Question

Briefly share your thoughts about shareholder wealth maximization. Then, explain the advantages and disadvantages of wealth maximization from the perspective of a company’s Chief Financial Officer. Include the effect on company stakeholders – internal (managers, employees) and external (suppliers, shareholders).

Attention: Make sure that you include the effect on company stakeholders – internal (managers, employees) and external (suppliers, shareholders).

Answer 1

The shareholders wealth maximization objective is to maintain highest market value of shares. It is generally in accord with the interests of the various groups such as owners, employees, creditors and society, and thus, it may be consistent with the management objective of survival.

In the shareholders' wealth maximisation criterion a question may arise: Is wealth maximisation the objective of the firm? Does a firm exist with the sole objective of serving the interests of owners? The business firms do not exist with the main objective of maximising the welfare of shareholders. The survival and the future growth of the firm always depends on how it satisfies its customers through the quality of goods and services. Further, the firms in practice set their vision or mission concerned with technology, leadership, market share, image, welfare of employees, etc. Hence, the firm designs its strategy around such basic objectives in the areas of technology, production, purchase, marketing, finance, etc. For this, the firm takes its decisions, which are consistent with its strategies. Therefore, the wealth maximisation objective is the second level criterion, which ensures to meet the minimum standard of the economic performance. As a matter of fact, the management is not only the agent of owners, but also trustee for the owners. Hence, it is the responsibility of the management to harmonise the interests of owners with that of creditors, employees, government, society, etc.

ADVANTAGES OF WEALTH MAXIMIZATION MODEL

Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as a goal of a financial decision.

• Firstly, the wealth maximization is based on cash flows and not on profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated with accounting profits. Profit can easily be manipulative, if there is a change in accounting assumption/policy, there is a change in profit. There is a change in method of depreciation, there is a change in profit. It is not the case in case of Cashflows.
• Secondly, profit maximization presents a shorter term view as compared to wealth maximization. Short-term profit maximization can be achieved by the managers at the cost of long-term sustainability of the business.
• Thirdly, wealth maximization considers the time value of money. It is important as we all know that a dollar today and a dollar one-year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value. Suppose there are two projects A and B, project A is more profitable however it is going to generate profit over a long period of time, while project B is less profitable however it is able to generate return in a shorter period. In a situation of an uncertainty, project B may be preferable. So, timing of returns is ignored by profit maximization, it is considered in wealth maximization.
• Fourthly, the wealth-maximization criterion considers the risk and uncertainty factor while considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.

One of the disadvantage is

It is argued that a company is not concerned with shareholders alone. Employees, customers, creditors, local societies at large are also connected with the company. A business enterprise has to operate as a socially responsible entity. It has to honor certain obligations towards different social groups.

The concept of wealth maximization has been criticized, since it tends to drive a company to take actions that are not always in the best interests of its stakeholders, such as suppliers, employees, and local communities. For example:

• A company may minimize its investment in safety equipment in order to save cash, thereby putting workers at risk.
• A company may continually pit suppliers against each other in the unmitigated pursuit of the lowest possible parts prices, resulting in some suppliers going out of business.
• A company may only invest minimal amounts in pollution controls, resulting in environmental damage to the surrounding area.

Because of these types of issues, senior management may find it necessary to back away from the sole pursuit of wealth maximization, and instead pay attention to other issues, as well. The result is likely to be a modest reduction in shareholder wealth.

Given the issues noted here, wealth maximization should be considered just one of the goals that a company must attend to, rather than its only goal.