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PROFIT MAXIMIZATION AND WEALTH MAXIMIZATION PROFIT MAXIMIZATION Profit maximization is the short run or long run 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 revenuetotal cost perspective relies on the fact that profit equals revenue minus cost and focuses on maximizing this difference, and the marginal revenuemarginal costperspective is based on the fact that total profit reaches its maximum point where marginal revenue equals marginal cost. Profit maximization is the main aim of any business and therefore it is also an objective of financial management. Profit maximization, in financial management, represents the process or the approach by which profits (EPS) of the business are increased. In simple words, all the decisions whether investment, financing, or dividend etc are focused to maximize the profits to optimum levels. Profit maximization is the traditional approach and the primary objective of financial management. It implies that every decision relating to business is evaluated in the light of profits. All the decision with respect to new projects, acquisition of assets, raising capital, distributing dividends etc are studied for their impact on profits and profitability. If the result of a decision is perceived to have positive effect on the profits, the decision is taken further for implementation. DEFINITION Any costs incurred by a firm may be classed into two groups: fixed costs and variable costs. Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages of employees whose numbers cannot be increased or decreased in the short run, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category, which also includes the wages of employees who can be hired and laid off in the span of time (long run or short run) under consideration. Fixed cost and variable cost, combined, equal total cost. Revenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as equity shares or debt issuances). 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 the quantity of output. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is 80 dollars.

Profit Maximization Theory / Model: The Rationale / Benefits:


Profit maximization theory of directing business decisions is encouraged because of following advantages associated with it. Economic Survival: Profit maximization theory is based on profits and profits are a must for survival of any business. Measurement Standard: Profits are the true measurement of viability of a business model. Without profits, the business losses its primary objective and therefore has a direct risk on its survival. Social and Economic Welfare: The profit maximization objective indirectly caters to social welfare. In a business, profits prove efficient utilization and allocation of resources. Resource allocation and payments for land, labor, capital and organization takes care of social and economic welfare.

Limitations of Profit Maximization as an objective of Financial Management:


Profit maximization is criticized for some of its limitations which are discussed below: Haziness of the concept Profit: The term Profit is a vague term. It is because different mindset will have different perception about profit. For e.g. profits can be the net profit, gross profit, before tax profit, or the rate of profit etc. There is no clear defined profit maximization rule about the profits. Ignores Time Value of Money: The profit maximization formula simply suggests higher the profit better is the proposal. In essence, it is considering the naked profits without considering the timing of them. Another important dictum of finance says a dollar today is not equal to a dollar a year later. So, the time value of money is completely ignored. Ignores the Risk: A decision solely based on profit maximization model would take decision in favor of profits. In the pursuit of profits, the risk involved is ignored which may prove unaffordable at times simply because higher risks directly questions the survival of a business. Ignores Quality: The most problematic aspect of profit maximization as an objective is that it ignores the intangible benefits such as quality, image, technological advancements etc. The contribution of intangible assets in generating value for a business is not worth ignoring. They indirectly create assets for the organization. Profit maximization ruled the traditional business mindset which has gone through drastic changes. In the modern approach of business and financial management, much higher importance is assigned to wealth maximization in comparison of Profit Maximization vs. Wealth

Maximization. The loosing importance of profit maximization is not baseless and it is not only because it ignores certain important areas such as risk, quality, and time value of money but also because of the superiority of wealth maximization as an objective of business or financial management.

WEALTH MAXIMIZATION The goals of financial management may be such that they should be beneficial to owners, management, employees and customers. These goals may be achieved only by maximizing the value of the firm. The elements involved in the maximization of the wealth of a firm is as below: 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 practicefor a firm to formulate and implement all possible plans of expansion and take every opportunityto maximize its profits. In theory, profits are maximized when a firm is in equilibrium. At thisstage, the average cost is minimum and the marginal cost and marginal revenue are equal. Aword of caution, however, should be sounded here. An increase in sales will not necessarilyresult in a rise in profits unless there is a market for increased supply of goods and unlessoverhead costs are properly controlled. Reduction in Cost: Capital and equity funds are factor inputs in production. A firm has to makeevery 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 itsvalue. The sources of funds are not risk-free. A firm will have to assess risks involved in eachsource of funds. While issuing equity stock, it will have to increase ownership funds into thecorporation. While issuing debentures and preferred stock, it will have to accept fixed andrecurring 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 commonadage. However, in the world of business uncertainties, a corporate manager will have tocalculate business risks, financial risks or any other risk that may work to the disadvantage of thefirm 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 pureor 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 toaffect the prospects of a firm rather adversely over a period of time. For permanent progress andsound reputation, it will have to adopt an approach which is consistent with the goals of financialmanagement in the long-run. Advantages of Wealth Maximization o Wealth maximization is a clear term. Here, the present value of cash flow is taken into consideration. o The net effect of investment and benefits can be measured clearly.

o (Quantitatively)v It considers the concept of time value of money. The present values of cash inflows andoutflows helps the management to achieve the overall objectives of a company. o The concept of wealth maximization is universally accepted, because, it takes care of interestsof financial institution, owners, employees and society at large.Wealth maximization guide the management in framing consistent strong dividend policy, toearn maximum returns to the equity holders. o 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 isassociated with the investments.