PAPER PRESENTATION ON TOPIC: WEALTH MAXIMIZATION Submitted by NAME: CLASS: MBA-1st Year; SECTION: A ROLL NUMBER: 11PBA REGISTER

NUMBER: 11BIA

WEALTH MAXIMIZATION:

Wealth maximization is a modern approach to financial management. Maximization of profit used to be the main aim of a business and financial management till the concept of wealth maximization came into being. It is a superior goal compared to profit maximization as it takes broader arena into consideration. Wealth or Value of a business is defined as the market price of the capital invested by shareholders. Wealth maximization simply means maximization of shareholders wealth. It is combination of two words viz. wealth and maximization. Wealth of a shareholder maximize when the net worth of a company maximizes. To be even more meticulous, a shareholder holds share in the company /business and his wealth will improve if the share price in the market increases which in turn is a function of net worth. This is because wealth maximization is also known as net worth maximization.

Finance managers are the agents of shareholders and their job is to look after the interest of the shareholders. The objective of any shareholder or investor would be good return on their capital and safety of their capital. Both these objectives are well served by wealth maximization as a decision criterion to business.

How to calculate wealth? Wealth is said to be generated by any financial decision if the present value of future cash

flows relevant to that decision is greater than the costs incurred to undertake that activity. Wealth is equal to the present value of all future cash flows less the cost. In essence, wealth is the net present value of a financial decision.

Wealth = Present Value of cash inflows Cost. Where, Present Value of inflows cash = (1 + K) CF1 + CF1 (1 + K) 2 +.+ CFn (1 + K) n

Why wealth maximization model is superior to profit maximization? Wealth maximization model is a superior goal because it obviates all the drawbacks of profit maximization as a goal to financial decision.

1. Firstly, the wealth maximization is based on cash flows and not profits.

Unlike the

profits, cash flows are exact and definite and therefore avoid any ambiguity associated with accounting profits. 2. Secondly, profit maximization presents a shorter 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. 3. Thirdly, wealth maximization considers the time value of money. It is important as we all know that a dollar today and a dollar one year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value. 4. Fourthly, the wealth maximization criterion considers the risk and uncertainty factor while considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.

In the light of modern and improved approach of wealth maximization, a new initiative called Economic Value Added (EVA) is implemented and presented in the annual reports of the companies. Positive and higher EVA would increase the wealth of the shareholders and thereby create value.

Economic Value Added = Net Profits after tax Cost of Capital.

In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders achieve their objectives and therefore is superior to profit maximization. For financial managers, it is a decision criterion being used for all the decisions.

WEALTH MAXIMIZATION AND FINANCIAL MANAGEMENT: Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm. It is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. Thus, Financial Management is mainly concerned with the effective funds management in the business. On the other hand, wealth maximization is one of the objectives of the financial management.

WEALTH MAXIMIZATION AS AN OBJECTIVE OF FINANCIAL MANAGEMENT: Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as: 1. Profit maximization 2. Wealth maximization Profit Maximization Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features. 1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization. 2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. 4. Profit maximization objectives help to reduce the risk of the business. Favourable Arguments for Profit Maximization The following important points are in support of the profit maximization objectives of the business concern: (i) Main aim is earning profit. (ii) Profit is the parameter of the business operation. (iii) Profit reduces risk of the business concern. (iv) Profit is the main source of finance. (v) Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization The following important points are against the objectives of profit maximization: (i) Profit maximization leads to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the sake holders such as customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization Profit maximization objective consists of certain drawback also: (i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. (ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. (iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.

Wealth Maximization: Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business.

