Question

I have some doubts related to the firm's shareholders wealth and profit maximisation:
1) What is profit maximisation? Is it important in compared with shareholders' wealth maximation?
2) Why does a firm need to maximise its shareholders' wealth? What're benefits? And how to archive?
3 What is "investment trade off"?
Thank you!

Answer 1

1. Profit Maximisation -

This is a traditional approach followed by companies to maximise their profits in short run. Profits can be derived from the simple formula Sales - Costs. The profit so achieved is then distributed among shareholders as dividend. In this approach the shareholders were concerned only about the dividend received and nothing else. Key factor is dividend per share.

2. Wealth Maximisation -

This is a modern approach followed by companies in which the focus is not just on Profits but on creating wealth. Wealth creation takes a longer time horizon and is done by increase in share prices, networth of the company, market capitalisation, market share, diversification, etc. This approach believes in distributing reasonable dividends and reinvesting the remaining part back into business to increase the return on investment. Key factor is Earnings per share.

3. Benefits of Wealth Maximisation -

a. Investors not only get benefited by dividends, but also by increase in share prices and other benefits such as bonus shares, right shares, etc. Investors not only receive short term benefits, but also long term increase in market prices of shares. Wealth maximisation always benefits the investors in long run.

b. Profit maximisation considers profits earned which is a relative term and can vary with respect to many factors such as accounting method and judgements. Whereas Wealth Maximisation considers cash flows which are constant and give realistic results in all cases. Methods to measure wealth maximisation are Net Present Value, etc.

4. Investment Trade off -

Investment trade off or Risk return trade off is the concept by which an investment is rated. Risk and return are directly proportional to each other. MOre the Risk, MOre will be the expected return. Lesser the Risk, less will be the Expected return. So the Decision to invest depends on the investors ability to take risk. Investment is evaluated by the risk which it bears.

Trade off in Economics means opprtunity Costs. Hence the reurn expected from a return should be atleast equal to the opportunity costs of funds invested. Example - we use cost of capital as a discounting rate while evaluating a project by its Net Present Value.