of debt, and liquidity position.
These policy decisions determine the size of the profitability and riskiness of the business of the firm.

Finance Function – Objectives

Assessing the Financial Requirements
Proper Utilization of Funds
Increasing Profitability
Maximizing the Value of the Firm

Financial Manager

Estimating the Amount of Capital Required
Determining Capital Structure
Choice of Sources of Funds
Procurement of Funds
Utilization of Funds
Disposal of Profits or Surplus
Management of Cash
Financial Control

Forms of Dividend

Cash Dividend: A cash dividend is the usual method of paying dividends. Payment of dividends in cash results in an outflow of funds and reduces the company’s net worth, though the shareholders get an opportunity to invest the cash in any manner they desire.
Scrip or Bond Dividend: A scrip dividend promises to pay the shareholders at a future specific date. In case a company does not have sufficient funds to pay dividends in cash, it may issue notes or bonds for amounts due to the shareholders.
Property Dividend: Property dividends are paid in the form of some assets other than cash. They are distributed under exceptional circumstances and are not popular in India.
Stock Dividend: Stock dividends mean the issue of bonus shares to the existing shareholders. If a company does not have liquid resources, it is better to declare a stock dividend. The stock dividend amounts to the capitalization of earnings and distribution of profits among the existing shareholders.

Advantages of the Issue of Bonus Shares

A. Advantages to the Company

It makes available capital to carry a larger and more profitable business.
It is felt that financing helps the company get rid of market influences.
When a company pays a bonus to its shareholders in the value of shares and not in cash, its liquid resources are maintained, and the working capital of the company is not affected.
It enables the company to make use of its profit on a permanent basis and increases the creditworthiness of the company.
It is the cheapest method of raising additional capital for the expansion of the business.
An abnormally high rate of dividend can be reduced by issuing bonus shares, which enables a company to restrict the entry of new entrepreneurs into the business and thereby reduces competition.
The balance sheet of the company will reveal a more realistic picture of the capital structure and the capacity of the company.

B. Advantages to Investors or Shareholders

It is generally said that an investor gains nothing from the issue of bonus shares. It is so because the shareholder receives nothing except some additional share certificates. But his proportionate ownership in the company remains unchanged.

Bonus Issue (Stock Dividend) vs. Stock Split

A stock dividend means the issue of bonus shares to the existing shareholders of the company. It amounts to the capitalization of earnings and distribution of profits among the existing shareholders without affecting the cash position of the firm. A stock split, on the other hand, means reducing the par value of the shares by increasing the number of shares proportionately.

Types of Dividend Policies

Regular Dividend Policy: Companies following this policy distribute dividends to their shareholders on a regular basis, regardless of their yearly profits or losses. It’s a consistent and predictable approach, ensuring shareholders receive a dividend at specified intervals.
Irregular Dividend Policy: Under this policy, companies do not have a fixed pattern for dividend distribution. They distribute dividends only when they have surplus profits. The payouts are unpredictable and depend on the company’s financial health at any given time.
Stable Dividend Policy: Companies with this policy commit to paying a certain amount as dividends every year, irrespective of their actual profits. This provides shareholders with a sense of reliability, knowing they’ll receive a set dividend amount annually.
No Dividend Policy: Companies adopting this policy retain all their earnings and do not distribute any dividends to shareholders. They usually reinvest these earnings to fuel growth, expansion, or other business activities.
Residual Dividend Policy: In this type, the company uses its earnings to pay for its expenses, investments, and savings. Whatever money is left (residual) is given as dividends.

Determinants of Dividend Policy

Factors Affecting the Dividend Policy/Determinants of Dividend Policy

Legal restrictions are significant as they provide a framework within which dividend policy is formulated. These provisions require that dividends can be paid only out of current profits or past profits. In general terms, dividends can be paid only when the firm’s balance sheet shows positive retained earnings.
The Companies Act further provides that dividends cannot be paid out of capital because it will amount to a reduction in capital, adversely affecting the security of creditors.
The amount and trend of earnings are an important aspect of dividend policy. As dividends can be paid only out of the present and past years’ profits, the earnings of the company fix the upper limits on dividends. The past trends of the company’s earnings should also be kept in consideration while making the dividend decision.

