Funancial Management

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Article On;Profit Maximization vs. Wealth Maximization

Profit Maximization

Profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue -- total cost method relies on the fact that profit equals revenue minus cost, and the marginal revenue -- marginal cost method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost.

Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed costs are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of output, increasing as more products is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost when combined, equal total cost.

Revenue is the total amount of money that flows into the firm. This can be from any source, including product sales, government subsidies, venture capital and personal funds.

Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. It may also be defined as the addition to total cost as output increase by a single unit.

Traditional approach of financial management was all about profit maximization. The main objective of companies was to make profits.

Profit Maximization has to define after taking into account many things like:

   a. Short term, mid term, and long term profits

   b. Profits over period of time

Wealth Maximization

Wealth maximization is all about;

How to achieve maximum wealth while minimizing costs and inefficiencies  • how to spend and enjoy your wealth without the fear of ever outliving it  • how to pass along your wealth to whomever you choose  • how to ensure your plan for financial success works under all circumstances

Modern Approach is about the idea of wealth maximization. This involves increasing the Earning per share of the shareholders and to maximize the net present worth.

Wealth is equal to the difference between gross present worth of some decision or course of action and the investment required to achieve the expected benefits.

Gross present worth involves the capitalized value of the expected benefits. This value is discounted a some rate, this rate depends on the certainty or uncertainty factor of the expected benefits.

The Wealth Maximization approach is concerned with the amount of cash flow generated by a course of action rather than the profits.

Hence we can have;

Profit maximization relates to profits *only* while shareholder wealth also involves total company equity, debt ratios, etc. Management could focus on profit maximization over a longer period of time, while the shareholder would rather see stock values and corporate total value increase immediately. If management focused on short-term profit maximization, say at the expense of long term sales revenues, then shareholder wealth (stock price) could actually decrease as a result of the loss of market share.

Shareholder wealth (more commonly referred to as shareholder value) is talking about the value of the company generally expressed in the value of the stock. Profit maximization refers to how much dollar profit the company makes. It might seem like making as much profit as possible would yield the highest value for the stock but that is not always the case.

When investors look at a company they not only look at dollar profit but also profit margins, return on capital and other indicators of efficiency. Say there are two companies doing the same thing. Company A had sales of $100 million and profit of $10 million. Company B had sales of $200 million and profit of $12 million. Wall Street could look at Company B and say they are less valuable because they clearly do no operate as efficiently as Company A. So even though Company B had more profit Company A will have more shareholder value.