The main purpose of running a business is to make profit. In this case it can be said that 2 things are considered as the main goals of financing: –
1) Profit Maximization
2) Wealth Maximization
1. Profit Maximization
Increasing the profit of an organization is called profit maximization. In general terms, after deduction of total expenses from total revenue, what remains is called profit. An organization can increase profits by reducing costs and providing quality products and services.
“A company measures profitability through earnings per share. That is, profitability is measured by how much money a company has earned against each common share in a certain period”.
Earnings per share of a company can be calculated by the following equation.
Mr. Robin Williams is the head of finance at ABC LLC and has two investment projects in hand, one of which he wants to take on.
Earnings per share and lifespan of projects are shown:
According to the profit maximization concept, project ‘B’ is preferred over project ‘A’ because the total earning per share of project ‘B’ is higher than project ‘A’ in the next three years. So, Mr. Robin Williams should take project ‘B’ if he considers profit maximization as the sole objective of the organization.
Now the question is whether profit maximization is a reasonable goal of an organization? Is it the ultimate measure of the economic prosperity of the company’s owners?
The answer is: No.
The goal of profit maximization cannot be considered as a management criterion for achieving the overall economic prosperity of the owners.
The reasons are:-
a) Timing of Profit/Return Ignored:
The profitability of investment projects varies over time. Since the organization invests funds to earn profit, the sooner these funds are recovered the better. In the example shown, although the total income of project ‘A’ is less than the total income of project ‘B’, the earning per share of project ‘A’ is much higher in the 1st year. By reinvesting this higher amount of income, future profits can be much higher. But project ‘B’ is accepted as total profit of project ‘B’ is higher. So, the profit maximization objective does not consider the time to achieve profit.
b) Cash Flows are not Considered:
Profit and Cash flow are two different concepts. Profit is measured through the accrual system. Cash flow is measured through cash basis transactions. An increase in profits does not necessarily mean that cash flow to shareholders has increased. Shareholders can get cash flow in 2 ways. 1) dividend 2) capital gain. Capital gain here means that the share has been sold for more than the purchase price. So, the increase in earnings per share – EPS does not mean that the company’s board of directors will immediately increase the amount of dividend.
Also earning per share – EPS increase does not mean share price will increase. In many companies, despite the increase in profits, the share price does not increase. In this case, the share value will increase only if the future cash flow increases with the increase in profits.
c) Risk is Ignored:
Another particular disadvantage of the profit maximization concept is that it does not consider the risk involved in achieving future expected profits from investments. Here risk refers to the variability of expected returns. So, there needs to be balance between profit and risk.
2. Wealth Maximization:
Asset maximization refers to the increase or maximization of share value. Shareholders’ wealth maximization is an important objective of the organization. Owners’ wealth of the firm is measured by the current market value of the shares.
Share price depends on three factors; a) Time to earn profit, b) Amount of income/cash flow, c) Risk. Note that, it helps to accurately measure wealth by eliminating the weaknesses of profit maximization. As a result, it is perceived as a logical goal. Every financial decision must be taken in a way that increases the value of the company’s shares. Since share price measures the amount of wealth owned by the firm’s owners, an increase in the share price increases the wealth of the firm’s owners. That is, management aims to increase the current market value of each share.
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