Dividend Decision and Valuation of Firms/Valuation of Shares

The value of the firm can be maximized if the shareholders’ wealth is maximized. There are conflicting views regarding the impact of dividend decisions on the valuation of the firm. According to one school of thought, the dividend decision does not affect the shareholders’ wealth and hence the valuation of the firm. On the other hand, according to the other school of thought, the dividend decision materially affects the shareholders’ wealth and also the valuation of the firm. The two schools of thought can be grouped as:

The Relevance Concept of Dividend or The Theory of Relevance
The Irrelevance Concept of Dividend or The Theory of Irrelevance

Theory of Relevance

According to this school of thought on dividend decisions, dividend decisions considerably affect the value of the firm. The advocates of this school of thought include Myron Gordon, Jone Linter, James Walter, and Richardson. According to them, dividends communicate information to the investors about the firm’s profitability, and hence dividend decisions become relevant. Those firms that pay higher dividends will have greater value compared to those that do not pay dividends or have a lower dividend payout ratio.

Assumptions of Walter’s Model

The investments of the firm are financed through retained earnings only, and the firm does not use external sources of funds.
The internal rate of return (r) and the cost of capital (k) of the firm are constant.
Earnings and dividends do not change while determining the value.
The firm has a very long life.

Prof. Walter’s model is based on the relationship between the firm’s return on investment (r) and the cost of capital or the required rate of return (k).

In the case of normal firms where r = k,

P = D + r/ke (E – D)

P = market price per share

D = dividend per share

r = internal rate of return

E = EPS

ke = cost of equity

Criticism of Walter’s Model

The basic assumption that investors are financed through retained earnings only is seldom true in the real world. Firms do raise funds by external financing.
‘r’ does not remain constant.
The assumption that k (cost of capital) will remain constant also does not hold well.

Myron Gordon has also developed a model on the lines of Prof. Walter, suggesting that dividends are relevant and that the dividend decision of the firm affects its value.

Assumptions

The firm is an all-equity firm.
No external financing is available or used. Retained earnings represent the only source of financing investment programs.
The rate of return on the firm’s investment r is constant.
The retain ratio (b) once decided upon is constant. Thus, the growth rate of the firm g = br, is also constant.
The cost of capital of the firm remains constant, and it is greater than the growth rate, i.e. k > br
The firm has a perpetual life.
Corporate taxes do not exist.

According to Gordon, the market value of a share is equal to the present value of the future stream of dividends. i.e.

P0 = E1 (1-b)/ k –br

P = price of a share

E = EPS

B = retention ratio

br = g = growth rate

D = dividend per share

The Irrelevance Concept of Dividend

Residual Approach
MM Model

a. Residual Approach

According to this theory, the dividend decision has no effect on the wealth of the shareholders or the prices of the shares, and hence it is irrelevant so far as the valuation of the firm is concerned. This theory regards the dividend decision merely as a part of the financing decision because the earnings available may be retained in the business for reinvestment. But if the funds are not required in the business or if there is anything balanced after reinvestment, it may be distributed as dividends. Thus, the decision to pay dividends may be taken as a residual decision.

b. Modigliani & Miller Approach

Modigliani and Miller have expressed in the most comprehensive manner support for the theory of irrelevance. They agree that the dividend policy has no effect on the market price of the earning capacity of the firm.

Assumptions of MM Hypothesis

The MM hypothesis of the irrelevance of dividends is based on the following assumptions:

Perfect capital markets
Investors behave rationally
Information about the company is available to all without any cost.
No flotation and transaction costs
No investor is large enough to affect the market price of shares.
No taxes, or there are no differences in the tax rates applicable to dividends and capital gains.
The firm has a rigid investment policy.

i.e. Po = D1 + P1

1 + ke

P1 =Po (1 + ke) – D1

Po = market price of the share at the beginning or prevailing market price

P1 = market price/share at the end of the period

D1 = dividend to be received at the end of the period

ke = cost of equity

MM says that the investment needed by the firm on account of the payment of dividends is financed out of the new issue of equity shares. In such a case, the number of shares to be issued can be computed with the help of the following equations:

m = I – E – nD1

Value of the firm formula:

nPo = (n + m) P1 – (I-E)