Favourable Arguments for Wealth Maximization (i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. (ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. (iii) Wealth maximization considers both time and risk of the business concern. (iv) Wealth maximization provides efficient allocation of resources. (v) It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization (i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. (ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization. (iii) Wealth maximization creates ownership-management controversy. (iv) Management alone enjoy certain benefits. (v) The ultimate aim of the wealth maximization objectives is to maximize the profit. (vi) Wealth maximization can be activated only with the help of the profitable position of the business concern. Wealth maximization has been accepted by the finance managers, because it overcomes the limitations of profit maximization. Wealth maximization means maximizing the net wealth of the

companys share holders. Wealth maximization is possible only when the company pursues policies that would increase the market value of shares of the company. WEALTH MAXIMIZATION AS A FUNCTION OF FINANCE: Wealth maximization is one of the goals of financial Management and functions of finance. Wealth Maximization:

Wealth maximization has been accepted by the finance managers, because it overcomes the limitations of profit maximization. Wealth maximization means maximizing the net wealth of the companys share holders. Wealth maximization is possible only when the company pursues policies that would increase the market value of shares of the company.

There are some arguments which are superior in wealth maximization:

Wealth maximization is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand there are many subjective elements in the concept of profit maximization.

It considers time value of money translates cash flows occurring of different periods into a comparable value of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream.

An example of Wealth maximization:

X LTD is listed company engaged in the business of FMCG (fast moving consumer goods). Listed means the companys share are allowed to be traded the officially on the portals of the stock exchange, the board of directors of X LTD.

Take a decision in one of the bond meeting to enter into the business of power generation. When the company informs the stock exchange of the conclusion of the meeting of the decision taken the stock market reacts unfavorably with result that the next days closing of quotation was 30%

less than of the previous day.

The question now is why the market reacted in this manner. Investors in this FMCG Company might have thought that the risk profile of the new business (power) that the company wants to take up is higher compared to the risk profile of the existing FMCG business as X LTD. when they want a higher return, market value of companys share declines. Therefore the risk profile of the company gets translated into a time value factor. The time value factor so translated becomes the required rate of return. Required rate of return is the return that the investors want for making investment in that sector.

Any project which generates positive net present value creates wealth to the company. When a company creates wealth from a course of action it has initiated the share holders benefit because such a course of action will increase the market value of the companys share.

Goals of financial Management:

Goals means - financial objective of a firm. Experts in financial management have endorsed the view that the goal of financial management of a firm is maximization of economic welfare of its shareholders. Maximization of economics welfare means - maximization of wealth of its shareholders. Shareholders wealth maximization is reflected in the market value of the firms shares. A firms contribution to the society is maximized when it maximizes its value. There are two versions of the goals of financial management of the firm which are profit maximization and wealth maximization.

Functions of finance: Finance functions are closely related to financial decisions. The functions performed by a finance manager are known of finance functions. In the course of performing these functions finance manager takes the following decisions:

Financial decision:

To survive and grow, all organizations must be innovative. Innovation demands managerial proactive actions. Projective organizations continuously search for innovative ways of performing the activities of the organization. Innovation is wider in nature.

Investment decision: Investment decisions are also know as capital budgeting decisions. Capital budgeting decisions lead to investment in real assets.

Dividend Decisions: Dividend yield is an important of an investors attitude towards the security (stock) in his portfolio management decisions. But dividend decision is a major decision made by a fianc manager. Dividend policy influences the dividend yield on shares. Since companys range in the capital market have a major impact on its ability to procure funds by issuing securities in the capital markets, dividend policy.

Liquidity Decision: Liquidity decisions are concerned with working capital management. It is concerned with the day-to-day financial operation that involves current assets and current liabilities.

The important element of liquidity decisions are: 1.Formulation of inventory policy. 2.Policies an receivable management. 3.Formulation of cash management strategies. 4.Policies on utilization of spontaneous finance effectively. Thus, wealth maximizations are primary goal of any firm. ELEMENTS OF WEALTH MAXIMIZATION: Increase in Profits: A firm should increase its revenues in order to maximize its value. For this purpose, the volume of sales or any other activities should be stepped up. It is a normal practice

