Profit Maximisation and Wealth Maximisation
Profit Maximisation means maximizing the rupee income of firms.Firms produce goods and services. They may function in a market economy, or in a government-controlled economy. In a market-economy, prices of goods and services are determined in competitive markets. Firms in a market economy are expected to produce goods and services desired by society as efficiently as possible.
Price System directs managerial efforts towards more profitable goods or services. Prices are determined by the demand and supply conditions as well as the competitive forces, and they guide the allocation of resources for various productive activities.
Would the price system in a free market economy serve the interests of the society.
While maximizing profit, a firm either produces maximum output for a given amount of output, or uses minimum input for producing a given output. It is assumed to cause the efficient allocation of resources under the competitive market conditions, and profit is considered as the most appropriate measure of a firm’s performance. The Only aim of the single owner then was to enhance his or her individual wealth and personal power, which could easily be satisfied by the profit maximization objective. The business firm today is financed by shareholders and lenders but it is controlled and directed by professional management. The other interested parties are customers, employees, government and society. In the new business environment, profit maximization is regarded as unrealistic, difficult, inappropriate and immoral.
1. It is Vague
2. It ignores the timing of returns
3. It ignores risk
It means maximizing the Net Present Value (NPV) or wealth of a course of action to shareholders. The net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and, therefore, is desirable. A financial action resulting in negative NPV should be Rejected since it would destroy shareholder’s wealth. Between a number of mutually exclusive projects the one with the highest NPV should be adopted. The NPV of a firm’s projects add. Therefore, the wealth will be maximized if this criterion is followed in making financial decisions.
Therefore, the wealth maximization principle implies that the fundamental objective of a firm is to maximize the market value of its shares.
The Financial Decisions of firm are interrelated and jointly affect the market value of its shares by influencing return and risk of the firm.
Risk-Return Trade-off : Return= Risk free rate(Compensation for time) + Risk Premium(risk).
Higher the risk of an action, higher will be the required return on that action. A proper balance between return and risk should be maintained to maximize the market value of a firm’s shares.