Wealth Maximisation Decision Criterion
This is also known as value maximization or pet present worth maximization. In current academic, literature value maximization is almost universally accepted as an appropriate operational decision criterion for financial management decisions as it removes the technical limitations which characterless the earlier profit maximization criterion. Its operational features, satisfy all the three requirements of a suitable operational objective of financial course of action, namely, exactness, quality of benefits and the time value of money,
The value of an asset should be viewed in terms of the benefits it can produce. The worth of a course of action can similarly be judged in terms of the value of the benefits it produces less the cost of undertaking it. A significant element in computing the value of a financial course of action is the precise estimation of the benefits associated with it. The wealth maximization criterion is based on the concept of cash flows generated by the decision rather than accounting profit which is the basis of the measurement of benefits in the case of the profit maximization criterion. Cash-flow is a precise concept with a definite connotation. Measuring benefits in terms of cash flows avoids the ambiguity associated with accounting profits. This is the first’operational feature of the net present worth maximization criterion.
The second important feature of the wealth maximization criterion is that it considers both the quantity and quality dimensions of benefits. At the same time, it also incorporates the time value of money. The operational implication of the uncertainty and timing dimensions of the benefits emanating from a financial decision is that adjustments should be made in the cash-flow pattern, firstly, to incorporate risk and, secondly, to make an allowance for differences in the timing of benefits. The value of a stream of cash flows with value maximization criterion is calculated by discounting its element back to the present at a capitalization rate that reflects both time and risk. The value of a course of action must be viewed in terms of its worth to those providing the resources necessary for its undertaking. In applying the value maximization criterion, the term value is used in terms of worth to the owners, that is, ordinary shareholders. The capitalization (discount) rate that is employed is, therefore, the rate that re flew the time and risk preferences-of the owners or suppliers of capital. As a measure of quality (risk) and timing, it is expressed in decimal notation. A discount rate of, say, 15 per cent is written as 0.15. A large capitalization rate is the result of higher risk and longer time period. Thus, a stream of cash flows that is quite certain might be associated with a rate of 5 per cent, while a very risky stream may carry a 15 per cent discount rate.
For the above reasons, the net present value maximization is superior to the profit maximization as an operational objective. As a decision criterion, it involves a comparison of value to cost. An action that has a discounted value reflecting both time and risk is that exceeds its cost can be said to create value. Such actions should be undertaken. Conversely, actions, with less value than cost, reduce wealth and should be rejected. In the case of manually exclusive alternatives, when only one has to be chosen alternative with the greatest net present value should be selected. In the’ words of Ezra Solomon.
The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefit, discounted (or capitalized)at a rate with reflects their certain and uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital Investment required to achieve the benefits being discussed. Any financial action with creates wealth or which has a net present above zero is of desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive i.e. if only one can be undertaken),then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth.
Using Ezra Solomon’s symbols and methods, the net present worth can be calculated as shown below:
The operational objective of financial management is the maximization of W in Eq. (1.1). Alternatively, we can be expressed symbolically by a short-cut method as in Eq. (1.4). Net present value (worth) or wealth is
where A1, A2, … A represents-the stream of cash flows expected to occur from a course of action over period of time;
K is the appropriate discount rate to measure risk and timing; and
C is the initial outlay to acquire that asset or pursue the course of action
It can. thus, be seen that in the value maximization decision criterion. the time value of money and handling of the risk as measured by the uncertainty of the expected benefits is an integral pan of the exercise. It is, moreover, a precise and unambiguous concept, and therefore, an appropriate and operationally feasible decision criterion for financial management decisions.
It would also he noted that the focus of financial management is on the value to the owners or suppliers of equity capital. The wealth of the owners is reflected in the market value of shares. So wealth maximization implies the maximization of the market price of shares. In other words, maximization of the market price of shares is the operational substitute for value/wealth/net present value maximization as a decision criterion.
In brief, what is relevant is not the overall goal of a firm but a decision criterion which should guide the financial course of action, Profits/EPS maximization was initially the generally accepted theoretical criterion for making efficient economic decisions, using profit as an economic concept
and defining profit maximization as a criterion for economic efficiency. In current financial literature, it has been replaced by the wealth maximization decision criterion because of the shortcomings of the former as an operational criterion, as (i) it does not take account of uncertainty of risk, (ii) it ignores the time value of money, and (iii) it is ambiguous in its computation. Owing to these technical limitations, profit maximization cannot be applied in real world situations. Its modified form is the value maximization criterion. It is important to note that value maximization is simply’ extension of profit maximization to a world that is uncertain and periodontist in nature. Where the time period is short and degree of uncertainty is not great, value maximization and profit maximization amount to essentially the same thing
However, two important issues are related to the value/share price-maximization, namely, economic value added and focus on stakeholders.