for a firm to formulate and implement all possible plans of expansion and take every opportunity to maximize its profits. In theory, profits are maximized when a firm is in equilibrium. At this stage, the average cost is minimum and the marginal cost and marginal revenue are equal. A word of caution, however, should be sounded here. An increase in sales will not necessarily result in a rise in profits unless there is a market for increased supply of goods and unless overhead costs are properly controlled. Reduction in Cost: Capital and equity funds are factor inputs in production. A firm has to make every effort to reduce cost of capital and launch economy drive in all its operations. Sources of Funds: A firm has to make a judicious choice of funds so that they maximize its value. The sources of funds are not risk-free. A firm will have to assess risks involved in each source of funds. While issuing equity stock, it will have to increase ownership funds into the corporation. While issuing debentures and preferred stock, it will have to accept fixed and recurring obligauons. The advantages of leverage, too, will have to be weighed properly. Minimum Risks: Different types of risks confront a firm. "No risk, no gain" - is a common adage. However, in the world of business uncertainties, a corporate manager will have to calculate business risks, financial risks or any other risk that may work to the disadvantage of the firm before embarking on any particular course of action. While keeping the goal of maximization of the value of the firm, the management will have to consider the interest of pure or equity stockholders as the central focus of financial policies. Long-run Value: The goal of financial management should be to maximize long run value of the firm. It may be worthwhile for a firm to maximize profits by pricing its products high, or by pushing an inferior quality into the market, or by ignoring interests of employees, or, to be precise, by resorting to cheap and "get-rich- quick" methods. Such tactics, however, are bound to affect the prospects of a firm rather adversely over a period of time. For permanent progress and sound reputation, it will have to adopt an approach which is consistent with the goals of financial management in the long-run.

Advantages of Wealth Maximization 1. Wealth maximization is a clear term. Here, the present value of cash flow is taken into consideration. The net effect of investment and benefits can be measured clearly. (Quantitatively). 2. It considers the concept of time value of money. The present values of cash inflows and outflows helps the management to achieve the overall objectives of a company. 3. The concept of wealth maximization is universally accepted, because, it takes care of interests of financial institution, owners, employees and society at large. 4. Wealth maximization guide the management in framing consistent strong dividend policy, to earn maximum returns to the equity holders. 5. The concept of wealth maximization considers the impact of risk factor, while calculating the Net Present Value at a particular discount rate, adjustment is made to cover the risk that is associated with the investments.

Criticisms of Wealth Maximization The concept of wealth maximization is being criticized on the following grounds: The objective of wealth maximization is not descriptive. The concept of increasing the wealth of the stockholders differs from one business entity to another. It also leads to confusion in, and misinterpretation of financial policy because different yardsticks may be used by different interests in a company. As corporations have grown bigger and more powerful, their influence has become more pervasive; they have created an imbalance which is widely believed to have been instrumental in generating a movement to promote more socially conscious business behaviour. Academicians and corporate officers alike have urged the advisability of more socially conscious business management. Financial management will then have to rise equal to the acceptance of social responsibility of business.

Financial management should not only maintain the financial health of a business,but should also help to produce a rate of earning which will reward the owners adequately for the use of the capital they have provided. To the creditors, the management must ensure administration, which will keep the business liquid and solvent. Moreover, financial management will have to ensure that expectations raised by the corporation are fulfilled with a proper use of several tools at is disposal. In other words, it should ensure an effective management of finance so that it may bear the desired fruits for the organization. If it is properly supported and nurtured by efficient activities at all stages, it will positively ensure desired results. Financial management should take into account the enterprises legal obligations to its employees. It should try to have a healthy concern which can maintain regular employment under favourable working conditions. However, a good financial management alone cannot guarantee that a business will succeed. But it is a necessary condition for business success, though not the only one. It may, however, be described as a pre-requisite of a successful business. In other words, there are various other factors which may support or frustrate financial management by supportive or non- supportive policies. Wealth maximization is as important objective as profit maximization. The operating objective for Financial Management is to maximize wealth or the net present worth of a firm. Wealth maximization is an objective which has to be achieved by those who supply loan capital, employees, society and management. The objective finds its place in these segments of the corporate sector, although the immediate objectives of Financial Management may be to maintain liquidity and improve profitability. The wealth of owners of a firm is maximized by raising the price of the common stock. This is achieved when the management of a firm operates efficiently and makes optimal decisions in areas of capital investments, financing, dividends and current assets management. If this is done, the aggregate value of the common stock will be maximized.